Environmental, Social, Governance criteria: An overview

Anyone looking for fair, sustainable alternatives on the stock market might be quickly overwhelmed. Not every stock that looks environmentally friendly or socially conscious at first glance will make good on those promises. That’s where Environmental, Social, Governance (ESG) criteria come in. The various ESG criteria address whether a company meets a number of standards regarding the environment, social responsibility, and governance.

What are Environmental, Social, Governance criteria?

ESG criteria are a set of standards that have become a mainstay in the area of investment. Both institutional and private investors place more and more value in making sustainable and ethical investments. Now companies can voluntarily commit to upholding the various ESG criteria through the UN organization Principles of Responsible Investments. The organization has over 4,000 signatories worldwide, who with their participation have committed to integrating ESG principles into their business practices.

Overview of ESG criteria

The various Environmental, Social, Governance criteria touch on the three components of environment and sustainability, social responsibility, and leadership/governance.

Environment

The first category of ESG focusses on environmental sustainability. These criteria aim to ensure that, for example, the company is pursuing the use of renewable energy and protecting the environment. There is a wide range of environmental criteria — these are the most important ones:

Criterion

Explanation

Conservation of biodiversity

The company must ensure that it’s not endangering biodiversity. For example, deforesting rainforests and overfishing should be avoided.

Conserving resources

The company must work in a way that conserves resources, for example implementing recycling programs.

Climate protection/low emissions

The company must take action to slow climate change. For example, CO2 emissions can be reduced by shortening supply chains.

Investing in renewable energy

The company must get its power from green energy sources, for example using green hosting.

Social

The next area of ESG criteria is social responsibility, which emphasizes fair and ethical business practices as they relate to other people. Some major social criteria include the following:

Criterion

Explanation

Equal opportunities

The company needs to implement equal opportunities measures, for example ensuring that all genders are paid equally and that its workforce is diverse at all levels.

Human rights

Human rights must be respected. The company must avoid purchasing goods that were produced in inhumane conditions.

Employee protection and labor rights

The company must comply with applicable labor law with respect to its own employees. Moreover, the company must watch out for the health of its employees by providing safe working conditions.

Freedom of assembly and the right to unionize

The company must support employees’ right to unionize and the freedom of assembly.

Corporate social responsibility (CSR)

The tenets of CSR should be upheld.

Sustainability standards with suppliers and subcontractors

The company should ensure that ESG standards are implemented by suppliers and subcontractors.

High standards for health and safety

The health and safety of employees must be of high priority.

Governance

The last aspect of ESG criteria is governance and leadership. These criteria are meant to ensure that certain values are upheld in the way that the company is run. These are the most importance governance criteria:

Criterion

Explanation

General business ethics

The company needs to commit to moral principles and act ethically.

Prevention of corruption and bribery

Corruption and bribery should be prevented at every level of the company.

Wages and compensation

All employees should be paid a fair wage. The company might consider using part of the board’s compensation to implement further environmental measures.

Corporate governance

In accordance with corporate governance, the company should ensure transparency, risk management, and equality.

How do the ESG criteria work?

Acting sustainably is not always an end in itself. For many companies, investing in sustainability pays off in the long term. This is in part because sustainability has taken on a bigger and bigger role in wider society in recent years.

However, assessments of sustainability using ESG criteria don’t work the same for all companies. The sector that a company is operating in plays a big role, especially when it comes to the environmental arm of ESG. CO2 emissions will play a much bigger role in the evaluation of an energy company than a business in the service sector. For the service sector, the social criteria will be far more important.

It’s only with regard to the governance criteria that almost all companies are held to the same standard. When it comes to corporate governance, considerations like having an independent board and establishing fair business ethics should be promoted across all sectors.

ESG ratings

Ratings determine how safe an investment is. Generally, the distinction is made between bank internal and bank external ratings. The latter are carried out by a specialized company, called a rating agency. A large number of agencies specialized in ESG ratings have sprung up on the market. These ratings are a way for investors to determine whether their own standards for sustainability, social responsibility, and governance are fulfilled by a company. The American agency ISS ESG and the Dutch company Sustainalytics are two of the most well-known ESG rating agencies. Classic rating agencies like S&P also offer ratings with regard to the ESG criteria.

Compliance with ESG criteria

Compliance with ESG criteria is checked by rating agencies on behalf of investors. The agencies use different point systems to deliver ESG scores for companies. Due to the differences between their scoring systems, it’s hard to compare ESG ratings from different agencies. However, what each rating system has in common is that it is based on the ESG criteria. Concrete factors such as CO2 emissions and wages are scored based on reports from the company. What’s harder to evaluate are intangible factors such as employee satisfaction.


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