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ESG–also referred to as sustainable investing–has quickly become a key differentiator for investors, one that can tip the scales in many cases between similarly positioned companies, or even shore up an otherwise disadvantaged prospect.
Given the rise of this framework and the sway that it can have on market decisions, companies and investors alike are taking an interest in how ESG works and what insights it can provide into the markets.
What is ESG?
What does ESG stand for and how does it relate to the broader category of sustainable investing? ESG–or “environmental, social and governance“–is a score used to measure a company’s competency in multiple fields relating to sustainability, legal standing and business practices. An organization’s ESG score is developed by measuring its performance in relation to metrics such as environmental impact, internal and external dynamics, treatment of workers and transparent and legal use of funds. The scores for each category can point to strengths and weaknesses in a potential investment and serve as an indicator of future performance and liabilities.
When considering the meaning of ESG scores, it is important to note the distinction between ESG as a numerical value and ESG as an investment framework. The former serves as the basis for the latter, which seeks to use positive ESG scores as a means of identifying possible investments and quantifying the level of risk that a certain prospect with lower scores may entail.
The ESG framework’s reliance on this single factor and exclusion of economic or financial considerations creates a major blind spot, but also provides a unique lens that differs from conventional asset-based analysis. Given this position, ESG is most effective when used alongside other criteria and frameworks to evaluate investments. ESG should not be seen or applied as an investment strategy but can serve as a complement to one.
Why is ESG important?
ESG helps signal a company’s stance on societal issues, while also being an actionable tool for investors to use to measure and anticipate potential risks. If a company scores low in its environmental competency, possibly due to behaviors such as dumping or not following federal regulations, it stands to reason that it may be involved in an even more severe event in the future.
If said company were to cause an environmental crisis, such as an oil spill or something of similar magnitude, they could very well to face legal repercussions, including lawsuits which could negatively impact one’s investment.
By the same token, low scores in the “social” or “governance” fields could indicate the possibility of events such as strikes, employee health and safety crises or the discovery of illegal dealings. The three titular aptitudes of ESG–, environment, social and governance–, represent some of the most common and impactful pitfalls a company is likely to encounter, making this framework a valuable addition to any sort of preliminary or ongoing research around investments.
By performing an ESG risk analysis in advance, investors can avoid scenarios such as the ones listed above and only target companies that fit their own personal risk parameters. As evidenced by these examples, ESG can cover a valuable subset of information that can’t be extracted from company financials, staff lists and other more traditional resources.
When paired with these other metrics, ESG can generate new insights, such as predicting leadership choices in companies with high ESG scores, and contribute to a more holistic image of a company.
The growing popularity of ESG
With the ESG data market reaching $1 billion in 2021 and continuing to grow at a 20% annual rate, it’s clear investors see it as a valuable reference, but what accounts for this recent interest? One of the foundational causes behind ESG’s current momentum is the increased regulatory pressure to disclose ESG data in places such as the United States and European Union. This push has been compounded by an increased affinity for ESG data and analytics from investors and advisors, who are actively seeking more data and using it towards new and increasingly varied applications.
One such use case that demonstrates the demand and flexibility of ESG is its viability as an industry analysis tool, looking beyond one-to-one comparisons and using ESG metrics to find larger market trends. As ESG continues to generate new uses and interested parties, it will continue to grow in scope and grow in regard as a requirement to approach new markets.
ESG standardization and adoption
Though ESG has seen significant traction in recent years, there is some that worry about its implementation and viability as a widely used standard. This outlook stems from the concern that ESG scores are too narrow to account for the nuances of different regions, industries, etc. and would leave some parties at an inherent disadvantage. According to these arguments, sectors like energy would be predisposed to receive poor ESG scores, thereby diminishing the utility of the framework and the willingness to adopt it.
In 2018, the Sustainable Accounting Standards Board (SASB) established a common framework for ESG reporting across all businesses. Through the involvement of asset managers, allocators, companies and other relevant parties, they were able to define ESG in financially material terms appropriate for the financial risk involved.
Another important characteristic of the SASB’s ideation is that ESG standards are specific to each industry, but universal across regions. This means that it can vary based on the demands and intricacies of each industry, while also remaining applicable to a global audience.
What are ESG funds?
The importance of ESG has not only led to the creation of widely applied ESG standards, but also dedicated ESG funds. Like other ETFs and mutual funds, ESG funds represent a portfolio of related stocks, rather than a single investment. Their main point of differentiation, as the name would suggest, is that they take ESG scores into account when selecting stocks, though this is far from the only thing they consider.
Despite being connected by the use of a common framework, there are many areas in which ESG funds may diverge. For example, the weight given to scores relative to other factors can vary from fund to fund, as can fund standards for what a good ESG score is.
Furthermore, different funds may choose to focus on different components of ESG in their investments. You may find that one fund favors companies with a strong environmental commitment, while another only targets those with balanced scores in all three categories.
Regardless of their differences, ESG funds generally benefit from being more stable than other types of ETFs and mutual funds. By choosing companies with high ESG scores, these funds can operate with a higher degree of assurance and insulate their investors from drastic shifts.
Company ESG strategies
With ESG seeing use among LPs, GPs and service providers, many businesses have also begun to leverage ESG data in order to target investors. One of the many incentives for companies to raise and maintain their score is making it through the various filtering tools and techniques used by investors to screen for potential prospects based on ESG.
More visibility leads to more capital from investors and better valuations, which in turn attracts more investments. A favorable ESG score can also improve relationships with other potentially beneficial parties, such as regulatory bodies and partnered businesses, who also leverage these scores as a source of insight.
Addressing ESG concerns can be a key factor in improving external relations, but it can also support internal development efforts. For example, efforts to reduce environmental damage by cutting water and oil consumption will also likely lead to reduced operation costs, effectively addressing two challenges at once. On a similar note, efforts to create and maintain safe working facilities can cut down on the need for maintenance and can lead to greater retention and morale.
ESG data integration
PitchBook recently added new ESG data integration features, which will allow users to easily view company ESG risk profiles and the factors that contribute to their scores. This feature also offers options to see how a company compares to industry averages and see the best ESG scores within a given space.
ESG FAQs
What is an ESG score?
An ESG score is a measurement of a company’s aptitude towards different types of sustainable efforts. It is used to anticipate risk and determine whether or not a company may be a worthy investment.
What does ESG stand for?
ESG stands for environmental, social and governance, the three performance metrics that make up ESG scores and central concerns of sustainable investing.
What is a good ESG score?
Different agencies will use different scales to measure ESG, but examples include MSCI, which rates on a scale from 1-10, 10 being the highest, with the average company hovering somewhere around 5. Conversely, Sustainalytics scores companies from 1-40, with a lower score being more desirable.
What is the difference between ESG and SRI?
ESG is a score and framework for evaluating companies, while SRI (socially responsible investing) describes the active process of investing in ethical companies or projects.
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