What it means
The three letters stand for different areas, and environmental criteria look at matters such as energy use, emissions, waste and water. Social criteria cover how a company treats employees, customers, suppliers and communities, including safety, pay and diversity.
Governance criteria examine how the company is run, including board structure, executive pay, shareholder rights and internal controls. The reason ESG has become important in finance is that these factors can affect profit and risk.
A factory with high emissions may face new taxes or fines, a company with poor working conditions may lose staff or face legal claims, and weak governance can allow fraud or poor decisions. Investors want to understand these risks before committing money.
In practice, ESG information comes from company reports, data providers and rating agencies. Providers score companies using their own methods, so the results can differ widely, and a business that looks strong on one rating may look average on another.
Finance teams are therefore asked to supply data and to explain their policies clearly. ESG is also linked to funding.
Some lenders offer cheaper loans when a borrower meets sustainability targets, and some investment funds screen out companies that fall below certain standards. Regulators in many places now require larger companies to disclose some of this information in a consistent way.
A nuance is that ESG is not a single universal rulebook, and opinions differ on what should be measured and how much it matters. Critics point to inconsistent ratings and the risk of exaggerated claims, which is sometimes called greenwashing.
Strong programmes rely on measurable targets, verified data and honest reporting of progress and setbacks. Smaller companies can start modestly.
A short list of measures, such as energy use, staff turnover, health and safety incidents and board independence, gives a useful baseline without a large reporting team. As customers and lenders ask for more detail, the programme can be expanded in stages.
In practice
Real-world examples.
Example
A pension fund screens a list of companies and excludes those with the weakest governance scores. It then compares the remaining firms on emissions and workforce measures. The fund explains its approach in its annual report to members.
Example
A manufacturer arranges a $50,000,000 loan whose interest margin falls if it reduces emissions by an agreed percentage. The finance team tracks the data each quarter and reports to the lender. Meeting the target saves the company interest costs.
Example
A retailer sets up a supplier code of conduct requiring safe working conditions and fair pay. It audits factories and ends contracts with those that fail to improve. The company reports the results to investors as part of its social disclosures.
Formula
Calculation
Overall ESG score = (Environmental score x weight) + (Social score x weight) + (Governance score x weight)
Suppose a rating provider scores a company 70 for environmental, 60 for social and 80 for governance, using weights of 40%, 30% and 30%. The environmental contribution is 70 x 0.40 = 28. The social contribution is 60 x 0.30 = 18, and the governance contribution is 80 x 0.30 = 24. The overall score is 28 + 18 + 24 = 70 out of 100. Weights differ between providers, so the same company could receive a different score elsewhere.Case study
Seen in the real world.
Evergreen Bakeries is a fictional food company, and this case study is illustrative. A major investor asked the company to explain how it managed energy use, staff turnover and board oversight. The finance director realised that the information was scattered across departments and that the company could not answer clearly.
She formed a small working group to collect data and set simple targets, such as cutting energy use per tonne of product by 10% and reducing staff turnover. The company published a short report each year and found that its next bank loan carried a lower margin because of improved controls and reporting. The finance director noted that the process also exposed some wasteful practices that were then fixed.
Two years later, the company's investor presentation included a one-page summary of its targets and progress, along with a note explaining where it had fallen short. Analysts said that the openness about missed targets made the rest of the report more believable.
Watch out
Common mistakes.
- Treating ESG as a marketing exercise instead of a way to manage real risks and opportunities.
- Comparing scores from different providers as if they used the same method.
- Making claims without data to support them, which can lead to accusations of greenwashing and legal risk.
Questions
People also ask.
Is ESG the same as sustainability?
They overlap, but ESG is a framework for measuring and reporting specific factors, while sustainability is the broader goal of operating in a way that lasts.
Does ESG affect investment returns?
Evidence is debated, but many investors believe that strong management of these factors reduces risk, and the effect varies by sector and time.
Who is responsible for ESG in a company?
The board oversees it, senior management sets strategy, and finance, operations, human resources and legal teams all supply data and carry out the plans.
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