What is “ESG” and what does it mean for us consumers?
By: Shahab Ahanchin
Shahab Ahanchin, a third-year Osgoode Hall Law student, is passionate about consumer rights advocacy. Starting this summer in 2024, Shahab is thrilled to begin his articles at Osler, Hoskin, and Harcourt.
The following are key questions consumers should be informed of regarding ESG.
1. Does the “G” in ESG have an important role to play to get companies to engage in ESG?
In today’s business landscape, the Environmental, Social, and Governance (ESG) framework has evolved into an important tool for assessing a company’s sustainability practices and has become a consideration for many consumers in choosing which businesses to support.[1] The role of the “G,” representing corporate governance, emerges as particularly influential in pushing companies towards active participation in ESG initiatives. Corporate governance concerns the rules, processes, and structures that guide a company’s direction and control such that its impact on ESG is multi-faceted.
First, corporate governance promotes ethical leadership and decision-making. Companies with strong governance structures are more likely to prioritize ethical considerations and values, setting the stage for a corporate culture that embraces sustainability. This ethical leadership, in turn, allows for a long-term perspective that resonates with sustainable business practices. Subsequently, this ethical corporate culture boosts firm value and profitability.[2]
Second, governance structures play an important role in risk management. Effective governance is a foundational aspect of a successful business: it supports management in implementing strategy, managing costs, attracting investment, and ultimately, responding to risk.[3] By having robust governance, companies can ensure that risks are not only identified but also proactively addressed.
Third, the “G” underscores the importance of stakeholder engagement. Corporate governance principles demand a holistic approach that involves balancing the interests of various stakeholders, including investors, employees, and the wider community.[4] This engagement allows companies obtain insights into ESG concerns and expectations.
Finally, transparency and accountability, cornerstones of corporate governance, further promote the impact of the “G” on ESG. Companies adhering to strong governance principles are more likely to disclose relevant ESG information to the public.[5] This transparent reporting allows stakeholders to better evaluate a company’s ESG performance. In turn, this establishes trust and confidence in a company’s commitment to sustainable practices.
Q2. Does ESG result in tangibly better ROI and profitability for companies and investors?
Return on investment or ROI is an approximate measure of profitability.[6] The relationship between ESG practices and ROI is and remains an evolving area. While the impact of ESG factors on financial performance varies across industries and over time, evidence suggests a positive correlation between strong ESG performance and profitability.[7] In fact, studies indicate that “ESG leaders earned an average annual return of 12.9% compared to an average 8.6% earned by laggard companies.”[8] This represents about a 50% premium in profitability in terms of relative performance by top-rated ESG companies.
Particularly, companies with strong ESG practices often demonstrate better risk management, addressing environmental and social risks to mitigate potential financial losses from regulatory fines, legal disputes, or reputational damage. Among other advantages, ESG initiatives can effectively help combat rising operating expenses (such as raw-material costs). According to a McKinsey research, costs can be reduced by as much as a staggering 60%![9] Subsequently, this positively contributes to a company’s bottom line.
Further, companies with strong ESG performance may enjoy a productivity uplift. Research has cited that a commitment to ESG values attracts and retains top talent. It enhances employee motivation by instilling a sense of purpose, contributing to higher productivity and innovation. This higher productivity leads to happier and more engaged employees, thus promoting a company’s profitability. Nevertheless, it is important to acknowledge that the impact of ESG on financial performance is not universally guaranteed, and only represents a correlation (not causation). Indeed, ESG’s effectiveness on ROI can depend on various factors, including industry dynamics and regional differences.
Q3. Do ESG-compliant companies get more consumer support and sales versus non or less-compliant companies?
The influence of ESG compliance on consumer support and sales is becoming increasingly evident, with an influential impact on consumer behaviour. As societal awareness of environmental and social issues rises, consumers are displaying a heightened interest in the ethical and sustainable practices of the companies they choose to support. ESG-compliant companies, which actively demonstrate a commitment to environmental, social, and ethical responsibility, stand to benefit from the changing consumer landscape. The positive correlation between ESG practices and consumer behaviour is underpinned by factors such as enhanced brand reputation and trust.
Moreover, ESG compliance provides companies with a competitive advantage, particularly in industries where consumers have various options. By differentiating themselves through sustainable and responsible practices, companies can attract consumers who prioritize aligning their values with their purchasing decisions. The influence of ESG is particularly pronounced among younger demographics, such as Millennials and Gen Z, who are more attuned to sustainability and ethical considerations. Studies indicate that these generations are more likely to support and purchase from companies that actively pursue ESG principles.[10] This suggests that ESG compliance may be a key factor in capturing the loyalty of these consumer segments.
