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What is ESG? Definition & Theory

Background

With the emergence of the ‘responsible investment’ movement, this is no longer the case that a business that does not care for its employees, customers, and the planet outperform its competitors, but otherwise, sustainable and responsible one has more chances. The implementation of the ESG strategy can give insight about not only making smarter investment decisions by increasing the company’s financial metrics but also contributing to the community and the world.

Environmental, Social, and Governance (ESG) reporting has gained more popularity among organizations and socially responsible communities. Stakeholders and fund managers believe that firms with high ESG disclosures yield better operating performance, higher returns, and lower firm-specific risk. The quantitative and qualitative disclosures are made available through the annual and Corporate Social Responsibility (CSR) and Global Reporting Initiatives (GRI) reports. Environmental Social Governance (ESG) is a company standard in its investment practice which consists of three concepts or criteria, namely Environmental (Environment), Social (Social), and Governance (Corporate Governance).

ESG considerations is not only about evaluating a company’s goods and services, but also about evaluating its actions, supply chain, and other aspects of business operations. It means ESG disclosure does not only take into account historical data to analyze ESG risks and opportunities, but also its strategy, overall impact in commitment for the future. Some corporations think that ESG increases cost and affect negatively financial performance. Taking ESG issues into consideration in decision-making can be challenging for companies, considering that its effect is mainly seen in the long term.

 

ESG Factors

Environmental Factors

Through their production and output activities, companies can cause negative externalities through pollution and the depletion of natural resources, with associated detrimental impacts on ecosystems, the climate, and human health, among others. Environmental factors comprise measures to protect and minimize the risks to the environment and efforts to conserve resources. Examples include reducing greenhouse gas emissions, complying with government regulations on pollution, and conserving and managing resources through water and waste management and energy-saving practices.

In a sustainable society, there are four conditions for maintaining the health of the natural world: 1) Nature is not being thoroughly exposed to higher concentrations of substances extracted from the Earth, 2) Nature is not being exposed to progressively increasing concentrations of substances produced by society, 3) Nature is not being damaged physically, and 4) people all over the world have all their needs met.

Social Factors

The social scope of ESG investment relates to the positive impacts and opportunities that a company may provide for society as well as the management of any social risks. These factors can apply generally to society, affecting how companies use their corporate influence to benefit society and how society in turn views the company and its reputation. The factors may also apply more specifically to social aspects within a company, such as the relations between the company and its workers and the implementation of safe working practices and standards, with impacts on company values. Social factors include social and policy impact evaluation, health and safety measures, and employee relations.

Social includes human rights, labor standards in the supply chain, exposure to illegal child labor, and more routine issues such as workplace health and safety compliance. Social value also increases if the company is well integrated into its local community and has a ‘social license to operate with consent.

Governance Factors

These are related to the structure and management practices of companies and can be viewed as a commitment to business ethics and proper business conduct. Companies can attract long-term investment by showing their willingness to align with the interests of shareholders and management. Examples of governance factors include transparency measures and corporate governance.

Governance refers to a set of rules or principles defining rights, responsibilities, and expectations between stakeholders in corporate governance. A well-defined corporate governance system can be used to balance or align interests between stakeholders and can serve as a tool to support the company’s long-term strategy.

The result shows that ESG investment is associated with greater profitability (Figure 1.4): ESG firms are, on average, more profitable than non-ESG firms, confirming the growing trends and prospects for ASEAN ESG investment presented in section 2. Second, the adoption of ESG investment and SDG-related strategies is gaining momentum. ASEAN-5 shows a promising trend for ESG investment, while greater efforts are necessary for the rest of the ASEAN Member States. Third, ESG investment varies by industry: ESG firms are mainly in the food, beverage, and tobacco industry; the industrial machinery and materials industry; and the transportation industry, while adoption of ESG investment has been slow in the hotel, restaurant, and leisure industries and the retail and trading industry.

Lastly, ESG investment has been implicitly and unsystematically implemented among ASEAN firms, implying potential for ESG investment growth. The main challenge is that even though ESG factors are found in firms’ sustainability and governance strategies, the firms still face difficulties in fully integrating ESG investment into their core business strategies. Therefore, further efforts should be spent on the explicit and systematic integration of ESG investment.

 

In contrast, Trillium looks for investments meeting the following ESG criteria:

Environment

  • Publishes a carbon or sustainability report
  • Limits harmful pollutants and chemicals
  • Seeks to lower greenhouse gas emissions and CO2 footprint
  • Uses renewable energy sources
  • Reduces waste

Social

  • Operates an ethical supply chains
  • Avoids overseas labor that may have questionable workplace safety or employ child labor
  • Supports LGBTQ+ rights and encourages all forms of diversity
  • Has policies to protect against sexual misconduct
  • Pays fair (living) wages

Governance

  • Embraces diversity on board of directors
  • Embraces corporate transparency
  • Someone other than the CEO is chair of the board
  • Staggers board elections

 

Companies with strong ESG performance have a keen knowledge of the long-term strategic issues in their industries and managers at these companies can manage by long-term goals. Such companies make the necessary long-term decisions to ensure the success of their business over longer time periods to remain sustainable.

Research shows that responsible management of ESG issues creates a business spirit and environment that builds both a company’s integrity within society and the trust of its stakeholder. Therefore, companies that disclose ESG practices in universal media were reported as having reputation gains, thereby increasing investor confidence; efficient use of resources and remain competitive.

Indonesia is among the least active of the ASEAN-6 members on ESG issues. However, it is a hub for Islamic funds, demonstrating the fastgrowing demand for sustainable investment in ASEAN. Indonesia has strong potential gains from increased ESG awareness because the country is highly vulnerable to natural disasters and climate change. Indonesia does, however, face many ESG challenges. Environmental challenges include pollution, environmental degradation, and resource conservation. Social challenges include unemployment, income inequality, health and safety issues, and discrimination. Governance challenges include lack of corporate transparency, risk and volatility, and corruption.

The government has taken steps to improve ESG disclosure by requiring all listed companies to include in their annual reports information on discharging their social and environmental responsibilities. The market regulator also requires such companies to report on their CSR. Several regulations are related to ESG, including laws on labor inspections and occupational safety, regulations that require stateowned enterprises to report on their partnership and community developments, and legislation requiring enterprises to report on their environment-related developments.

An index created by the Indonesia Stock Exchange and KEHATI (an Indonesian biodiversity foundation) scores private companies based on their CSR efforts, to promote and recognize those with a strong focus on sustainable development.

 

Source:

Ayan S. 2021. ESG (Environment, Social, Corporate Governance) Effect On Firm’s Performance. Azerbaijan State Oil And Industry University (ASOIU).

Nemoto N, Morgan PJ. 2020. Environmental, Social, and Governance Investment: Opportunities and Risks for Asia.

Shaikh I. 2022. Environmental, Social, And Governance (ESG) Practice And Firm Performance: An International Evidence. Vilnus Tech, V23: 218-237.

Tarmuji I, Melah R, Habibah NT. 2016. The Impact of Environmental, Social and Governance Practices (ESG) on Economic Performance: Evidence from ESG Score. International Journal of Trade, Economics and Finance: Vol 7 no. 3.

https://www.investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp

 

 

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