Author: Urtė Karklienė, Sustainability Manager at Oxylabs

Environmental, social, and governance (ESG) term was first mentioned in a 2004 report by United Nations – Who Cares Wins. Their report was an outcome of a collaborative effort to improve asset management, securities brokerage services, and related research operations with respect to environmental, social, and corporate governance concerns.

ESG movement has come a long way since the Who Cares Wins report – the field of ESG investing has expanded to encompass financial materiality, ethical considerations, and alignment with values. What in 2004 was just a presumption, now, according to a McKinsey report, establishing a strong ESG strategy is undoubtedly connected to increased company value creation. ESG factors are now incorporated alongside traditional financial analysis by many investors into their investment process.

Understanding ESG investing

ESG investing is an investment approach that considers environmental, social, and governance factors in addition to traditional financial considerations when making investment decisions.

It is a type of values-based investing where investors seek to invest in companies that align with their personal values and have a positive global impact. This alignment is based on the long-term future, so more factors, such as avoiding investments in companies that produce or sell addictive substances or activities and favoring companies committed to social justice, environmental sustainability, and alternative energy/clean technology, should be included.

Impact on organizations

There is a rising recognition of the need to address ESG issues. This awareness has been partly driven by high-profile corporate scandals such as Volkswagen emissions misconduct and partly by increasing pressure from society, customers, and employees for companies to take actions related to sustainability. According to a Porter Novelli Tracker report, nearly 70 percent of employees say they wouldn’t work for a company without a strong purpose.

Report results show that sustainability issues are important to employees and consumers, which means that this topic helps to attract and retain employees and increase sales, resulting in investor interest in companies with sustainability strategies.

On the other hand, initiatives such as JFK Airport building microgrids and solar panels on the new terminal’s rooftop or Lululemon launching first products with nylon from plants instead of fossil fuels show that companies are transitioning and looking for more sustainable ways to conduct business.

Additionally, investors increasingly recognize that ESG factors can impact financial performance. In fact, according to Honeywell, more than 90% of companies are planning to increase their budget for environmental sustainability in 2023.

A study has also found that companies with strong ESG practices tend to outperform those with weak ESG practices. As investors become more sophisticated, they are starting to consider ESG factors when making investment decisions.

It is postulated that ESG-driven companies are better managed, have stronger governance structures, and generate higher returns for investors. Additionally, companies focusing on ESG factors tend to be more resilient to macroeconomic shocks and environmental risks.

There’s an increasing trend among institutional investors to include ESG factors in their strategies. Several large institutional investors, including pension funds, have made commitments to integrate ESG factors into their decision-making, resulting in a considerable impact on the ESG market.

Finally, government regulations are starting to catch up with the growth of ESG investing. In some countries, including the United States and European Union, regulators are beginning to require the disclosure of certain ESG information. This will likely increase pressure on companies to improve their ESG practices.

Shifting investor focus

The asset management industry is expected to see a substantial increase in ESG-related assets under management (AuM) over the next few years, according to a 2022 report by PwC. The report predicts that by 2026, global ESG-related AuM will rise to $33.9 trillion, up from $18.1 trillion in 2021.

This corresponds to an annual compound growth rate (CAGR) of 12.9%, and ESG assets are on track to comprise 21.5% of the world’s total AuM within the next five years. These figures illustrate a significant and ongoing asset and wealth management (AWM) industry shift.

Additionally, according to PwC’s projections, the growth of ESG-focused AuM will outpace the overall AWM market. The United States, the largest AWM market globally, is expected to see its ESG-focused AuM more than double from $4.5 trillion in 2021 to $10.5 trillion by 2026.

In Europe, ESG-focused AuM is projected to increase by 53%, reaching $19.6 trillion, following a 172% increase in 2021 alone. Other regions are also experiencing growth in ESG investments. The Asia-Pacific area is predicted to have the highest growth rate percentage, with ESG AuM more than tripling to $3.3 trillion by 2026. Additionally, ESG products are gaining traction in Africa, the Middle East, and Latin America, accounting for $25 billion in AuM.

The pressure of reducing emissions and becoming more sustainable businesses is not only influenced by the shifting focus of the investors. Institutions are also taking action to incentivize sustainable business development. Starting from the 2025 financial year, companies in Europe in the scope of the Non-Financial Reporting Directive (NFRD) will be required to provide ESG reporting.

Starting With ESG

Developing ESG processes is critical for companies that want to demonstrate their commitment to sustainability and social responsibility. There are several steps that businesses should take to start forming ESG processes, such as:

• Keep up with regulations and compliance. Identify the ESG-related regulations and reporting standards that apply to business and make arrangements in advance to ensure that the company complies with them. There are various frameworks companies can use to create their ESG plan. For instance, the UN Sustainable Development Goals (SDGs) and the Sustainability Accounting Standards Board provide insight into ESG issues.
• Identify key ESG issues. Companies should identify the most critical ESG issues relevant to their business.
• Set appropriate ESG goals. Once the key issues have been identified, companies should set specific goals and targets to address them.
• Create an ESG policy. An ESG policy outlines a company’s commitment to sustainability and social responsibility.
• Engage stakeholders. Companies should engage with key stakeholders, including employees, customers, suppliers, and investors, to get their input on ESG issues and goals.
• Measure and report on progress. Companies should establish metrics for tracking their progress toward ESG goals and report on their performance regularly.

Conclusion

With increased awareness of sustainability issues and a growing desire for businesses to be held accountable for their actions, investors recognize the potential benefits and rewards of aligning their portfolios with ESG principles.

Companies and investors prioritizing environmental responsibility now consider a company’s ESG metrics when making investment choices. As we move towards a more sustainable future, integrating ESG principles will continue to be a critical component of the business landscape.