What Are Environmental, Social, and Governance (ESG) Criteria?

Environmental, social, and governance (ESG) criteria create a framework for helping investors who want to incorporate personal values into their investment approach. The ESG screening process identifies companies that have built sound environmental practices, strong social responsibility tenets, and ethical governance initiatives into their corporate policies and everyday operations.

If you're interested in aligning your investments with your values, take a closer look at ESG criteria—how to find it, how ESG compares to other types of socially conscious investing, and whether ESG investing impacts performance.

What Are Environmental, Social, and Governance Criteria?

ESG criteria allow investors insight into a company’s adherence (or lack of adherence) to ethical practices. The three components are defined in the following ways:

Environmental: A company’s impact on the environment and its ability to mitigate various risks that could harm the environment. This may include a company’s carbon footprint as well as its record regarding energy efficiency, waste management, conservation of water and other natural resources, and treatment of animals.

Social factors: Assesses a company’s relationships with other businesses, its standing in the local community, its commitment to diversity and inclusion among its workforce and board of directors, its charitable contributions, and whether it is noted for employee policies that foster health and safety.

Corporate governance: Assesses a company’s internal processes, such as transparent accounting methods, executive compensation, and board composition, as well as its relationships with employees and stakeholders. It may also include internal regulations designed to prevent conflicts of interest and unethical behavior.

How ESG Works

Many companies measure their own performances regarding ESG metrics and tout those performances in annual reports and other documents. ESG performance for individual companies is also measured and reported by third-party providers such as Morningstar, Bloomberg, and MSCI, as well as the media.

Investors can research companies to find out how they score in terms of ESG criteria by using websites such as Sustainalytics, a division of Morningstar, which reports companies’ ESG rank and compares it to other companies in that industry.

You can also search online by company name and “ESG report.” Keep in mind, however, that companies often report on themselves, so third-party validation is recommended.

The Emergence of ESG

According to Commonfund Institute, an asset management firm that serves nonprofits and public pensions, responsible investing dates as far back as Colonial times when some religious groups refused to invest their endowment funds in the slave trade.

However, socially responsible investing (SRI) didn’t emerge until the middle of the 20th century. It was driven in the 1960s by opposition to the Vietnam War and by the civil rights movement, and in the 1970s, by an increase in environmental awareness and broad opposition to apartheid in South Africa.

As interest in values-based investing grew, models for evaluating it transformed. The emergence of ESG criteria over the past two decades flipped the concept of socially conscious investing from one of excluding companies to a process of including companies that rank high on ESG criteria.

According to George Padula, principal, and chief investment officer at Modura Wealth Management, LLC, “People decided they’d rather include companies that have certain aspects—good governance, inclusion, and diversity, and environmental qualities—rather than simply exclude the so-called ‘sin stocks’ [tobacco, firearms, gambling, and alcohol].”

Types of ESG Criteria

ESG issues can be difficult to classify neatly, but the CFA Institute has effectively broken them down as follows:

Other Terms for and Alternatives to Environmental, Social, and Governance Criteria (ESG)

An increasing number of people are seeking to match their investment approach with their values, and different terms are used for doing this. Common terms that intersect and overlap with ESG criteria are as follows:

• Corporate social responsibility investing (CSR): CSR typically refers to the exclusion of “sin stocks.”
• Socially responsible investing (SRI): Interchangeable with CSR.
• Sustainable investing: Interchangeable with ESG, or it can be specific to environmental practices.
• Values-based investing: A broad term that could be inclusive of any of these others.
• Impact investing: Investing in companies in order to effect specific mission-related social or environmental change.

ESG vs. CSR

CSR and SRI are considered by many to be interchangeable terms that refer to more nebulous and volunteer measurements and reporting of corporate practices that have a positive environmental and social impact. ESG investing is tied more closely to an inclusive approach that assesses companies by their positive actions across environmental, social, and governance criteria via more quantifiable metrics.

Also, measuring CSR is an internal function, while ESG is an external one. That is, CSR programs are internally proposed and executed. It’s up to those within the company to measure the success of CSR programs, decide which ones to continue, and rework the ones that aren’t achieving the desired results.

ESG, on the other hand, is a measurement that outside analysts can use to objectively compare the effectiveness of ESG across companies.

Performance of ESG Investing

One of the most common concerns about following sustainable investing guidelines is whether it produces returns that trail broader market indexes or comparable investments. But according to a 2019 Morningstar study, “41 of the 56 Morningstar’s ESG indexes outperformed their non-ESG equivalents (73%) since inception.”

Padula adds that “with the growth of ESG ETFs and index funds, the expense ratio has come way down while the [number of options] has gone way up. The returns are competitive with every asset class they follow and some have done better.”