What is ESG?
ESG stands for environmental, social and governance. Together, these three principles form a framework that’s used to measure how sustainably, ethically, and responsibly an organization is acting. ESG is most often used to describe the efforts companies take to mitigate the potential negative outcomes of their operations. It also refers to a style of investing that focuses on building a portfolio of ESG-compliant companies.
ESG is about taking a holistic approach to business that emphasizes long-term sustainability and responsible practices rather than just focusing on short-term profits. By considering ESG factors, companies can improve their reputation, attract and retain talent, and reduce risks associated with negative social and environmental impact.
To properly understand the meaning of ESG, it’s helpful to break its three component categories down into more detail. Here’s what each category aims to measure:
Environmental factors measure how well a company manages its environmental impact. This generally involves both mitigating negative environmental outcomes from operations and proactively contributing to the fight against climate change. In short, it’s about ensuring regular operations don’t cause avoidable damage to the natural world.
Factors that fall into the environmental category and can be controlled include:
- The scale of energy use and CO2 emissions
- Use of renewable energy sources
- The approach to managing waste and pollution
- The impact on local ecosystems and habitats
- Compliance with local and national environmental regulations
Social factors in ESG refer to how an organization relates to its stakeholders, including employees, customers, local communities, and supply chain partners. They aim to measure how responsibly companies serve their stakeholders, balancing operational goals with maintaining a positive social impact.
Factors that fall into the social category include:
- Attitudes and practical application of human rights and labor practices
- The extent of diversity and inclusionary policies within the workforce
- How well consumer/customer protection policies are implemented
- The amount of community engagement and philanthropy
- The quality of health and safety processes
Finally, governance factors cover internal corporate policies, procedures, and systems. These all generally relate back to how responsibly a company operates – measuring transparency, accountability, and ethicalness. Governance is crucial for ensuring long-term sustainability and mitigating risks, and it helps build trust and confidence among stakeholders and shareholders alike.
Factors that fall into the governance category include:
- The structure and composition of the board or management team
- Compensation policies and how well they serve long-term business objectives
- How well shareholder rights are implemented, exercised, and monitored
- The rigorousness of codes of ethics and conduct, but also compliance with them
- How well risk assessment and management are handled
How ESG came about
While the term ESG might be relatively recent, the concepts behind the framework have existed for decades. The idea of socially responsible investing (SRI) emerged in the 1960s and arguably started the conversation.
The framework for measuring compliance was first known in the US as EHS (Environmental, Health, and Safety) before rebranding as Corporate Sustainability. By the early 2000s, the principles of ESG were better known as CSR (corporate social responsibility).
Throughout all these periods, the emphasis was on reactivity rather than proactivity. The emergence of ESG in the 2010s flipped that, implying that the burden for managing the negative outcomes of business was on the business, not society.
ESG is now a broadly recognizable term, and the framework is used by stakeholders and investors alike to evaluate the long-term sustainability of businesses. Many companies now actively report on their ESG credentials, and investors are increasingly insistent on complete corporate transparency.
The growing importance of ESG has resulted in an entire industry being built around the framework. There are various independent ESG evaluators who can create ESG ‘scores’, putting a tangible number to the ESG performance of a company.
What does ESG mean for corporates?
In the modern climate, where environmental and social issues, in particular, are close to both consumers’ hearts and legislators’ pens, ESG is of increasing importance to corporates.
Here are some examples of what makes ESG such an important consideration for corporate businesses in particular:
- Brand reputation: Consumers are increasingly concerned with ESG factors and generally want to support businesses with a good sustainability track record and ethical values. Organizations with good ESG compliance can benefit from their efforts through a more favorable reputation, resulting in more sales. Conversely, companies that don’t follow ESG principles may suffer reputational damage, whether through activated risk exposure or by lagging behind the rest of their market.
- Risk management: Large parts of the ESG criteria essentially relate to how well businesses protect themselves against both internal and external risks. Climate change, human rights violations, data breaches, and other risks all have the potential to damage a companies’ finances or reputation. By incorporating ESG factors into their risk management process, companies can identify and mitigate these risks.
- Access to capital: Just like consumers, investors are increasingly interested in companies with strong ESG performance. Many major capital outlets integrate ESG factors into their investment decisions, and companies with a better track record may receive more investment opportunities than those without. This can help fuel sustainable growth.
- Competitive advantages: In the process of addressing ESG failures and driving better ESG performance, companies are naturally being innovative. This can create new opportunities for growth. For example, a company that chooses to adopt more sustainable supply chain practices for ESG reasons may also find that they lower their supply chain risk profile, protecting them against a catastrophe that might beset less prepared competitors.
The implications of ESG on supply chain activities
The adoption of ESG principles has significant implications for the supply chain activities of companies. It requires them to consider the impact of their supply chain operations, including sourcing, production, transportation, and disposal. Encouraging them to address any negative outcomes.
From an environmental standpoint, companies are expected to reduce their carbon footprint, conserve natural resources, and minimize waste throughout the supply chain. This may require changes in product design, raw material sourcing, transportation modes, and waste management practices.
From a social standpoint, they’re expected to ensure that their suppliers and partners operate ethically, treat their workers fairly, and respect human rights. This may require the establishment of clear social standards, auditing processes, and training programs to ensure compliance with those standards.
From a governance standpoint, they’re expected to ensure that their supply chain activities are conducted with transparency and accountability, with proper risk management processes in place to mitigate any negative impacts.
In practice, those considerations can manifest in three main ways:
Companies looking to maximize their ESG credentials can look to their supplier network and relationships with individual suppliers for areas of improvement. Both supplier selection and supplier management processes can be tailored for ESG.
The former involves being more particular about who joins your network as a supplier and integrating ESG assessments into the supplier selection process to ensure you only work with companies that meet your own ESG standards.
The latter can be handled by monitoring existing suppliers’ ESG performance and incentivizing improvements. This can be done through favorable payment terms, availability of discounts, or even higher order quantities.
The movement of materials and inventory through the supply chain can make up a large part of a company’s overall environmental impact, and the flow of inventory is also prone to plenty of risks. Both factors can be mitigated by putting ESG principles at the center of your approach to inventory management.
One of the most effective methods of doing this is by changing the inventory management strategy you use. Some strategies, like the just-in-time (JIT) method, minimize waste. This can both cut costs while also reducing negative ESG outcomes.
As you’d expect, though, there is a balance to be struck. Minimizing waste also increases the risk of being too short on inventory to effectively meet demand. This risk, and others, can be mitigated by adopting an inventory management system that gives you access to features like total inventory visibility, safety stocks, and vendor-managed inventory.
Other approaches include optimizing for sustainability in how goods flow through your supply chain, with more sustainable packaging and transportation.
Supply chain financing
Finally, companies can implement ESG into their approach to adopting supply chain financing solutions.
Digital solutions such as reverse factoring, dynamic discounting, and virtual cards not only offer a way of freeing up capital from the supply chain and facilitating simpler commerce but also reduce the need for paper checks and invoices, making them ESG-compliant.
But their ESG-readiness can go a lot further. Dynamic discounting, for instance, can be used as an incentive for strong ESG performance from suppliers, offering variable discounts depending on ESG scores.
And, in the same way that suppliers can be chosen based on their ESG-compliance, companies looking for a supply chain finance solution can prioritize choosing a partner with a good track record in ESG.