ESG, or environmental, social and governance, has moved from a niche investment management tool into the mainstream. Still, despite its rapid growth, it is widely misunderstood by investors, the media and even practitioners in financial services.

When the term ESG was coined in 2004 it was defined as a set of business risks and opportunities companies face that weren’t covered in traditional financial reports. Unfortunately, it is now commonly used as a much broader moniker. It has come to describe strategies wherein investors apply their personal preferences, like avoiding guns or abortion or nuclear power.

Investing with personal preferences was historically called SRI—socially responsible investing. When this term fell out of favor, ESG became a substitute. Unfortunately, such a broad definition, where ESG combines both business risks and personal preferences, serves no one well.

Investment approaches that integrate consideration of business risks like pollution, product safety or workers’ rights are not going away. Metrics that relate to risk will always be relevant for investors. This is especially the case for large institutional investors with long investment horizons. In fact, 12 of the 15 largest pension funds in the world incorporate ESG metrics in their investment management. 

The use of ESG as a risk screen resonates with investors who have sought accountability at large companies—think Enron and Arthur Anderson in the late 1990s. These reputable companies appeared to generate reliable returns, but unchecked accountability meant that investors ultimately lost out.

New regulations, including Sarbanes-Oxley, were introduced in the aftermath of these corporate implosions. Investors also began designing a better mousetrap to identify these risks before they lost their shirts again. Why not check in advance to see if the company’s audit committee is actually providing appropriate oversight? Why not look into employee lawsuits and worker accident rates to see if the company has labor issues? Why not ask a real estate owner if they have assessed their buildings’ exposure to flood risk and wildfire? Why not ask companies to disclose their energy, water and waste use in case future regulation increases costs?

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A Brief History of ESG

Corporate sustainability reporting got its start in the 1990s when investors wanted to address gaps in the traditional financial reporting package. The balance sheet, income statement and statement of cashflows all provided much needed information. But after a series of corporate crises—Bhopal in India, the Exxon-Valdez oil spill in Alaska—some investors in large publicly listed companies realized the standard financial reporting boilerplate, even with management discussion and analysis, was not sufficient to reveal all relevant risks.

Non-financial reporting started as voluntary reporting with the Global Reporting Initiative (GRI) in 1997. The GRI’s framework aimed to show linkages between the environmental, social and economic aspects of enterprise performance to all types of stakeholders. Questions ask companies to reflect on strategies for energy use, water use, investment in human capital and executive pay ratios.

Shortly after, in 2002, the Carbon Disclosure Project (now known as the CDP) was founded to encourage companies to report their greenhouse gas emissions and energy use. In the early days, only a handful of companies volunteered this information. As of 2023, more than 25,000 companies globally provide CDP reports.

Today many companies are voluntarily providing corporate sustainability reporting outside their financial reports. Since 1993 KPMG has been conducting a global survey on sustainability reporting that evaluates over 5,800 companies in 58 countries. As of 2023, 79 percent of these firms publish sustainability reports. Of the largest 250 companies globally, 96 percent publish sustainability reports and 64 percent acknowledge climate change as a business risk.

Materiality and Standardization

As more companies, both large and small, around the world voluntarily created sustainability reports, stakeholders looked for standardization in reporting to better facilitate comparisons. The GRI and CDP questionnaires were instrumental to get companies to collect data for and report on non-financial topics. But they were largely sector agnostic and as such compelled companies to report on metrics that were not always relevant to their business. Banks don’t usually face water use risks for example. Rather than count gallons of water used, banks should monitor for relevant risks, like data protection and cybersecurity.

Investors wanted an increased focus on materiality in reporting. Materiality refers to the risks and opportunities to a company’s business model and operations that will drop to the bottom line.

In 2011, The Sustainability Accounting Standards Board (SASB) responded to investors’ interests in identifying financial material metrics by industry. SASB identified 77 distinct industries and mapped corresponding risks most likely to affect an entity’s cash flows, access to finance and cost of capital.

