In order to pursue sustainable investments, investors need to know which companies have a positive impact on the world. But before you can measure impact, you must be able to define it. That makes a systematic categorization of a company’s potential effects a necessary step.
One widely accepted framework for this assessment consists of three factors: environmental, social, and governance—or ESG. The ESG investing framework can be used for both positive screening (choosing companies with good records) and negative screening (excluding companies with poor records).
Each of the three ESG pillars comprises several issues. When generating ESG strategies or funds, companies use different categories to come up with a final score. While there is variance, and not all approaches are equally rigorous, there are some regular fixtures. Portfolio analytics company MSCI has an in-depth methodology behind its rating system.
The environmental pillar generally evaluates a company’s effect on the natural world, including ecosystems, climate, and natural resources. Businesses can do serious damage to the environment if they, for example, rely on unsustainable manufacturing or mining processes. While environmentally conscious firms can produce or use renewable energy and take steps to eliminate water waste.
Common areas of evaluation include:
- Climate change: Many investors are concerned about the risks to people and planet posed by climate change. They want to know if the companies in their portfolio are adding to the problem or helping to solve it. Subcategories in this area include carbon emissions and climate change vulnerability, as certain industries are more likely to be affected by climate change.
- Natural resources: Water waste, land use, and raw material sourcing are all commonly found in this category. Are there policies in place to ensure raw materials are extracted in an environmentally sensitive manner? Are firms taking proactive steps to use water more efficiently?
- Pollution and waste: And when a company uses water, does it leave polluted or potable? This category looks at how a company deals with waste. Responsible waste disposable can prevent harmful substances from winding up in communities. This category rewards companies that take steps to mitigate pollution.
The social pillar of ESG deals with a company’s relationship to its workers, customers, local communities, and society as a whole.
Some important issues in this category are:
- Supply chain labor standards: An important way companies affect people is through supply chains, since many more people may produce goods in a company’s supply chain than work for it directly as employees. ESG investors look for companies that have policies in place to ensure that workers are treated fairly across the entire supply chain.
- Product safety: Does a company adhere to safety regulations and industry standards? Does a company take steps to ensure their products are made using materials that go above and beyond regulatory standards? ESG investors are likely to refrain from funding businesses that put short-term profits over safety and place consumers at risk of injury. “Safety” in this context extends to data safety, evaluating whether digital products protect the data of users with adequate safeguards. This category also gives favorable ratings to companies that have policies to limit or eliminate predatory lending.
- Social opportunities: A broad category, this evaluates whether a company’s mission increases access to capital, healthcare, the internet, and/or nutritious food. For example, companies that develop medical treatments for undertreated conditions or for diseases that are prevalent in developing countries could score well in this category.
The governance pillar of ESG investing is concerned with corporate governance and corporate behavior.
Examples of issues in this category include:
- Corporate Governance: This category rewards companies with effective checks and balances. Questions asked include: Is there an independent chair and CEO? Are there an adequate number of independent directors? What is the ratio between the CEO’s pay and the pay of the average employee?
- Corporate Behavior: This category gives high scores to companies that go the extra mile to ensure ethics and transparency. What are their audit and business ethic standards and policies? Are there conflicts of interest in the ownership structure? Are they transparent about their taxes?
This is an overview of only some of the considerations made when assigning a company’s ESG rating. ESG ratings have meaning because evaluators think deeply and investigate thoroughly. Thanks to this, institutions and individuals can adhere to their values and support companies that are creating positive change.