The MSCI KLD 400 Social Index, launched in May 1990, is a capitalization weighted index of 400 US securities with
outstanding Environmental, Social and Governance (ESG) ratings and excludes companies whose products have negative
social or environmental impacts. The Index is designed for investors seeking a diversified benchmark comprised of
companies with strong sustainability profiles while avoiding companies incompatible with values screens.  (Source: MSCI)

What is ESG?

The measurement of the sustainability and ethical impact of businesses and organizations consist of three central factors: Environmental, Social, and corporate Governance, or more commonly referred to as ESG. It is a set of criteria used to determine if an industry or a company has a positive impact as well as if they are a Socially Responsible Investment. Depending on how well said company meets the criteria, it will be given an ESG score that reflects the sustainability of its practices. There are numerous companies that have decided to report  their processes surrounding these measures and to be transparent about the scores given to them by agencies.

Environment

The environmental factor is composed of the impact from an industry’s business practices in relation to its revenue. This can include their carbon footprint, gas emissions, plastic waste, energy usage (is it from a renewable or a non-renewable source?), waste management and disposal, and consumption of water. It aims to measure the direct or indirect impact of a company’s activity on the environment. How a company sources its raw materials, how much waste it produces in its operations, and whether its product packaging is disposable is examined and recorded as well. Avoiding bad practices is not the only thing that matters for a decent score. A corporation can also have a higher environmental score if it makes positive ESG contributions with initiatives such as the use of clean technology or the construction of green buildings. Green buildings consist of infrastructure that is sustainable, such as installing solar panels onto the tops of roofs or using building materials that are less harmful to the planet than traditional materials.

Social

On the social front, how companies deploy their human labor is critically important in the evaluation of their ESG practices. This aspect measures the direct or indirect influence on a number of different groups:

Customers

Employees

Stockholders

Local communities

Society in general

The social measurement focuses on respect for human rights, international labor standards, and anti-corruption practices, etc. Labor management practices and the measures taken by a corporation to ensure the health and safety of its workers are also assessed when determining its score. ESG analysts will also take into account the labor practices of the suppliers that businesses use, alongside the impact of the products and services on its customers. Companies that manufacture low-quality products that put their customers at risk would have low social scores. On the other hand, companies engaged in positive initiatives, such as delivering products that help improve nutrition for low-income populations or enhance health care for consumers in undeveloped regions, would receive high social scores.

Governance

Governance refers to the decision-making, policymaking, and the distribution of rights and responsibilities within a corporation. It aims to measure the processes, regulations, laws, and institutions which are influenced by the way the company is managed, controlled, and conducted in day-to-day business. Particularly, this includes the relationships between the company’s stockholders, management, and board of directors. Some examples are: the balance of powers, business ethics, fraud, and anti-competitive practices, etc. 

Executive compensation is a key consideration, especially as to where executive compensation falls relative to the company’s industry, with lower governance scores given to firms whose executive compensation is excessive. A history of engagement in corrupt practices will bring down a governance score, while strong safeguards to support and encourage business ethics will raise a score. The rights of shareholders, and the protections provided for the interests of minority shareholders, are key considerations as well.

Putting it Together

Combining these three scores together, the ESG score reflects the sustainable and ethical practices of the company. A company with a low score has had, and continues to have, a negative impact on our society and environment, and may also participate in poor management of human resources and treatment of workers. On the other hand, a company with a high score has been evaluated to have positive impacts on the environment and our society, and contributes to them. They also may have adequate working conditions and management as well as proper worker and consumer care. Generally, companies that have a better ESG score outperform ones that are lower ranked. Using ESG criteria as a guide, investors can build financial plans that reflect their personal values and can help for change within the corporations they invest in. Shareholders can use their influence, if they own enough stocks, to drive businesses to have more ethical practices. ESG investing is also useful for avoiding negative purchases in companies for recent, future, or ongoing controversies.