What is ESG?

Environmental, Social, and Governance—aka, “ESG”—has quite possibly been the fastest growing economic concept our country has seen in decades. ESG issues have taken corporate governance by storm. What started out as factors to assess companies’ sustainable and societal impact has grown into a broader set of factors used to evaluate a company’s long-term economic success.

Traditionally, the concept’s three letters, E, S, and G, subdivide various issues depending on perspective.

• The “E” generally focuses on environmental issues such as climate change, sustainability, and pollution.
• The “S” generally focuses on social issues such as workforce development, diversity, and community impact.
• The “G” generally focuses on governance issues such as executive compensation, board diversity, and corporate culture.

Traditionally, while many of these issues were seen to relate in some way to corporate performance, they were not incorporated into a company’s financial metrics. This is because they did not meet the test for what information is considered financially material and relevant to a reasonable investor. That is the current standard for materiality, with boards of companies given the discretion—based on their intimate knowledge of a company—to determine what information is or is not material.

The materiality standard was set by the U.S. Supreme Court to help determine the balance between how much information is enough for investors and how much is overwhelming. Companies are not required to disclose information merely because investors or the general public want it. Rather, they must disclose those things that are financially material to the well-being of the company.

ESG shifts the debate over materiality. Previously, as noted, the question was about how much material economic information should be disclosed. Now, new questions have been raised about inclusion of traditionally non-economic factors in the materiality analysis. In many cases, too, those non-economic factors are judged by qualitative measures, adding another layer of debate.

With ESG gaining more attention and prominence, disclosure becomes central to evaluating companies—and central to the issues that policymakers will find themselves addressing. This is to say nothing about the added complexity when considering various global regulating agencies and associated geopolitical issues involved in assessing ESG.

Once a piece of information is considered material and therefore should be disclosed, the next step is determining how it will be disclosed. Unlike traditional quantitative economic data, the qualitative nature of ESG data becomes more difficult to disclose in a comparable format. As a result, several organizations have developed disclosure frameworks to help with this process, and the SEC is currently looking into mandating certain types of disclosure.

For instance, climate change has been seen as a societal and public policy issue. However, many argue that a company’s risks associated with climate change should be disclosed as financially material. There are others that claim these types of risks must already be disclosed under existing law. Given the sheer number of disclosure frameworks, it appears that the SEC is moving toward, at a minimum, some type of benchmark. Benchmarking would certainly give companies the flexibility to determine materiality and provide the needed comparability aspect of the data disclosed.

Once ESG information is publicly disclosed, the question becomes how the information will be used. While the information has historically been used for investment purposes, because it involves more than just pecuniary issues, it may well be used more broadly to assess companies’ political and social impact on communities, the nation as whole, and toward global issues.

While most investment companies have internal support to review the disclosed information, other investment companies rely on ratings companies to review the disclosure and rank individual companies on a set of their own criteria. This initially led to issues of inconsistency on, for example, metrics and data determining the criteria. As the quality of data has improved to include that which is materially financially relevant, the ratings have begun to be more consistent. There are a variety of different types of investors who use this information, from those wanting to have a societal impact, to those who want to affect the environment, to those who want only to maximize their investment returns. Whatever the interest, ESG information will help guide their investment decisions.