Overview of ESG Criteria: Challenges & Opportunities
WHAT DOES ESG MEAN?
ESG criteria bring together all environmental, social, and governance considerations. It is a character, a notion related to one of these three components: environment, social, and governance. Each of these three categories of criteria has its distinct parameters.
The environmental criterion concerns everything related to natural resources, greenhouse gas emissions, biodiversity, or climate change. In short, it concerns the environment, from a scientific point of view, fauna and flora, climate, and energy. It is the “green” footprint of ESG criteria.
The social criterion takes on a human dimension, referring to the population as a whole: employees, customers, and the community. In short, it's all about human society and the challenges it faces to evolve in a sustainable way. These challenges include gender equality, well-being, diversity, inclusion, and working conditions.
The governance criterion concerns how a company directs and controls. In short, it is the process by which an entity makes decisions to meet the needs of its stakeholders or to demonstrate compliance with the law. The latter covers all aspects of a company’s transparency and accountability, the independence of its board of directors, its business ethics, its fight against corruption, and the rights of its shareholders.
Brief background: Under France’s 2015 Energy Transition law (Article 173), companies and institutional investors are required to disclose information on how they integrate ESG criteria into their investments.
WHAT ROLES DO ESG CRITERIA PLAY?
Today, ESG criteria are becoming increasingly important for investors. They enable them to choose investments aligned with their values and sustainable objectives. While financial aspects have always been at the heart of analysis, extra-financial analysis is gaining importance as the challenges of global warming and new regulations take center stage.
There are many reasons why investors want to take a more significant account of ESG criteria:
To direct their capital towards activities that respond to global challenges;
To generate long-term value since sustainable practices are more able to withstand the risks and changes of an economy in transition;
Exert influence to encourage better practices;
Achieve better sustainability performance from their portfolios;
Benefit from innovation influenced by sustainability concepts.
HOW TO ANALYZE ESG CRITERIA?
An ESG criterion has a score that can be calculated: the ESG score. It is a quantitative measure of a company’s sustainability performance.
There are several ESG rating agencies, such as Sustainalytics and Refinitiv. Each applies its methodology, which includes data on all three pillars − environment, social, and governance − and bases its results on public reports or company surveys.
A good ESG rating sends out clear signals: the company is doing its best to manage the risks and opportunities associated with the three criteria. It also suggests that it is demonstrating long-term resilience and responsible corporate governance.
Therefore, an investor can use his ESG scores in his decision-making. A poor score would signal “beware of potential risks.” A good score would signal a company that is permanent in terms of sustainability. It means “better risk management,” hence a greater likelihood of long-term success.
OPPORTUNITIES
Adopting and improving ESG criteria can open a wide range of opportunities for a company.
These include:
Enhanced reputation and credibility: a company with a good ESG approach will be better perceived by investors, along with consumers, and talents;
Attract institutional and individual investors with important ESG objectives: improves access to financing and capital;
Better risk management due to changes in regulations, markets, and disasters linked to climate change;
Aligning with new regulations: companies will increasingly be required to report on their ESG performance, as is the case with the Corporate Sustainability Reporting Directive (CSRD) in Europe;
More subtly, ESG criteria integration reinforces thinking about innovative products and services that may have a long-term financial interest;
Improve corporate performance through better control of energy consumption and resource management;
Retaining stakeholder commitment: employees, customers, investors, and the community are increasingly aware of sustainability issues and will be more inclined to associate with a company that shares the same concerns.
CHALLENGES
The challenges of ESG criteria differ according to the size of the company (SME or large corporation). From a global perspective, here are the main ones:
ESG standards are not yet uniform: benchmarking ESG criteria can still be very tough due to the large number of ESG standards and frameworks, making harmonization sometimes wearisome. The CSRD should enable greater harmonization over time in Europe;
Data quality: can be compromised by different, incomplete, or inconsistent sources, making the sustainability performance assessment unreliable;
Greenwashing: ESG criteria can be used as a marketing tool, giving the impression of a strong commitment without convincing results or actions;
Quantifying ESG impact: practices and efforts in terms of ESG criteria do not always make it possible to assess the tangible outcomes of these efforts;
ESG ratings from different rating agencies can vary significantly due to the contrasting methodologies used by each of them making analysis very complex for the investor.