The specific list of risks for each of the 77 industries SASB identified varied greatly, but 75 of the industries counted climate change as one of their most material risks. In 2017, TCFD or the Task Force on Climate-related Financial Disclosures was formed by the G20 Financial Stability Board. TCFD set out a robust reporting framework to outline a companies’ preparedness to climate change through corporate governance, strategy, metrics and targets, and climate scenario analysis. The climate risks were split into physical and transition risks.

For example, in real estate, there are physical risks if a property is in an area with significant heat or water stress. Keeping a property rentable in Phoenix or Austin, Texas, may require significant additional investment in air-conditioning. There are also transitions risks which refer to emerging competition or regulatory policies that could require increased or unanticipated capital expenditure.

Nearly 50 cities around the U.S. are rolling out building performance standards (BPS) that require commercial, public and multifamily buildings to consume less energy and invest in energy efficient systems (See Exploring Building Performance Standards. Institute for Market Transformation (2020); imt.org/how-we-drive-demand/building-policies-and-programs/exploring-building-performance-standards).

On average the BPS enable buildings to reduce energy use in buildings by over 20 percent. Investors and financial advisors may not yet be aware of these changes, but building owners are and are evaluating investment or disposal of their real assets through this lens.

Many of these voluntary frameworks—initially requested by investors, consumers, nonprofits, lenders and management—have been used as the foundation to form new regulation.

• In March 2024, the SEC Enhancement and Standardization of Climate-Related Financial Disclosures was finalized after a two-year process including the consideration of over 16,000 comment letters, the vast majority of which were in support of the rule. The final rule is based on the CDP and TCFD voluntary frameworks requiring large companies to report on Scope 1 and Scope 2 emissions if financial material to their business.

• The California Climate Corporate Data Accountability Act SB 253 (October 2023) builds off the voluntary reporting CDP questionnaire requiring companies to report greenhouse gas emissions across their value chains including Scope 1, Scope 2 and Scope 3 emissions.

• The California Climate-related Risk Disclosure Act SB 261 (October 2023) follows the TCFD framework requiring companies to detail how they are managing climate-related financial risks and opportunities to operations.

• The EU Taxonomy in Europe includes many aspects of GRI, CDP, TCFD frameworks in the multilayer reporting requirements for both companies with the Corporate Sustainability Reporting Directive (CSRD) and financial services with the Sustainable Finance Disclosure Regulations (SFDR).

Accounting firms have seized the opportunity to help corporates manage these new reporting requirements. PwC and Deloitte have built sustainability reporting teams. EY started EY Carbon to advise institutional clients with risk management and modelling transition plans.

Accountants and auditors identify the material topics for their client’s business and the corresponding metrics to track through a materiality assessment. Voluntary frameworks are used as starting points cross-referenced with existing or pending regulation to cover all potential areas for non-financial reporting. Accountants help put in place reliable processes to collect and manage data, ensure data quality and standardize procedures. The data ranges from employee turnover to carbon emissions. For some clients, they tie it together and provide analysis and explanation of financial and non-financial data.

Helping Clients With ESG Investing

Understanding how non-financial voluntary reporting has evolved should go a long way to demonstrating ESG is not the same as values-based investing. ESG is about companies articulating and proactively designing their strategy for long-term value. SRI is about aligning portfolios to clients’ values. Helping your clients understand the difference will help them be better investors and help you streamline your practice.

Clients who are concerned about climate change or corporate malfeasance could be well served by a model portfolio of ESG ETFs or mutual funds. Clients with strong personal preferences on alcohol, tobacco, etc. would require a lengthier discovery process and custom portfolios.

It’s helpful to remind clients that ESG is not a political movement or an attempt to stymie corporate independence or profits. Non-financial reporting is about greater transparency, better prices and better decision making for market participants. This is why ESG approaches to monitor business risks and investments will persist.