ESG criteria: what they are and how to use them

ESG is an acronym, linked to sustainability, a subject talked about more and more often: it stands for "Environmental, Social and Governance" and refers to an innovative measurement of companies and organizations.

Framed within the context of sustainable finance, the ranking produced based on ESG criteria allows us to measure the ability of companies to adhere to those standards considered essential for sustainable development of the entrepreneurship of the future.

Here is a guide on the meaning and functioning of ESG criteria, together with an analysis of the innovation that the latter has introduced concerning the traditional concept of corporate sustainability.

What are ESG criteria

The acronym has now fully established itself in the financial sector. ESG criteria are useful for determining the environmental, social, and governance impact of companies, which are increasingly oriented - as can be seen in today’s communication strategies - to highlight the sustainability of their business.

ESG criteria can be used to rank companies based on their compliance with environmental, social, and governance parameters. Upon closer inspection, this is a re-elaboration of the concept of corporate sustainability, since traditionally the latter was linked almost exclusively to the company’s ability to produce value.

Now, these new criteria represent a new indicator for evaluating the quality of an investment, also aiming at the value that a company can produce for the benefit of society and the environment. ESG criteria are increasingly paid attention to by investors, as they can provide crucial elements on the risk of a given position.

In short, financial returns and technical fundamentals are being replaced by an approach that - thanks to the contribution of the younger generations - is more suitable for the economic architecture of the future.

Sustainable investments guaranteed by compliance with ESG criteria, on the other hand, make it possible to contain risks, while at the same time having a positive impact on society. Furthermore - as noted by Credit Suisse analysts - investors who observe sustainability parameters in their choices experience a better risk/return profile than that guaranteed by traditional investments based exclusively on the financial performance of a company.

Why it is important to talk about ESG

So why is it necessary to talk about ESG? The importance of these issues lies in their primary meaning: it is essential to review the paradigms of a company’s success to consider it as such.

Although today it is a very sensitive topic, it hasn’t always been like this: the importance of this concept acquired fame hand in hand with the awareness that the resources of the planet are limited and that, therefore, it is necessary to adopt a more sustainable business approach from multiple points of view.

Historically, it is possible to trace the roots of this awareness to the early 70s of the twentieth century. In 1972 a group of researchers from the Massachusetts Institute of Technology (MIT) published a report entitled “The Limits to Growth, in which the consequences of the continued growth of population on the terrestrial ecosystem and the survival of the human species.

The report stated that if human development continued at the same rate as that time, the world would run out of resources in the next hundred years, inexorably entering a period of recession.

By managing development, however, it is possible to reach a degree of equilibrium such that it is possible to escape the recession. According to the report, the state of global equilibrium should be designed so that the needs of every person on earth are satisfied, and everyone has equal opportunities to realize their human potential.

Simultaneously, the first United Nations Conference on the Human Environment was held in the same year, which subsequently led to the Stockholm Declaration. From the declaration, it emerged that mankind has a fundamental right to freedom and equality, as well as a responsibility to preserve the environment for future generations.

Subsequently, in 1987 the Brundtland Report was published by the World Commission on Environment and Development. The report, whose name derives from its client, Gro Harlem Brundtland, former Prime Minister of Norway, defines what is meant by sustainable development: “sustainable development is a development that meets the needs of the present without compromising the ability of future generations to satisfy their own needs.”

The concept of ESG as it is known today was born in 2005, during a conference called “Who cares wins”, during which analysts, institutional investors, members of various governments, and other leading figures to analyze the role of environmental, social and corporate responsibility components in investment management.

In 2015, in the wake of previous decisions, the 17 goals for sustainable development were established within the United Nations. The agreement, signed by 193 countries, provides for the achievement of the aforementioned objectives by 2030.

The Sustainable Development Goals aim to address a range of issues related to socio-economic development, which include poverty, hunger, right to education, access drinking water and energy, work, inclusive and sustainable economic growth, climate change and environmental protection, urbanization, social and gender equality, justice and peace.

