Over half a dozen institutions and nonprofits are involved in establishing metrics, providing disclosure guidelines, and constructing surveys to establish ESG metrics. ESG refers to companies that try to meet higher environmental, social, and governance standards and securities based on those organizations.
Given the growing interest in sustainable investing and new research that suggests these strategies can be as profitable as conventional investing, investors will benefit from the ability to measure and compare outcomes.
The SEC only recently proposed ESG-disclosure requirements for investment advisors and fund managers, which have yet to be implemented. As the industry consolidates, there’s a wide variance in disclosure practices.
What Are ESG Metrics?
While ESG investing began in the 1960s, the investment philosophy didn’t catch on in the mainstream until the past couple of decades, with the increase in the popularity of socially responsible investing (SRI). Socially responsible investing is a broader term in the industry and can be used interchangeably with ESG, although the two are different.
As noted above, ESG stands for environmental, social, and governance factors, each representing a set of standards that can be used to measure the risks and sustainability of a business. Each aspect features qualitative and quantitative metrics on how firms perform regarding environmental responsibility, social wellness, and corporate governance.
As it stands, two of the most prominent organizations that set disclosure standards for ESG metrics include the Global Reporting Initiative (GRI) and the Value Reporting Initiative (VRI), which is a merger of the Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC).
While there is much overlap amongst the existing standards for ESG, at their core, each organization seeks to establish a framework that 1) allows firms to represent their ESG metrics accurately and 2) allows those metrics to be comparable across firms.
The Importance of ESG Metrics
ESG metrics are essential because they allow investors to fairly gauge a firm’s impact on environmental, societal, and corporate responsibility issues against comparable peers. Since many investors who are interested in ESG strategies are also committed to making an impact with their money, being able to measure outcomes is essential.
In theory, companies that perform well in ESG categories have lower capital costs, are more innovative, and may help to support positive environmental, social, and corporate governance outcomes. However, it can be difficult to correctly measure ESG policies across companies, as no official regulations for standardized ESG reporting currently exist.
Still, two recent studies suggest that socially responsible funds tend to outperform conventional mutual funds. The Morningstar “Sustainable Funds U.S. Landscape Report” from February 2022 found that “two-thirds of sustainable offerings in the large-blend category topped the U.S. market index last year compared with 54% of all funds in the category.”
Also, a Morningstar analysis of European-based funds found that most ESG funds outperformed non-ESG strategies over one-, five-, and 10-year periods.
Investors also face difficulty when comparing ESG metrics across different industries. For example, comparing energy companies and financial institutions on emissions-related issues are complex, as the two represent entirely different industries. This can easily lead to apples-to-oranges comparisons if not monitored closely.
Finally, some of these standards are qualitative and may be subject to subjectivity, making the ESG evaluation process difficult to quantify. These can all present challenges if you try applying ESG principles to your investing strategy. It’s, therefore, essential to identify an appropriate, widely accepted set of ESG metrics to ensure that investors evaluate investments using the proper framework.
9 Common ESG Metrics Businesses Track
Commonly employed ESG metrics are varied and consist of qualitative and quantitative metrics across all three environmental, social, and governance sub-categories.
We break down some of the industry’s most commonly tracked ESG factors, organized by category.
3 Common Environmental Metrics
Environmental metrics measure the long-term ecological sustainability of a firm’s actions. These can be related to emissions, finite natural resources, and the environment, among other things.
Many of these metrics can be tracked on an aggregate basis or relative to other operating metrics (per capita, per unit produced, etc.).
• Emissions: Quantifies how much a firm emits in greenhouse gases or works to reduce carbon emissions through its operations.
• Waste: Measures how much waste a company generates or recycles. It can also deal with a company’s impact on its surrounding ecology.
• Resource Usage: Tracks the efficiency and intensity of a firm’s operations when using energy, water, or other vital resources.
3 Common Social Metrics
Social metrics evaluate how a firm’s policies impact human capital and society. Attempts to quantify these metrics have primarily been implemented per occurrence or as a rate over time.
• Human resources: Evaluate how a company treats its workforce, frequency/magnitude of workplace litigation, and employee turnover.
• Labor safety: Tracks a firm’s commitment to safe labor practices via metrics like frequency of workplace accidents and lost productivity.
• Products: Examines a firm’s product quality and sustainability through metrics like the number of recalls, complaints, or even frequency of litigation. It can also be linked to the environment regarding how product inputs are sourced.
3 Common Governance Metrics
Governance metrics include business ethics issues, agency risk mitigation, and reporting transparency. These can be measured regarding how executives are compensated, board policies, and accounting choices.
• Ownership Structure: Reviews how reliable a firm is to its shareholders regarding metrics like the number of independent directors on the board or how voting rights are distributed between management and shareholders.
• Executive Compensation: Measures executive compensation relative to industry standards or company profitability. It can also be tied to society when measuring how compensation structures vary for genders/minorities.
• Financial Reporting: Tracks a firm’s accounting policies and how comprehensive and accurate they are. This could involve reviewing a firm’s books for critical disclosures or the frequency of one-off exceptions.
How Can Investors Use ESG Metrics?
Investors will want to adopt a long-term perspective when evaluating investments using ESG metrics, as the principles of ESG are built based on long-term secular trends regarding technology and social issues. The goal is to invest in companies with favorable ESG traits while avoiding or underweighting firms with negative ESG traits.
Investors will want to be discerning when investing in specific firms or funds that advertise an ESG approach. The wide range of ESG frameworks means some firms may cherry-pick which ESG metrics they wish to disclose. Investment and exchange-traded funds (ETFs) that tout an ESG-based approach may use their proprietary metrics when deciding how to allocate ESG investments, making them difficult to compare.
When using ESG metrics, you’ll want to examine all ESG-related disclosures closely and ensure consistency in the reported data. Depending on the metric you’re reviewing, you may wish to avoid making comparisons across disparate industries and focus on identifying “best-in-class” investments for a single sector.
How do Firms Report ESG Metrics?
How each firm reports its ESG metrics depends on its policies regarding disclosures.
When it comes to policy implementation, firms often set ESG targets to meet or exceed guidelines set by governments, non-profits, or agencies; they may survey their stakeholders and shareholders to gauge how they view company performance on ESG issues or hire third parties to monitor their customer base on their behalf.
Adopting ESG frameworks can vary widely by a firm, and disclosure of these metrics is still voluntary. Additionally, specific metrics may be difficult to quantify, and in some cases, management, stakeholders, or shareholders may disagree on the impact of certain ESG factors.
As a result, professional money managers may sometimes solicit the assistance of third-party ESG consultants to obtain an independent assessment of how a company performs on ESG metrics.
The Takeaway
When appropriately used, ESG metrics offer another functional dimension for evaluating investments, as it focuses on a unique set of risk factors for firms that aren’t captured by traditional fundamental metrics.
However, adopting a unifying set of standards among firms remains elusive and will likely remain so until regulators choose to codify their ESG reporting requirements.
As with any investment strategy, investors will want to manage their expectations appropriately and employ ESG metrics as part of a more extensive toolbox for investment analysis.
