What is 'Environmental, Social and Governance (ESG) Criteria'

Environmental, Social and Governance (ESG) Criteria is a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria look at how a company performs as a steward of the natural environment. Social criteria examine how a company manages relationships with its employees, suppliers, customers and the communities where it operates. Governance deals with a company’s leadership, executive pay, auditsinternal controls and shareholder rights.

BREAKING DOWN 'Environmental, Social and Governance (ESG) Criteria'

Environmental, social and corporate governance (ESG) criteria refer to three main factors investors consider with regards to a firm's ethical impact and sustainable practices. The criteria are used in ESG investing, also sometimes referred to as sustainable, responsible and impact investing or socially responsible investing. Examples of ESG criteria used by investors include determining a company's impact on climate change or carbon emissions, water use or conservation efforts, anti-corruption policies, board diversity, human rights efforts and community development.

Investors who want to purchase securities that have been screened for ESG criteria can do so through socially responsible mutual funds and exchange-traded funds. According to the US SIF Foundation, the value of ESG funds totaled more than $2.5 trillion by the end of 2016, while U.S. investments in companies that actively pursue responsible, sustainable growth accounted for about $8.7 trillion in assets under management (AUM) at the end of 2015. 

Determining ESG Standards

What constitutes an acceptable set of ESG criteria is subjective, so investors will need to do the research to find investments that match their own values. Apart from the ethical component, ESG standards are developed to help investors avoid firms at risk of suffering tangible losses as a result of their ESG practices — as evidenced by BP's 2010 oil spill and Volkswagen's 2015 emissions scandal, both of which rocked the firms' stock prices and resulted in billions of dollars in associated losses.

Environmental criteria look at a company’s energy use, waste, pollution, natural resource conservation and animal treatment. They also evaluate which environmental risks might affect a company’s income and how the company is managing those risks. For example, a company might face environmental risks related to its ownership of contaminated land, its disposal of hazardous waste, its management of toxic emissions or its compliance with the government’s environmental regulations.

Social criteria look at the company’s business relationships. Does it work with suppliers that hold the same values that the company claims to hold? Does the company donate a percentage of its profits to the community or perform volunteer work? Do the company’s working conditions show a high regard for its employees’ health and safety? Are stakeholders’ interests taken into consideration?

With regard to governance, investors want to know that a company uses accurate and transparent accounting methods, and they want to see that common stockholders are allowed to vote on important issues. They also want companies to avoid conflicts of interest in their choice of board members. Finally, they prefer not to invest in companies that engage in illegal behavior or use political contributions to obtain favorable treatment.

Examples of Firms' ESG Criteria

As ESG-minded business practices gain more traction, firms are increasingly tracking their ESG progress. Financial services companies such as JPMorgan Chase, Wells Fargo and Goldman Sachs have published annual reports that extensively review their ESG approaches. Such efforts often include prohibition of certain types of transactions, portfolio reviews to gain an understanding of ESG risk exposure and engaging clients to help with potential improvements.

US SIF found that by the end of 2016, there were more than 1,000 funds incorporating ESG criteria into their investment decisions. Boston-based Trillium Asset Management, with more than $2.5 billion in AUM, integrates ESG factors to help identify companies positioned for strong long-term performance. Trillium's ESG criteria, determined in part by analysts who identify issues facing sectors and industries, include avoiding investments in firms with known exposure to coal mining and in firms with greater than 5% of revenues from nuclear power or weapons. The firm also says it avoids investing in firms with major recent or ongoing controversies related to workplace discrimination, corporate governance and animal welfare, among others.

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