What Is ESG? Environmental Social Governance Basics

Updated October 18, 2022

When investors select which businesses they want to invest their money in, doing a thorough review of that company's operations is an important part of the process. Many investors review information about an organization's operational details to ensure they're investing in a sustainable and ethical business. Understanding what ESG is and what it means for the investment process is helpful for anyone involved with investor proposals or relations in their career. In this article, we review the basics of ESG, including the criteria for each aspect and its importance during the investment review process.

What is ESG?

ESG stands for environmental, social and governance and refers to aspects of an organization that investors use to determine its level of ethical consciousness. Many investors review ESG criteria when deciding on their next investment prospects because they want to invest in opportunities that reflect their personal values. Choosing companies through ESG criteria can also be a risk assessment strategy, because customers may prefer to purchase from businesses with positive ESG metrics, making those companies more appealing to investors. Investors review the connections between sustainability, social responsibility and financial success during their assessments.

Here are the main types of ESG investing criteria:

Environmental

Environmental investing criteria emphasize a company's sustainability and influence on the environment and ecosystem. Investors gather data to learn about an organization's business practices related to using and preserving energy, disposing of company waste and developing policies regarding environmental protection. They use this information to determine the risks of investing in that business, such as contributing to environmental issues or having a negative impact on customer perceptions. Some examples of environmental metrics that investors may research include:

Compliance with government standards regarding the environment
Use of sustainable energy compared to nonrenewable resources
Management of trash and wastewater
Use of energy-efficient technology
Carbon emissions from company operations
Impact on ecosystems through pollution or deforestation

Investors may also consider trends in a company's view on sustainability. Some investors may be interested in working with companies that recently adopted policies supporting green energy because they want to invest in sustainable technology for that business.

Social

The social element of ESG refers to how an organization treats its relationships with employees, stakeholders, business partners and community members. Having a positive social reputation is important for many investors, so they conduct in-depth research about the social reputation of each investment opportunity and which specific policies caused that perception. Social criteria involve policies and patterns regarding how a company interacts with key shareholders. Businesses with positive social criteria consider the interests of their community and strive to uphold considerate business practices in all aspects of the company. Here are some social investment criteria:

Fair wages for employees
Safe working standards
Community engagement through donations or volunteering
Diversity and inclusion policies
Commitment to customer satisfaction
Ethical use of customer data
Relationships with current shareholders

When reviewing the social element of ESG criteria, investors compare a company's values to its actual behaviors. Transparent, ethical companies have social behaviors that are consistent with the values they state publicly.

Governance

Governance refers to the internal operations, structure and function of a company. This includes transparency regarding how the business manages its finances, its connections to political groups, how executives and board members make decisions and how business leaders ensure compliance throughout their business. Reviewing governance information is essential for ensuring that investors choose organizations that comply with industry regulations and follow the law. Investors use their research about governance practices to understand if a potential investment opportunity can manage itself and spend the investment in an ethical, transparent way. Here are several governance criteria examples:

The number, topic and outcome of any lawsuits
Company donations to political candidates or parties
Lobbying practices or connections to the government
Salaries and bonuses for executives
Reports of internal corruption
Auditing practices
Fines or warnings for breaking government regulations
Public records and releases of financial information

Why is environmental, social and governance investing important?

ESG investing is important because it encourages businesses to be more responsible with their business practices. As more investors review environmental, social and governance practices before making a financial commitment to a business partner, many companies may become more proactive about how their business impacts the environment and their community. Some companies may adopt green energy policies or improve their internal governance to attract more investors, which also benefits their employees and community. This can create lasting benefits for labor relations and sustainability practices. They may also become more compliant with government and industry standards.

ESG criteria can also indicate which companies have other risks, such as causing expensive lawsuits from environmental or labor infractions. Investors can use an ESG analysis to determine which investments are most reliable and which ones may have risks due to unethical business practices. Every element of ESG criteria has the potential to influence financial success, so ESG investing can benefit both the company and its investors.

Pros and cons of using ESG investing

ESG investing is becoming a standard practice for many corporate investors. There are several advantages for both the investor and the company receiving the investment, but it's important to be aware of a few challenges to ESG investing. The benefits of ESG investing include:

Building lasting partnerships: By using ESG investing criteria, investors and businesses can develop long-lasting professional relationships. Because they share similar social goals and ethics, it can be easier for them to develop a long-term strategy and collaborate.
Identifying innovation opportunities: During an ESG assessment, investors may notice particular areas for growth, such as types of green technology programs that they want to invest in or social initiatives that interest them. This can be the basis for a successful investor relationship and inspire innovation in the business' development.
Establishing expectations: When investors use ESG criteria before committing money to a company, it establishes expectations for a certain standard of ethical behavior and transparency between both the investor and the company as business partners.

Some cons of the ESG investing process include:

Time investment: Conducting thorough ESG research takes time and effort, so investors need to be committed to gathering and verifying information throughout the process.
Imperfect businesses: It's almost impossible for businesses to be perfect in all three categories of ESG criteria, so investors often prioritize certain factors during their assessment.
Limited opportunities: When investors decide that certain ESG criteria are essential for an investment opportunity, this can limit the number of available investment opportunities and their chance at financial success.