ESG Explained: Why It Matters for Business and Investment

Felipe Lemann
Oct 22, 2024
3 min read

What is ESG?

In recent years, the concept of Environmental, Social, and Governance (ESG) has become a central focus in both investment strategies and corporate operations. ESG is a set of criteria used to evaluate a company's impact on society, the environment, and its internal governance practices. This framework helps investors and businesses assess sustainability and ethical behavior, providing a roadmap for long-term success.

Components of ESG:

Environmental: The managing environmental impact component of ESG evaluates how a company interacts with the environment. As time goes on, companies are expected more and more to reduce their ecological footprint, and improve their sustainability efforts. This aspect focuses on a few key concepts such as:

Resource Conservation and Biodiversity Protection: Promoting the sustainable use of natural resources and preserving ecosystems
Carbon Footprint and Greenhouse Gas Emissions: Measuring and reducing emissions that contribute to climate change
Energy Consumption and Efficiency: Evaluating the use of renewable energy and the company's efforts to optimize energy use
Waste Management and Pollution Control: Ensuring proper disposal and reduction of waste, and minimizing pollution

Social: The social sector of ESG focuses on a company's relationships with its employees, customers, suppliers, and the communities in which it operates (Stakeholders). Companies that prioritize social responsibility tend to build stronger organizations. Key areas of focus include:

Labor Practices and Employee Rights: Ensuring fair labor practices, employee well-being, and respect for workers' rights
Diversity and Inclusion Initiatives: Promoting workplace diversity and creating an inclusive environment where all employees can thrive
Community Engagement and Social Impact: Contributing positively to the communities they serve and addressing social issues

Governance: Governance refers to the internal systems and processes by which a company is managed. Strong governance structures ensure accountability, fairness, and transparency, helping businesses navigate risks and encourage ethical conduct. Key factors in governance include:

Accountability Practices and Ethical Conduct: Upholding ethical business practices and maintaining accountability to shareholders and other stakeholders
Transparency in Financial Reporting: Providing clear and accurate financial reports to stakeholders
Accountability Practices and Ethical Conduct: Ensuring ethical business operations and ensuring responsibility toward shareholders and other stakeholders

Where can ESG be used?

Investment Decisions: ESG factors have become critical for investors as they evaluate potential risks and opportunities. Companies with strong ESG practices are often seen as lower-risk investments, as they demonstrate a commitment to sustainability, social responsibility, and ethical governance. Investors increasingly view ESG as a sign of a company's ability to manage long-term risks and take advantage of growth opportunities.

Enhancing Corporate Reputation: For businesses, adopting ESG principles can significantly make their reputation better. Consumers are more likely to support companies that prioritize sustainability, ethical practices, and social responsibility. A strong ESG helps attract customers who value environmental and social awareness, creating a positive brand image.

Regulatory Compliance: As governments globally implement stricter regulations on environmental and social responsibilities, a strong ESG structure becomes essential. Companies that set ESG into their operations are more prepared to meet new regulations, mitigate legal risks, and stay ahead of industry expectations.

How is ESG risk rating different?

What is it? Different from ESG, ESG risk ratings measure how exposed a company is to ESG-related risks and how well it is managing those risks. An example of this is

the shift from fossil fuels to renewable energy, because sources could expose companies to risks in transitioning technologies or changing regulatory landscapes.

Purpose: The focus is to assess the financial impact that ESG-related risks could have on the company itself. This is more about how ESG factors pose risks to the company’s financial performance or operations. The better a company is at managing these risks, the lower its ESG risk rating.

Difference: The key difference is that ESG assesses how a company’s operations impact broader societal and environmental concerns, while ESG risk rating focuses on how well a company is managing the potential financial risks associated with ESG factors.

The Bottomline

In the end, environmental, social, and governance (ESG) criteria are more than just a trend, they offer a clear way for companies to include sustainability in their everyday operations. By following ESG principles, businesses can improve their reputation, attract investors who value social responsibility, and meet regulatory requirements. As ESG continues to shape how companies are run and where people invest, it's clear that focusing on sustainability and ethical behavior is essential for long-term success.