What Is ESG? And Why Is Everybody Talking about Sustainability?

But let’s begin with the basics. ESG stands for environmental, social, and governance, and denotes a set of criteria used to evaluate the sustainability and ethicality of a company’s business practices.

The term “environmental” in ESG refers to all aspects of a company’s use of natural resources and its handling of environmental impacts and climate change. It encompasses aspects such as recycling management, energy efficiency, and CO₂ emissions.

The term “social” encapsulates a company’s relations with it stakeholders, i.e. with its employees, customers, suppliers, and with society as a whole. Working conditions, equal opportunities, diversity and inclusion, and social engagement are examples of social aspects.

The term “(corporate) governance” deals with the way in which a company is run and managed. Corporate transparency, adherence to ethical standards, managerial compensation, and prevention of corruption are examples of potential factors used to measure compliance with this criterion.

For obvious reasons: climate change is forcing everyone to take action. At the same time, issues such as gender equality and social responsibility are becoming more and more important in global society. This greatly affects businesses as well. There are two main drivers behind companies’ ESG efforts. First, consumer behavior has changed considerably in recent years. Customers these days are placing more value on sustainability. Businesses that operate sustainably and adhere to ethical standards get preferred by customers. Those that don’t are at a disadvantage and sometimes even face shitstorms for irresponsible or environmentally harmful conduct.

Second – and arching back to the beginning of this blog post – ESG has gained considerable importance in recent years also in the realm of investments. Institutional and retail investors have recognized that sustainability is a long-term driver of business success. There are quite a number of ESG funds and ESG indices these days that have been enjoying growing popularity in recent years. If a company is not sustainable enough, it gets excluded from those financial instruments and misses out on investments.

To put it in a hyperbolized nutshell, companies with a good ESG rating potentially sell more and at the same time become more attractive for investments.

So far, so good. But who determines how sustainable a company is? And how is that calculated, exactly? Since regulatory guidelines on ESG scoring have only been around for a short time and these frameworks are still incomplete, private ESG rating agencies were the first to rush into this data void with their own proprietary models by which the assessment of the sustainability of a company can be calculated and expressed in an ESG rating. MSCI, Morningstar subsidiary Sustainalytics, and RobecoSAM (part of Standard & Poor’s) are some of the prominent providers of ESG ratings on the market.

To determine an ESG rating, the rating agencies analyze the impacts that a company’s products and business practices have on our environment and society. The company’s willingness and ability to address social and environmental issues also factor into the rating. The rating agencies base their analyses on information drawn from companies’ annual reports and sustainability disclosures and from media reports, for example. The ESG factors applied in rating actions and their weights differ somewhat from one agency to the next.

As varied as the different rating agencies are, so too are the methodologies they use to determine ESG ratings. This causes some divergences in companies’ ESG ratings. Just because a company receives a very good ESG score from one rating agency doesn’t mean that a different methodology yields the exact same result. This has sparked criticism in the past.

Regulatory controls are tightening to prevent companies from falsely portraying themselves as being especially eco-friendly and responsible-minded (a practice known as “greenwashing”). New sustainability standards and regulatory guidelines are constantly being developed and enacted.

The world’s most advanced ESG regulatory framework is the EU Taxonomy, a system in force throughout the European Union for defining and classifying sustainable economic activities. Its aim is to provide the financial sector and investors with guidance and to incentivize the allocation of capital toward the green transformation of energy production and the economy. This framework also includes new regulations concerning corporate sustainability disclosures. The European Sustainability Reporting Standards (ESRS) also establish a clear and straightforward common framework for collecting company data. This framework is currently being harmonized with other global data collection standards. So, hopefully, minimal sets of publicly available, directly comparable ESG data on companies will soon exist alongside the often highly complex ESG ratings.