- May 5, 2022
What is ESG and How Does It Work? A Comprehensive Guide
ESG, or environmental, social and governance, has become an increasingly important concept within the business world. Investors and business owners who want to create a value-driven organization rely on ESG standards heavily in running their organizations.
Consumers are increasingly making their purchasing decisions based on the business practices of brands, with 56% of consumers avoiding businesses entirely that engage in unethical practices.
But what does ESG stand for in a business sense, and how does your business achieve ESG compliance?
If you’re wondering, “what does ESG mean?” the answer is not always straightforward. Essentially, understanding what ESG is can propel a business forward and enable it to maintain the high standards that impress customers and weave investors’ values into its fabric.
While the modern concept has only emerged in the last few years, it originates from Socially Responsible Investment (SRI). SRI began back in the 1960s with businesses and investors that were opposed to the Vietnam War. It would continue during the 1970s as opposition to apartheid in South Africa grew.
There are already established frameworks in place that highlight businesses building a strong adherence to environmentally friendly practices, a sense of social responsibility and ethical governance.
Additionally, there’s also the question of “what is ESG investing?” When evaluating their future business partnerships, groups of investors are increasingly seeking out ESG compliant businesses.
But what is ESG and the criteria that define it?
The climate crisis has grown more serious, and 45% of U.S. consumers have shown an interest in buying from organizations that put the environment at the heart of their business models.
Practices that mitigate carbon emissions, promote energy efficiency, good waste management and conservation of resources all count toward becoming a green business.
Social factors incorporate an organization’s relationships with other businesses, its reputation within its community, and its commitment to workplace equality. Other aspects include the charities it contributes to, health and safety regulations and how it supports its workforce through its workplace benefits programs.
How does your company function?
The good governance of an organization includes the transparency of its accountancy methods, compensation for executives, and the composition of the board. Governance further extends to the board’s relationships with its employees, investors and stakeholders.
To enforce proper governance, businesses must have processes in place to prevent corruption, unethical behavior and conflicts of interest.
Why is ESG Important?
Environmental, social and governance factors have never been more critical. Far from being a fad, this is something that is here to stay.
The COVID-19 pandemic has only put more focus on environmental and social issues, with investors and lawmakers recognizing the risks of the climate crisis, the pandemic and other factors impacting the global economy.
With society functioning through successful businesses that meet its needs, ESG is crucial to securing the future of everything from equality and employment to the protection of natural resources and the public interest.
Funds focusing on investing in businesses that comply with these complex frameworks have grown. But what are ESG funds?
These are mutual funds dedicated to businesses and ventures that prioritize environmental, social, and governance values. Throughout the pandemic, U.S. funds jumped to $250 billion. The global shutdown has shone the spotlight on all three of these categories like never before.
To sum up, ESG compliance is important because:
- Investor values are changing
- Consumer habits have evolved
- It can reduce costs
- It attracts better talent
- It improves the world as a whole
Developing a scheme that prioritizes these values is challenging for businesses of all sizes, but there are real benefits for those that achieve compliance.
How Does Environmental, Social and Governance Criteria Work?
Younger investors in particular have invested mainly in ventures that conform to their personal moral and ethical codes. With the rise of mutual funds, exchange-traded funds (ETFs) have popped up on the market consisting of businesses that follow ESG criteria.
Measuring performance is notoriously tricky because no centralized global body is responsible for rating businesses in this manner.
Most companies measure performance themselves and publish the results in their annual reports and other special publications. The obvious downside of this approach is a lack of objectivity or accountability. Organizations are free to exaggerate their credentials or outright gloss over unpleasant insights in whatever way they please.
To breed consumer trust, companies may also use third-party organizations to assess them. Companies like Bloomberg, Morningstar, MSCI and the mainstream media have played a role in evaluating major companies.
Investors also use specialized tools to determine how well a company has performed. Morningstar released a platform called Sustainalytics to report company rankings and allow investors to compare companies within the same industry.
Due to the recent emergence of the environmental, social, governance framework, consumers and investors often must piece together different resources to get an accurate picture of how a brand is performing.
Understanding the general criteria of ESG compliance is critical to making an accurate assessment of an organization.
Types of ESG Criteria
What makes someone compliant?
No single list of criteria exists. Several bodies have attempted to develop a basic framework of what constitutes compliance. Here is an example of the criteria put forward by the CFA Institute.
Contrary to popular belief, environmental issues focus not just on reducing your carbon footprint. While most companies have focused on carbon emissions exclusively, businesses must go further to evaluate the impact on the environment resulting from their activities.
The primary environmental issues to consider include:
- Carbon emissions
- Air pollution
- Water pollution
- Energy efficiency
- Waste management
- Water consumption
Not all of the above will apply to every business. However, companies must also consider their environmental impact on an indirect basis.
For example, an eCommerce provider may not be actively involved in deforestation, but its suppliers might.
Social matters concentrate on the impact of a business on local and worldwide communities. Are your activities affecting people positively or negatively?
The CFA Institute includes the following criteria under social issues:
- Community relations
- Customer satisfaction
- Data privacy
- Data protection
- Employee engagement
- Gender and diversity issues
- Human rights
Every business will likely need to consider the majority of these criteria. Comb through your internal processes and look into how your partners also perform.
Finally, consider how your organization is run and by whom. While most governance issues pertain chiefly to larger businesses, such as multinationals, every business can change the way they operate to practice the values of good governance.
The primary governance issues to take into account include:
- Composition of your board
- Audit committee structure
- Corruption levels
- Executive compensation
- Lobbying influence
- Political donations
- Whistleblower management
Compliance with governance issues is relatively simple for more minor companies with smaller teams, but governance issues become far more profound as businesses grow.
Take More Control of Your Business with CBX Software
Now that you understand what ESG is, it’s time to evaluate your business and determine where you need to make changes. Internal management of these criteria is one thing, but you must also delve into relationships with suppliers, distributors and retailers.
Managing relationships throughout your supply chain can be difficult, especially when dealing with overseas manufacturers. Gain more control over your business with CBX Cloud’s supply chain management software.
Our solutions provide end-to-end visibility throughout the entire supply chain. To learn more about how CBX Cloud’s solutions can streamline your operations, schedule your demo today.