One notable example is the outdoor apparel company Patagonia, renowned for its strong commitment to environmental responsibility. Patagonia’s emphasis on eco-friendly materials, fair labour practices, and environmental activism resonates with consumers who prioritize sustainability.[11] The company’s transparency about its supply chain and environmental initiatives not only enhances its brand reputation but also attracts a loyal customer base that values these ESG considerations in their purchasing decisions and brand support.
In the technology sector, Apple provides a compelling illustration of how ESG practices can influence consumer behaviour.[12] Apple has made significant strides in environmental responsibility, committing to using 100% renewable energy in its operations.[13] This commitment aligns with the preferences of environmentally conscious consumers, contributing to Apple’s positive brand image and promoting purchasing decisions.
However, it is important to acknowledge that the impact of ESG on consumer behaviour remains complex. It does not demonstrate a causal relationship that definitively indicates whether consumers bought these brands because of ESG-related claims or for other reasons.[14] Further, while a growing number of consumers prioritize companies with strong ESG credentials, others may still prioritize factors such as price or product quality.
Q4. Do ESG Indexes help produce accountability and results by companies? Do companies that score high on ESG indexes generate higher returns?
ESG indexes serve as critical tools in promoting corporate accountability by establishing benchmarks for sustainable business practices. These indexes, through their inclusion criteria, incentivize companies to focus on improving their ESG performance. Inclusion in prominent ESG indexes not only signifies compliance with specific sustainability standards but also subjects companies to increased scrutiny from socially responsible investors. This scrutiny acts as a catalyst for companies to enhance their ESG practices – reinforcing the commitment to environmental stewardship, social responsibility, and ethical governance.
The relationship between ESG indexes and higher returns has become a subject of considerable interest and research. Generally, studies have suggested a positive correlation between strong ESG performance and financial success. Consequently, companies prioritizing sustainability often experience improved operational efficiency, reduced risks, and enhanced long-term financial performance. For example, research has found that funds promoting ESG, known as ESG funds, feature lower portfolio volatility and improved risk-adjusted returns.[15]
Furthermore, companies with high ESG scores may attract a broader investor base, including those who prioritize sustainable investments, thereby positively influencing stock prices and overall returns. ESG practices, encompassing environmental, social, and governance dimensions, are often associated with long-term value creation. In turn, this positions companies to navigate future challenges and capitalize on emerging opportunities.
However, despite the benefits of ESG indexes, complexities can arise. Establishing causation between ESG performance and financial outcomes is challenging, and other factors beyond ESG considerations can significantly impact a company’s financial success.
Q5. What makes up the criteria for ESG indexes like Blackrock and Morningstar?
ESG indexes, such as those developed by BlackRock and Morningstar, use specific criteria to assess and select companies based on their environmental, social, and governance performance. These criteria encompass a comprehensive evaluation of a company’s practices across the ESG spectrum.
Blackrock:
In the environmental dimension, factors such as climate risks, natural resource scarcity, pollution and waste, and environmental opportunities are considered. Social criteria include labour issues and product liability, risks such as data security, and stakeholder opposition. On the governance side, criteria relating to corporate governance and behaviour such as board quality and effectiveness are examined.[16]
As for the criteria for inclusion in BlackRock’s ESG indexes, it often involves assessing companies based on MSCI ESG Research. This involves ranking companies according to their ESG scores and those with higher scores are likely to be included in the index. Rankings start from AAA (denoting ESG-leader companies) to CCC (for laggard companies).[17] The specific criteria may vary depending on the index in question, as BlackRock offers a range of ESG-focused products covering various regions and sectors.
Morningstar:
Morningstar is known for its extensive fund and investment research, and it has developed its own sustainability ratings to assess mutual funds and ETFs based on ESG factors. Morningstar’s sustainability ratings consider a fund’s portfolio holdings and evaluate them in terms of environmental, social, and governance criteria.
For example, Morningstar’s Sustainability Rating is expressed using a five-globe system indicating whether the fund is at the bottom end of the rating for its industry group (one globe), below average (two globes), average (three globes), above average (four globes) or at the high end (five globes). A higher number of globes indicates that the portfolio has a lower ESG Risk.[18]
Q6. Should governments implement a mandatory, publicly available, transparent ESG index? In other words, is there a business case to support the public policy argument of governments encouraging corporate participation in ESG indexes?
The consideration of whether governments should implement a mandatory, publicly available, transparent ESG index involves an evaluation of potential benefits and challenges. On the benefits side, such a measure could be a powerful tool to incentivize companies to adopt and enhance their ESG practices by making their performance publicly accessible and comparable. This could contribute to market standardization, providing stakeholders with a standardized framework for evaluating companies on ESG criteria. Investors, consumers, and other stakeholders could generally benefit from increased transparency. This leads to more informed decision-making and market integrity. In turn, this can mitigate information asymmetry, allowing investors and stakeholders to make more informed decisions.
