ESG and Sustainability

ESG and sustainability were once niche terms known mainly by activist investors, but a recent heightened focus on corporate social and environmental responsibility has thrust them into the mainstream vocabulary. While ESG and sustainability are sometimes used interchangeably, the two terms differ, even while sometimes sharing similar goals. ESG refers to the environmental, social, and governance issues that relate to companies. Environmental sustainability, perhaps the most popular form of sustainability, specifically explores a company’s long-term impact on the environment, though sustainability in general relates to the company’s long term prospects, period. In this article, we will take a closer look at the relationship between ESG and sustainability and explore the roles they play in guiding the actions and decisions of businesses worldwide.

What is ESG?

ESG is an expansive term that incorporates three broad categories of interest for investors and asset managers: environmental issues, social issues, and governance issues. Companies which adopt the framework consider the consequences of their actions on their community, employees, and partners alongside traditional financial considerations. Investors can similarly use a company’s track record on ESG issues to inform their investment decisions.

Environmental issues that companies and investors consider can be greenhouse gas emissions, waste management, reliance on fossil fuels and much more. This pillar of ESG is most closely related to environmental sustainability and is often the reason why the two terms are interchanged. As companies reduce their environmental footprint and switch to renewable energy sources, they can potentially reduce operating costs and set themselves up for long-term success – the Earth will eventually run out of oil, but some energy sources like sunlight and wind are in almost-infinite supply.

Social issues focus on a business’s impact on people - employees, customers, and the community. Some factors ESG-minded investors and companies consider are workplace safety, diversity, customer satisfaction, etc.

Governance issues are focused on a company’s leadership and structure. Factors of this criterion include executive compensation, board structure, and corporate policies among others.

Explaining Sustainability

Sustainability is a catch-all term that encompasses the entirety of a company’s efforts to create long-term stakeholder value though a business system capable of running indefinitely. It can apply to any beneficial change a company makes to enable it to operate for a long time without causing problems that will come back to haunt it later. Naturally, this precludes companies that destroy the planet that they live on. The term sustainability is often used as shorthand for environmental sustainability, in relation to “green” environmental reforms.

How Sustainability and ESG Differ

Explaining the difference between ESG and sustainability can be a challenge - even for the government. A recent rule proposal from the SEC concerning enhanced disclosure requirements for ESG funds declines to define ESG or any related term. While the two terms can seem nebulous in meaning and even at times appearing to overlap, the two terms can be distinguished by their end goals. A sustainable business cares about being able to operate for as long as possible, preferably forever, which means they cannot contribute to the destruction of their own environment. However, an ESG-centric company cares about its relationship with specific environmental, social, and governance issues. For instance, a clothing company may be considered an environmental sustainability success for having the most energy-efficient office in New York, even if it is underpaying its employees and subjecting them to a hostile work environment. Meanwhile using an ESG lens would place more emphasis on the company’s social shortcomings.

Another key difference between ESG and sustainability are the standards and metrics used. These frameworks are often based on standards set by lawmakers, investors, and reporting organizations such as the Task Force on Climate-Related Financial Disclosures. There are many ESG standards and reporting metrics that seem to provide conflicting scores, as ESG frameworks attempt to measure hard-to-quantify and compare variables such as employee satisfaction and board management decision success. Meanwhile, environmental sustainability standards, which can also be set by independent organizations such as the Greenhouse Gas Protocol, tend to focus on more quantitative metrics such as tons of carbon emitted.

A Difference Without a Distinction?

Part of the reason why sustainability and ESG are used interchangeably may be due to these terms trying to achieve the same goals through different means. Both terms seem to aim to incentivize businesses to be more socially conscious of their decisions and actions, with ESG and sustainability appearing to be closely intertwined on this score. We’ve discussed how sustainability plays a huge role in the environmental pillar of ESG. Now let’s go back to our previous example of the energy-efficient sweat shop. Even though their office might be carbon-neutral or even carbon-negative, can a business achieve long-term success if no one wants to work for it? Similarly, a business that treats its customers and employees well while running afoul of environmental regulations cannot be considered sustainable, as the government could fine or force it to cease operations.

From Sustainability to ESG

The modern sustainability movement in the United States, which gained ground between the late 19th and early 20th centuries, predates the newer ESG concept. Conservationists like Theodore Roosevelt and John Muir helped establish and design over 100 national forests, 50 federal bird reserves, and 5 national parks, which created strong connections between sustainability and the environment in the modern era. Conservationists, renewable resource champions, and even the corporate responsibility movement all united under the umbrella of sustainability well into the 21st century. However, in 2004, the UN partnered with major financial institutions to create a framework for integrating environmental, social and governance value into business practices and asset management. The resulting Who Cares Wins report in 2005 marked the first use of the phrase ESG and helped launch dialogues regarding the sometimes tense relationship between companies and their surrounding communities as opposed to simply commending companies for making environmental reforms that served their best interests. Time has molded the ESG framework into a broader indication of a company’s social performance and environmental footprint in a way that goes above and beyond environmental sustainability.

ESG Controversy

One critique of ESG and its various reporting standards and mandates is that they can lead to different pictures of the same company’s impact on humanity. There are also complaints about greenwashing and concerns that some ESG portfolios do not provide a truly ethical or sustainable option for investors. Additionally, some direct and indirect measures can be hard to quantify or measure. How responsible is a company for the carbon emitted by the fossil fuel trucks its third-party delivery service chooses to use? That delivery service could potentially produce a set of ESG metrics that portray its environmental impact in a more forgiving light.

Some progress has been made on this front. EU regulators have made it easier to evaluate corporate sustainability with the Corporate Sustainability Reporting Directive (CSRD) and to evaluate ESG advisors and issuers with the Sustainable Finance Disclosures Regulation (SFDR). Both regulations aim to improve transparency and reporting on ESG criteria. The SEC appears to have a similar goal with its proposal on enhanced disclosures for ESG funds and advisors. The United Nations launched its six Principles for Responsible Investment in 2006 as a framework for incorporating sustainability factors into investment decision-making. As of March 2021, over 3,800 signatories use the pillars of the UNPRI to guide business decisions towards creating better economic and environmental conditions for humankind.

Conclusion

ESG and sustainability remain important strategic considerations for all types of businesses globally. ESG’s holistic framework can provide a broader indication of a company’s total positive and negative ESG characteristics while an environmentally sustainable company would likely score high on the “E” pillar of ESG. Quantifying progress in all of these areas can help businesses thrive in the face of environmental and social challenges and enable them to make improvements that attract potential employees, investors, and customers. As the world transitions to more uniform regulation and reporting standards, investors and businesses could become more empowered to make the decisions needed to build a sustainable society.

Published July 15, 2022

References

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About the Author

Jesse Opoku joins the Humankind team from an expert network, where he first developed an interest in Business Operations. Jesse holds a B.A. in Global Affairs from Yale University. Jesse is an avid birdwatcher, with vultures being his favorite species.