In the same year, the Paris Agreement on climate protection was signed by 195 countries, which aims to strengthen the global response to the threat posed by climate change, in the context of sustainable development and efforts to eliminate the poverty, and taking into account the principle of common but differentiated responsibilities and respective capacities, in light of different national circumstances.

This shows that the concept of ESG has its roots in a relatively distant past, which has managed to establish itself given its importance.

ESG criteria: what are the evaluation parameters?

The ESG criteria, therefore, lead to the creation of a virtuous ecosystem in which profit does not necessarily conflict with elements of high ethical value - such as environmental protection or social inclusion - but which, on the contrary, it merges with the general concept of sustainability.

The criteria used to evaluate the assumption of environmental, social, and governance responsibility by companies are divided into three macro-categories:

Criteria E (Environmental): this parameter fits into the broad cauldron of the fight against climate change. To achieve the ambitious objectives outlined by the States, the business sector must act responsibly towards the environment. In this context, the data examined for ranking on the sustainability of companies concern, among others, the management of vital resources (such as water and air), respect for biodiversity, agri-food safety, and the containment of emissions of carbon dioxide.

Criteria S (Social): these parameters relate to company activities that have a social impact, and therefore on the community. The parameters aim to detect, for example, a company’s respect for civil and labor rights, the maintenance of an adequate work standard, compliance with laws relating to child labor, and the broader field of equality.

Criteria G (Governance): the last parameter concerns the governance responsibility of companies. This chapter is particularly important because the governance of a company gives external observers crucial indications about the corporate identity. It therefore puts under the lens remuneration strategies, respect for meritocracy and shareholder rights, the remuneration of the executive committee and the board of directors, and the quality and diversity of the latter.

What are the objectives of the ESG approach?

Having understood the importance of this topic, it is necessary to focus on the objectives that companies that embrace this philosophy wish to pursue.

The objectives are three: environmental, social and corporate responsibility.

For companies, adopting this philosophy means rethinking their way of relating to the environment, to the society in which they are located, and to their relationships with their employees.

In the environmental field, the company is committed to addressing the environment with a sustainable approach, producing its products with the least polluting materials possible and avoiding waste of any kind.

Achieving this goal can be complex for many companies, especially those that have achieved their success by exploiting low-cost materials and very pollutants. They are therefore called to reinvent themselves by using materials more in line with ESG directives.

The social objectives are equally complex: in this case, the objective that must materialize is to make the company involved in the social sphere.

Although it may seem like a very simple concept, its application is anything but obvious and risk-free. Companies are called to have a positive impact on society, by investing, for example, in cultural or artistic projects similar to their mission, demonstrating that they care about the environment in which they operate.

Finally, the objectives regarding corporate responsibility represent the latest challenge of this philosophy. In this area, the company is called to behave responsibly towards those who work within it. This can be especially tricky for those companies that have achieved their success based on unethical work values.

An example of this is represented by fast fashion companies which, thanks to numerous tricks such as negligible wages, the importation of low-cost labor, and the use of poor quality production materials, have managed to compete in the market.

What and how many are ESG strategies?

Finally, who are the actors most affected by ESG strategies? In a broad sense, everyone should be interested in these issues, as they play a central role in the daily lives of each of us.

In concrete terms, the choice to respect the values of ESG can be a vital strategy for a company, since this can influence its performance on the market.

On the side of investors and investment funds, some of these may be interested in investing only in companies that respect ESG values.

The same strategy applies to customers: today more than ever, many buyers are interested in knowing the origin of the products they purchase and the social and environmental behavior of the company.

Especially young people nowadays choose not to buy from companies that have a work ethic that is not in line with their values or that produce their products in an environmentally unsustainable way.

Original article published on Money.it Italy 2022-05-07 10:15:00. Original title: Criteri ESG: cosa significa, quali sono e come utilizzarli