ESG is a tool that seeks to extend a traditional analysis of company value by including environmental, social and governance measures. This approach recognizes that ESG factors, even if they are referred to as “non-financial” in traditional accounting terms, can nevertheless be essential to a company’s bottom line.
Almost twenty years ago, investors noted that companies with better control of ESG factors have tended to match or surpass (opens in a new tab) their peers, especially in the long term. In other words, companies that anticipated market stressors or sustainability-related opportunities, such as increasing water scarcity, would be better positioned to thrive in this future environment. Since then, ESG investing has grown into a multi-trillion dollar industry that relies on many different approaches.
What does ESG mean?
ESG investing breaks down these risks and opportunities into environmental, social and governance measures. What does this mean in practice?
- Environment. An environmental analysis of a company will assess the extent of the company’s impact on the environment and how it manages this impact. A beverage company, for example, may come under extra scrutiny because their business is water-intensive, but they can earn points if they effectively manage their water usage. Overall, the environmental score of a mining or industrial company is higher than that of, for example, a software company or a bank.
- Social. This category covers issues related to employees, supply chain workforce, customers, and communities affected by company operations. Some of these categories are particularly important in a given industry. Product safety, for example, is critical to the value of a pharmaceutical company, but less so to that of a publishing house. Good employee relations are universally important for maintaining and protecting a company’s reputation.
- Governance. Good governance relies on strong ethics and transparency. ESG investors look for companies that have a track record of clean accounting, reasonable executive compensation (bonuses linked to the company’s long-term results, for example), and direct and timely communication with shareholders.
Each piece of ESG information is generally grouped into ratings assigned by ESG rating companies. This way, investors can compare companies from different industries or geographies.
The gold standard of business valuation has relied heavily on the concept of “tangible assets,” which include equipment, land, raw materials, finished goods, and other physical assets that have value. fixed currency. In 1975, most companies held in the S&P 500 were considered valuable because of these tangible assets. Only around 17% of company value came from “intangible assets” such as brand equity and human capital, including many attributes captured by ESG metrics.
With the boom in information technology and corporate transparency, intangible assets have become the primary driver of business value. As the chart below shows, intangible assets accounted for 90% of the value of companies on the S&P 500 index by 2020. This shift represents an extraordinary shift in the economy.
To understand how increasing intangible value and ESG are intertwined, consider how far more important employee relationships are today than in the past. “Bargaining power has shifted from employer to employee, and turnover rates and wages have skyrocketed as a result,” says Peter Essele (opens in a new tab) of the Commonwealth Financial Network. “Companies are now implementing unique strategies to attract and retain top talent,” Essele explains, “because increasing revenue, in any industry, is costly to bottom line.”
Is ESG just greenwashing?
Is ESG simply investing in a marketing scam, engaging in “green laundering” or promising better environmental or social results than it delivers? Unfortunately, consumers may not always know the answer to this question because there is no standard definition of ESG. Remember that ESG was not originally designed to change the world, but to find corporate value that the market had overlooked. If good things came from this investment strategy, it was considered a bonus, but not the main goal.
European governments are crack down on companies offering ESG funds (opens in a new tab), ensuring that their purpose is made clear to investors. Similar efforts are underway in the USA (opens in a new tab) In the meantime, investors for whom impact is a top priority should look for products offered by companies in the American Sustainable Investing Forum (opens in a new tab) (USSIF). These companies are more likely to engage directly with companies to address ESG issues and collaborate with non-profit groups on corporate advocacy.