What are ESG Criteria?
Environmental, social, and governance (ESG) criteria are a set of screening standards that socially conscious investors use to select investments.
ESG criteria have come into focus in recent years following general economic trends and consumer preferences. Younger investors in particular are interested in aligning their investment goals with their values.
In response, brokerage firms and fund management companies are offering ESG-vetted products—for example, in exchange-traded funds (ETFs). Additionally, as the wave of fintech applications has surged into the market, thematic investing robo advisors have seen success with their own ESG-focused offerings.
Environmental ESG Criteria
Environmental criteria encompass a wide range of corporate guidance, operational history, and business practices.
ESG-minded investors ask questions like these:
What is this corporation doing to minimize its carbon footprint?
Is it a known emissions producer or is it leading the industry in emissions reduction?
Has its level of emissions output decreased over time? Has it even been tracking this information?
Corporations that have a history of contaminating the land that they use don’t pass the environmental smell test.
Similarly, corporations with pollution-producing supply chains, a history of animal mistreatment or cruelty as a byproduct of operations, or other environmental mismanagement blemishes won’t meet the threshold for many ESG investors.
This focus on aligning environmental values comes with a potential profit edge as well.
Companies that operate sustainably rarely run afoul of government regulations and thus avoid hefty fines or the PR fallout that comes with an environmental disaster.
Social ESG Criteria
Evaluation of a corporation based on its social criteria means examining the ways in which it does business with other companies, the ways in which it impacts the communities it works in, and the way it treats its employees.
In short, is this company a good corporate citizen?
A corporation that behaves differently than its mission statement dictates is a poor ESG candidate. Likewise, a corporation with a history of stiffing contractors, vendors, or suppliers is not a good corporate citizen.
These business practices are not only indicative of a lack of good values, but they can also have financial consequences that affect the returns of investors.
ESG investors assessing social criteria will look at the corporation’s regard for the health, safety, and living conditions of its employees.
Do the corporation’s operations disrupt the communities in which it operates, or does it enrich the lives of the people it serves?
Does the company stand for diversity—both diversity in the workplace and a diversity of ideas?
Governance ESG Criteria
Investors who are evaluating a corporation’s governance practices want to know that their voice will be heard and that the company’s finances are aboveboard. This means accurate and transparent accounting methods and an opportunity for shareholders to vote on important issues.
Companies with a known history of violating the law are not considered. Additionally, board members with clear conflicts of interest or entangling political relationships are marks against corporations in the eyes of ESG-minded investors.
Passing the Test
To be considered an ESG pick, a company doesn’t have to score full marks in every category. Plus, the values that are most important vary from investor to investor.
Someone who would only consider investing in a corporation with a minimum number of women on the board of directors, for example, might prioritize that aspect when assessing a business.
In past years, “passing the test” often meant a trade-off for investors. That is to say, the popular perception was that a company that put ESG values first could not be profitable.
But attitudes about sustainability have changed, and investors are now making ESG values a business case as well as an ethical one.
These values-forward business practices can contribute to a lower risk profile in some cases, as evidenced by the fallout experienced by companies that are infamous for their environmental, social, or governance-related scandals.