ESG (environmental, social and governance) is a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies.

ESG factors are a subset of non financial performance indicators that includes sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability.

Examples

The European Federation of Financial Analysts Societies (EFFAS) has defined topical areas for the reporting of ESG issues, and developed Key Performance Indicators (KPIs) for use in financial analysis of corporate performance. EFFAS has identified nine topical areas that apply to all sectors and industries:

1) Energy efficiency;

2) Greenhouse gas (GHG) emissions;

3) Staff turnover;

4) Training & qualification;

5) Maturity of workforce;

6) Absenteeism rate;

7) Litigation risks;

8) Corruption;

9) Revenues from new products.

Next to these nine areas sector-specific ESGs and KPIs (key performance indicators) have also been defined. [1]

ESG has quickly become part of investment jargon to describe the performance of investment and fund portfolios on environmental, social and governance criteria and the quality of their performance against measurable ESG factors that are reported to shareholders. ESG analysis can provide insight into the long-term prospects of companies which allows mispricing opportunities to be identified. Investors can find new market opportunities with companies that place the management of ESG factors at the core of the business.

Company-specific ESG factors offer a benchmark for investors to judge the overall quality of the board’s governance and risk management processes and their positioning within an industry sector. The UN-backed Principles for Responsible Investment (PRI) provides a voluntary ESG framework for companies and funds, from which investors can make informed investment decisions that relate to sustainability and governance practices.

The growing interest in ESG factors by institutional investors, in particular, reflects the view that environmental, social and corporate governance issues can affect the performance of investment portfolios and should therefore be given appropriate consideration by investors. As of March 2011, 882 asset owners and asset managers, representing combined assets of more than $22 trillion, had committed themselves to the six principles of the PRI.

Fund managers and financial analysts who can interpret and relate ESG factors to a company’s future prospects may potentially develop a competitive advantage should others fail to recognise the same risks or opportunities related to those factors.

Example
The Association of British Insurers, in its guidelines to institutional investors, expects that a company’s annual report should include information on ESG-related risks and opportunities that may significantly affect the company’s short and long term value, and how such risks and opportunities might impact on the future of the business. The annual report should also set out how the board fulfils its responsibilities for ESG policies, procedures and verification. [2]