The ESG (“environmental, social and governance”) index is used to evaluate a company’s environmental, social and governance practices, assessing their operations based on impacts along these three axes of sustainability.
The adoption of ESG principles in the analysis of companies has made it possible to incorporate issues that impact company results, in addition to being crucial for the well-being of society, for stewarding the planet’s resources, and for building a better world. The principles start from the premise that winning companies will prioritize their behavior as it relates to issues in these three areas.
In recent years investors, especially younger ones, have shown an interest in supporting companies whose principles align with their own, and brokers and fund companies have started offering exchange-traded funds (ETFs) and other financial products that follow ESG criteria.
But, after all, what does each axis of the ESG include?
The first axis of sustainability is environmental. Environmental criteria may include, among others, energy use, waste generation and treatment, pollution mitigation, proper use and conservation of natural resources, carbon footprint, and the treatment of animals. The criteria can be used to assess environmental risks that a company may face, or how the company is managing risks. For example, are there issues related to the ownership of contaminated land, the disposal of hazardous waste, the management of toxic emissions or compliance with government environmental regulations?
The social axis of sustainability takes into account a company’s business relationships: do they prioritize suppliers that have the same values as those the company claims to have? Does the company donate a percentage of its profits to the local community? Does it encourage employees to volunteer in the community? Do the company’s working conditions show deep consideration for the health and safety of its employees? Are the interests of other stakeholders taken into account? It includes aspects such as support for workforce diversity and measures to prevent discrimination of any social group, whether in the work environment or in brands’ public spheres, e.g., in advertising.
The third and last axis is corporate governance, which encompasses the ethical management of the business, transparency in accountability to society, and the fight against corruption. Investors may want to know if a company uses good governance practices and accurate and transparent accounting methods, and that shareholders have the opportunity to vote on relevant issues. Investors also want companies to avoid conflicts of interest in choosing board members, to not use political contributions to obtain unduly favorable treatment and, of course, to not engage in illegal practices.
A company’s ESG performance can be measured in a number of ways, as there is still no established method. Several institutions, investors, and agencies have developed their own methods. For example, MSCI has developed an AI platform that collects and standardizes public data, company disclosure documents, and news about the company. The company’s analysts then follow standardized methodology to provide an ESG investment rating score from AAA (highest) to EEE (lowest).
Everything suggests that increasing awareness of the impact of a company on society and the environment means that ESG investments will continue to gain relevance. Now, more than ever, choosing the right company to invest in is fundamental to benefit from a strong ROI. Assessing a company’s ESG impact through independent ratings appears to be an ever-more promising way to ensure that the investment brings the expected return.