Environmental, social, and governance (ESG) is a broad and not well-defined term that seems to have become associated with non-financial factors investors use to measure an investment or a company’s sustainability. Companies that may have ignored, resisted, or ‘green-washed’ ESG disclosures may be forced into such disclosures by large investors or the government. It may prove impossible to not be caught up in the coming wave of ESG requirements, both private and public.
As its name implies, there are three ‘pillars’ of ESG. An exact definition of each is difficult as each has been generally described to include any number of factors or criteria. The environmental pillar relates to the impact a company may have on the environment, such as its carbon footprint, including its direct and indirect greenhouse gas emissions, the chemicals involved in its manufacturing processes, or its overall stewardship of natural resources. The social pillar relates to a company’s relationships with its stakeholders or how it deals with people within the company and in the broader community, including diversity programs, hiring practices, and even how a company advocates for social good with its supply chain partners or in the wider world. The governance pillar refers to how a company is led and managed, including how leadership’s incentives are aligned with stakeholder expectations and the types of internal controls which exist to promote transparency and accountability by leadership.
Although the use of ESG metrics as an investing tool is relatively new, issues associated with the environment and sustainability have been around for a while. For example, the concept of waste minimization (for example, substituting non-hazardous chemicals for use as solvents or in a manufacturing process) has been around since the advent of the federal hazardous waste regulations. Additionally, corporate sustainability and corporate social responsibility concepts have existed for decades.
Now, the proactive use of ESG concepts to force change has emerged. Large capital investment companies develop and use ESG metrics to determine whether they will invest in a company or fund a project. Major shareholders of companies have sought to force compliance with ESG principles on corporate management. Even some major banking institutions are incorporating ESG criteria in loan decisions. Socially conscious investors factor in ESG considerations in making individual investment decisions.
The Biden Administration has also stepped into the fray to force ESG disclosures. The Securities and Exchange Commission has issued a sweeping proposed rule to mandate ESG reporting. According to the SEC, the proposed rule is designed to provide consistent standards for ESG disclosures which will allow investors to make more informed decisions as they compare various ESG investments. Certain funds would be required to disclose additional information regarding the greenhouse gas emissions associated with their investments. These funds would be required to disclose the carbon footprint and the weighted average carbon intensity of their portfolio to meet the demand from investors for consistent information regarding greenhouse gas emissions associated with their portfolios. The need for capital investment for a project or government regulation may force a company to pay close attention to ESG concepts. Even if a company has a negative view of ESG concepts, introducing and implementing those concepts at this time could be beneficial and may favorably sway an investor’s decision to invest in the company or a bank’s decision to provide a loan. In short, it may be better to ride the wave than drown in it.