ESG: definition, criteria and their widespread corporate adoption
Breaking down ESG terminology
Sustainable development, a term that first appeared in the 1980s in the report by the UN’s World Commission on Environment and Development, lay the groundwork for future environmental action. It is defined as “development meeting the needs of the present without compromising the ability of future generations to meet their own needs.” Initially, sustainable development only dealt with preserving the planet. The definition later evolved to include environmental, social and economic categories.
From an organizational and business standpoint, sustainable development is generally associated with the concept of corporate social responsibility (CSR). A term widely used in the 1990s, CSR can be seen as a company’s contribution to sustainable development. The rise of CSR may, in large part, be explained by modern society’s increased awareness of environmental and social problems. In addition to global warming and the soaring number of natural disasters, many populations are facing precarious situations. According to a 2018 report by the World Bank, about “143 million people could be displaced due to climate change,” especially as a result of water shortages, poor harvests, flooding, etc. Social movements like Black Lives Matter and #MeToo have also raised awareness around certain social issues over the last decade. CSR is a method of governance that has emerged as a major investment factor. The concept, often referred to as the Triple Bottom Line (TPL), encourages businesses not only to focus on their financial performance, but also on their environmental and social impact. TPL states that a company must be concerned with not one, but three growth objectives: profits, people and the planet.
But where do environmental, social and governance (ESG) criteria come in? Though the terms are often used interchangeably, CSR and ESG actually go hand in hand. ESG is an acronym referring to environmental, social and governance criteria. It is a tool for measuring a company’s commitment to social responsibility. In other words, “ESG criteria comprise the totality of measures and principles for assessing companies’ non-financial performance data.” ESG criteria make it possible to assess the level of a company’s social responsibility for the purpose of attaining its sustainable development objectives.
Although ESG is very important, it is not always well understood and is often perceived as having conflicting aims. Opinions on ESG factors vary even among experts, which further complicates how we assess a company’s ESG performance. Here are a few key elements of ESG criteria.
E for Environment
The environmental category mainly covers decarbonization, pollution, biodiversity and natural resources. There is consensus that the environmental aspect should be the guiding priority for corporations. This is, among other things, the factor where investments are increasing the most. Companies feel the urgency to take climate change action and many have already set carbon neutrality objectives (e.g., Formula 1) for the coming years. However, these goals have programs that focus predominantly on Scope 1 and 2 (direct and indirect emissions), when they should be more focused on Scope 3 (emissions indirectly related to company activities). The latter account for up to 50% of a company’s total emissions.
S for Social
The social aspect is concerned with issues like diversity, inclusion, health, safety and human rights. It has been observed that some companies are including different aspects of diversity (e.g., sex, visible minorities, Indigenous peoples, the handicapped, veterans and LGBTQ2S) in their internal representation objectives. The notions of diversity and inclusion go even farther if we consider, for example, neurodiversity and digital inclusion.
G for Governance
Lastly, the governance aspect covers organizational structure, risk management and ethics. The governance method makes it possible to attain specific environmental and social objectives. However, it has been established that this is the least frequently addressed criterion among the ESG dimensions. According to a recent Canadian study, 64% of companies declared that ESG issues are considered within their corporate strategy, but only 25% say that their board has a solid understanding of the risks. The chance of actually attaining environmental and social objectives is low if companies do not establish sound governance practices. Companies must develop a firm understanding of and expertise in governance so that ESG actions and impacts are reflected in all of their activities.
Why is ESG becoming more popular?
One of the main reasons for the widespread adoption of an ESG approach is all the pressure exerted on companies. According to a report by Gartner, clients (63%), investors (48%) and regulators (46%) are the three main stakeholders pushing companies to take action on sustainability. They are strongly influenced by disruptions and challenges occurring around the world.
To begin with, we must consider the repercussions from the global pandemic, which played a significant role in accelerating companies’ adoption of ESG criteria. COVID-19 and its associated consequences prompted investors to pay much closer attention to problems related to ESG (specifically the social aspect). The pandemic forced companies to face new social and governance challenges. This exacerbated certain social problems, further pushing companies to take the lead on environmental, social and governance issues.
The new wave of young investors may also contribute to the expansion of corporate ESG by introducing new values. According to a study, 80% of investors say they consider ESG as an important factor in their investment decisions. Here, we are referring to socially responsible investing(SRI), a term defined as “an investment approach that includes ESG criteria when selecting and managing placements and investments.”
ESG progress also ramped up as a result of stricter norms and standards, especially with regard to the environment (COP26, international ISO standards, government plans, etc.), requiring companies to publish more credible ESG data. Take, for example, the creation of the International Sustainability Standards Board (ISSB), developed within the scope of COP26, which makes it possible to establish clear ESG standards for making environmental financial disclosures internationally. Third-party organizations (S&P Global, MSCI and Refinity) have finalized an ESG performance measurement tool.
Putting ESG at the heart of a company’s mission
Over the next few years, we can expect a sharp increase in the number of companies considering ESG approaches. ESG will top the list of organizational priorities, be it to attract more investors, satisfy stakeholder requirements and/or have a positive social impact. More ESG data being published in company reports and the increased pressure on companies, there is a risk of greenwashing. Some are concerned that companies may project a false image to enjoy the benefits of being associated with CSR. The ESG criteria disclosed by companies must reflect real action and change. For this to be possible, companies must make ESG principles the very bedrock of their mission.