Additionally, a government-backed ESG index may allow for investor confidence in the reliability of ESG data. Consequently, this would attract socially responsible investments and give companies listed on the index a competitive advantage. Furthermore, the notion that companies excelling in ESG performance can build stakeholder confidence and enhance their corporate reputation adds weight to the business case. Despite these potential benefits, careful design of such an index is necessary to avoid regulatory burdens, address standardization challenges, and ensure the accuracy of reported ESG data. Achieving the right balance between promoting ESG practices and mitigating unintended consequences is essential for making the business case compelling.
However, before implementing such a government-ESG index, several concerns must be carefully addressed. Establishing a universally accepted set of ESG criteria applicable across all industries poses a significant challenge due to the diversity of sectors and establishing a common set of standards. The potential implementation costs associated with mandatory ESG reporting and index participation may be a concern, especially for smaller businesses. Ensuring the accuracy and reliability of ESG data is also important in preventing greenwashing or manipulation. Moreover, finding the right balance between promoting ESG practices and avoiding excessive regulatory burdens is critical. Finally, corporate support of a government-based ESG index requires public backing and an underlying sustainability and economic rationale for adoption by businesses.
References
[1] Henisz, W., Koller, T., & Nuttall, R. (2019). Five ways that ESG creates value . McKinsey Quarterly. https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights
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[2] Ethics Pays – Ethical Systems. (n.d.). https://www.ethicalsystems.org/ethics-pays/
[3] Deloitte. Governance in focus. deloitte.com/content/dam/Deloitte/uk/Documents/audit/deloitte-uk-governance-in-focus-risk-management.pdf
[4] Chen, J. (2023, March 22). Corporate Governance. Investopedia. https://www.investopedia.com/terms/c/corporategovernance.asp
[5] Wessel, R. (2023, July 12). Enhancing transparency and accountability: The importance of ESG reporting. GRESB. https://www.gresb.com/nl-en/enhancing-transparency-and-accountability-the-importance-of-esg-reporting/
[6] Beattie, A. (2022, August 11). How to Calculate Return on Investment (ROI). Investopedia. https://www.investopedia.com/articles/basics/10/guide-to-calculating-roi.asp#:~:text=Return%20on%20investment%20(ROI)%20is%20an%20approximate%20measure%20of%20an
[7] Whelan, T., Atz, U., Holt, T., & Clark, C. (2021). ESG AND FINANCIAL PERFORMANCE: Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies. https://www.stern.nyu.edu/sites/default/files/assets/documents/NYU-RAM_ESG-Paper_2021%20Rev_0.pdf
[8] Sustainable Brands Staff. (2023, September 13). Study Shows Stronger ROI for Companies with High ESG Ratings. Sustainable Brands. https://sustainablebrands.com/read/finance-investment/stronger-roi-companies-high-esg-ratings
[9] Henisz, W., Koller, T., & Nuttall, R. (2019). Five ways that ESG creates value . McKinsey Quarterly. https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Five%20ways%20that%20ESG%20creates%20value/Five-ways-that-ESG-creates-value.ashx
[10] Gurchiek, K. (2023, March 21). Survey: ESG Strategies Rank High with Gen Z, Millennials. www.shrm.org. https://www.shrm.org/topics-tools/news/survey-esg-strategies-rank-high-gen-z-millennials#:~:text=ESG%20initiatives%20are%20considered%20important
[11] Alonso, T. (2023, February 9). Strategy Study: How Patagonia Became The Benchmark In Sustainable Clothing. www.cascade.app. https://www.cascade.app/studies/patagonia-strategy-study
[12] Apple. (2022). Apple – Environment Social Governance. Investor.apple.com. https://investor.apple.com/esg/default.aspx
[13] Apple. (2022). Environmental Progress Report. https://www.apple.com/environment/pdf/Apple_Environmental_Progress_Report_2022.pdf
[14] McKinsey. (2023, February 6). Consumers Care about Sustainability—and Back It up with Their Wallets. Mckinsey & Company. https://www.mckinsey.com/industries/consumer-packaged-goods/our-insights/consumers-care-about-sustainability-and-back-it-up-with-their-wallets
[15] BMO Global Asset Management. (2023, May 22). Why ESG and Index Investing are a Perfect Match. https://www.bmogam.com/ca-en/advisors/insights/the-rise-of-esg-and-index-investing/#:~:text=There%20is%20an%20increasing%20body
[16] ESG integration – Sustainable investing – Themes. (n.d.). BlackRock. https://www.blackrock.com/lu/intermediaries/themes/sustainable-investing/esg-integration
[17] ESG Methodology – Sustainable Investing & MSCI ESG Ratings. (n.d.). BlackRock. https://www.blackrock.com/us/financial-professionals/tools/esg-360-methodology
[18] Morningstar. (2021). Morningstar Sustainability Rating Methodology. https://www.morningstar.com/content/dam/marketing/shared/research/methodology/744156_Morningstar_Sustainability_Rating_for_Funds_Methodology.pdf
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