Environmental, social, governance, or ESG, refers to a set of standards that investors use to measure how a company performs in certain areas of concern regarding environmental sustainability and social issues before committing to investing.
The intent is to encourage companies to act responsibly in relation to these standards by using them as leverage for greater investment. If a company scores well, more investors will be encouraged to invest in the company.
The company will also benefit, not just in terms of the greater investment it receives, but in terms of the returns it receives from its socially responsible behavior. The natural environment and surrounding community will benefit from the behavior, too.
ESG standards consist of three fundamental pillars, which are the namesake of the standard:
Environmental standards provide metrics for investors to evaluate how a company's policies and practices impact the natural environment. The metrics consider several environmental concerns, including climate action, energy consumption, toxic waste and other forms of pollution, conservation of natural resources, and the treatment of animals.
Social standards concern issues pertaining to social justice, which address a company's relationship to its workers and the surrounding community where it operates. Metrics address labor relations and working conditions, investment in the surrounding community including volunteering and charitable giving, and the humane treatment of local populations which may be impacted by the company's presence and activities.
Governance standards pertain to internal corporate methods. They are intended to assure investors that a business models certain behaviors pertaining to transparency and ethics in such processes as accounting, hiring, voting rights, and representation in leadership, decision-making, and politics. These standards can address such issues as diversity and inclusion (DEI), executive compensation, auditing and regulatory compliance, and policymaking.
The use of ESG standards in investing has increased in recent years. Several factors are contributing to this trend.
The rise of ESG investing reflects changing values and increased awareness in society, particularly among consumers, as well as increased government regulation about a myriad of issues.
Interest in and concern about issues such as climate change, environmental sustainability, diversity, DEI, corporate ethics, and financial integrity have grown over the years, from socially conscious groups operating on the margins of society into mainstream thought.
Investors and consumers are just as likely now to take these factors into consideration as they would other more traditional metrics and characteristics about a company or product that it sells.
Reflecting the same shift in public attitudes, government regulations also pressure businesses to embrace ESG.
Standards and regulations, such as the Paris Agreement on climate change, the European Union’s Sustainable Finance Disclosure Regulation, NASDAQ's board diversity rule, and many others, are shaping busing adoption of ESG.
Businesses can benefit from adopting ESG standards in a few ways.
ESG helps improve a company's standing and reputation which can help it attract investors and widen its customer base.
As it concerns business practices and financial integrity, ESG can help a company reduce risk and improve its performance.
A more inclusive workforce can lead to greater innovation and a free flow of creative ideas.
A business that adopts ESG standards will help reduce waste, energy consumption, and carbon emissions, which helps fight climate change.
Several patterns are emerging with the broader trend of ESG growth. Like any popular movement, there is often pushback.
In fact, ESG and some of its conceptual pillars have experienced pushback in recent years. For example, many state legislatures have adopted anti-ESG legislation. These include anti-ESG investing laws, anti-boycott laws, and anti-discrimination laws prohibiting ESG scores.
On the other hand, states like California have forged ahead with legislation supporting ESG, including several bills adopted in 2023 that require reporting and disclosures concerning greenhouse gas emissions, carbon offsets, and statistics related to diversity.
Other trends within the broader ESG movement are also emerging. For example, many regulatory agencies are moving toward consolidating and streamlining ESG standards. In 2023, the International Financial Reporting Standards (IFRS)
Foundation, an independent nonprofit organization that oversees the development of financial reporting standards, issued its inaugural standards, S1 and S2, which are intended to create a common language for disclosing the effect of climate-related risks and opportunities on a company’s prospects.
As ESG continues to evolve and grow, CFOs are in an ideal position to lead their company's efforts to face a changing landscape and meet heightened expectations. ESG standards have become intertwined with and integral to company financial planning and risk management.
In their role, CFOs can set the stage for applying and incorporating these standards into accounting practices. They can help the business navigate new and changing metrics and properly update reporting processes.
The CFO can incorporate ESG into decision-making processes, emphasize accountability, and lead collaborative efforts with other team leaders who need guidance in making these adjustments.
Read more about how CFOs are taking the lead in ESG Accountability.