What are ESG Principles and How do They Impact Financials?

Environmental, Social and Governance (ESG) principles for investing have become mainstream values for many companies and investors. Product sustainability is no longer a fringe concern but a driving force in today’s financial markets. And the results are promising. Pursuing ESG principles is not a financial sacrifice but one that may bring increased profits and a healthier planet. Ecologically-minded investors are happy to invest in responsible companies and increase their income without a negative impact on society. The movement is growing, so you should look at increasing your participation in ESG investment.  

The History of ESG 

The late Kofi Annan, former Secretary-General of the United Nations, was instrumental in creating ESG principles. In 2000, he initiated the UN Global Compact, a voluntary agreement that promoted corporate sensitivity in labor, human rights, anti-corruption and the environment. The goal was to encourage companies to think about their impact on society and the environment and not just on profits. The idea was not to lessen profits but to operate in a profitable yet responsible way. In short, companies needed to be good citizens of the planet. 

In 2004, Annan promoted a Global Compact initiative that sought to include social and corporate governance in capital markets. The initiative report, Who Cares Wins, explained how sustainable investing worked to benefit companies and their investors. The ESG movement sprang from Annan’s and the UN’s efforts.  

Currently, more than 7,000 companies have signed the Global Compact, and it includes 44 or the 50 biggest asset managers in the world. Soon, the question may not be, “Do you participate?” but rather, ”Why aren’t you involved?”.

What are ESG Principles? 

ESG investment has three parts that often intertwine. Although various companies interpret them differently, the three basic ESG principles are as follows: 

The E stands for environmental factors. It includes the energy your company uses and the waste it produces. You also must consider the human impact your energy use has, including carbon emissions and climate change. Every company should be assessing its current effect on the environment, but many have not even begun to understand the metrics. Sustainable investment means understanding this factor and working to reduce it.  

The S is for social criteria and includes labor relations, management/employee diversity, and inclusion efforts. These factors affect your relationships with individuals and the community and help to form your company’s reputation. If your company is serious about these issues, the public won’t need to ask about them -your commitment will be obvious. 

The G is for governance or the procedures and controls that your company uses to meet legal and ethical standards while benefiting your shareholders. A strong and ethical structure is essential for any company that wants to be socially responsible. The commitment to sustainable investing comes from the top down. 

To be an ESG company, you need to practice all three ESG principles, which naturally intertwine. Trying to separate one part from another ultimately weakens your efforts. ESG needs to be a corporate philosophy that manifests in all your company’s efforts. CFOs, brokers, accountants – everyone on staff needs to commit to the process. Soon, ESG becomes a natural part of your company’s philosophy and daily operations. 

Profitability 

Those companies that have not embraced ESG principles may fear that doing so will lower profits. This concern is unfounded. In more than 2,000 studies on ESG impact on equity returns, 63% showed ESG had a positive effect while only 8% showed a negative one.  

For some, these results may not make sense on the surface. ESG and positive financial returns can be explained by the following: 

• Prompts top-line growth – Sustainable products attract more B2B and B2C clients. 
• Reduces cost – ESG leads to less water intake and lowers energy use. 
• Minimizes legal and regulatory actions -You’ll see improved government support and earn subsidies. 

• Increases productivity – ESG principles attract more qualified employees and increase employee enthusiasm. 
• Optimizes expenditures – You will see better investment returns from sustainable equipment and manufacturing plants. 

In the case of ESG companies, “doing good” offers better returns. In fact, companies with strong ESG principles usually have excellent management teams. They plan for the long-term and use creative strategies to be a positive force for everyone concerned. 

Investor Reaction 

Investment managers’ reaction to ESG is, of course, partly determined by their clients’ interest in it. In Europe, many clients inquire about this aspect of their portfolio, which is probably why 49% of professionally managed assets in Europe follow some sustainability guidelines. Until recently in the US, only 26% of these assets followed any sustainability guidelines while only 18% did in Japan.  

Surprisingly, the pandemic has given a boost to sustainability investments. Impact investing index funds have now surpassed $250 billion, and the US market accounts for 20% of that amount. Perhaps COVID-19 has emphasized the fragility of the planet’s condition. 

To increase ESG participation, company leadership must actively embrace the concept. Many CEOs do not have sufficient incentive or encouragement to screen for ESG investments. Their compensation rarely includes consideration for sustainable investing. Client interest and pressure is working, though. Some investment firms have created their own criteria for ESG and keep their clients fully informed of their portfolio “scores.” They may also track the success of their portfolios using the UN and/or GSIA (Global Sustainable Investment Review) standards.  

Social and Ecological Impact 

The actual impact of ESG on society and the climate can only be positive, but measuring the exact benefits is difficult. The world’s climate experts are all in agreement that the situation is dire and that changes have to be implemented now to avoid catastrophe. ESG is one way to slow environmental harm and begin to address social issues. “Primum non nocere,” (First do no harm) is part of the medical oath, but more and more companies are adopting it as part of their operating principles as well. Investment managers can balance their clients’ bottom line while also protecting the planet.