ESG and its importance in the Finance Industry

ESG and its importance in the Finance Industry

 Introduction:

Imagine a company that produces biodegradable packaging materials and has a vision to reduce waste and promote environmental responsibility. For this, they ensure that their raw material is sourced ethically, takes good care of its employees, and is transparent about its ESG practices. For a mid-sized company like this, attracting mainstream investors a decade ago would have been difficult. Today, investors are also looking to support companies that act responsibly and give equal importance to profitability and sustainability. This shift in trend highlights that companies that prioritize ESG are not just doing good sustainably, they are also doing well financially. Let's now understand what ESG is-

What is ESG?

ESG refers to Environmental, Social, and Governance factors, which are used to assess the sustainability and ethical implications of investment decisions essential for assessing companies by investors, consumers, and stakeholders. Investment funds that incorporate Environmental, Social, and Governance criteria have experienced substantial growth, drawing in trillions of dollars. This momentum signals a wider movement toward responsible investing, where financial returns are weighed alongside social and environmental considerations

It sets the criteria that help companies in evaluating how the business operates- environmentally, assessing factors like sustainability and carbon footprints, social factors like corporate ethics and community impact, and governance factors like regulatory compliance.

According to Gartner, over 85% of investors considered ESG factors before making the investment decision in 2020 ^(3), and “ESG investment is expected to surpass $50 trillion by 2025,” according to a Bloomberg report ^(4). This clearly states that businesses embracing sustainability are gaining investors' confidence. Companies with strong ESG practices have also seen growth in their stock performance, and as a result, now 88% of publicly traded companies are incorporating ESG strategies to ensure long-term growth ⁽⁵⁾.

So, ignoring ESG now is not just about reputational risk but is considered bad business.  As the financial world grows, ESG is not a trend anymore, but it’s the future. 

ESG and Financial Performance: A Strategic Advantage

Environmental, Social, and Governance factors are not just ethical considerations but also key drivers of financial performance. Companies integrate ESG for better risk management, lowering operational costs, and gaining investor and consumer confidence.

•  Reduced Regulatory and Legal Risks

  Governments worldwide are working on ESG regulations and companies that proactively work towards ESG avoid fines, lawsuits and reputational damage.

  Example: The EU’s Sustainable Finance Disclosure Regulation mandates transparency in companies' ESG practices, pushing firms to adopt responsible practices ⁽⁶⁾.

•  Lower Operational Costs

  Adapting sustainable practices like waste reduction and energy efficiency leads to cost savings.

  Example: Unilever launched its Sustainable Living plan in 2010 to reduce its carbon footprint, cutting costs while improving brand reputation ⁽⁷⁾.

• Stronger Investor and Consumer Trust

  Investors look for ESG-compliant companies, leading to higher stock valuations and lower volatility. Consumers also increasingly support sustainable companies as they prefer brands that align with their values.

  Example: Patagonia uses recycled materials and encourages customers to repair old Patagonia clothes instead of buying new ones. This strategy has helped them in higher customer retention and increased revenue ⁽⁸⁾.

The Role of Carbon Markets in ESG and Finance

Carbon markets help businesses in managing their environmental impact by reducing carbon emissions, which aligns with their corporate social responsibility. Let's understand what the carbon market is and how it works.

Let’s assume a large manufacturing company, TextilesCO, emits 1,00,000 tons of Carbon Dioxide every year. The government has set a limit that allows companies to emit only 80,000 tons. Now, as this company exceeds the limits, it has 2 choices-

•  Reduce its emissions by adopting greener energy.
• Buy carbon credits from a company that emits less than its required limits.

Another company, GreenCorp, runs a massive solar farm and emits 20,000 tons of carbon dioxide by adopting clean energy. Since GreenCorp’s emissions are below the limits so it gets carbon credits, which it can sell to TextilesCO. So, TextilesCO buys 20,000 carbon points from GreenCorp to meet regulations and continue operating without violating emission limits. Meanwhile, GreenCorp gets additional revenue, rewarding its sustainable efforts.

So, the Carbon market is a system where companies can buy and sell carbon credits, helping businesses manage their carbon footprints while operating sustainably and profitably. It provides financial motivation for companies to minimize their environmental impact. 

Types of carbon markets-

• Compliance Carbon Markets

These are government-regulated and operate under mandatory carbon reduction programs. The emission limits are set by the government, and if companies are exceeding this limit, they either must reduce it by adopting sustainable practices or must purchase additional carbon points for compliance.

• Voluntary Carbon Markets

These markets operate outside government mandates, allowing businesses to buy carbon credits to offset their emissions without legal requirements. They buy Verified Emission Reduction (VERs) from projects like reforestation, renewable energy etc.

Example: Companies like Microsoft and Google invest in voluntary carbon credits for carbon neutrality.

How Carbon Markets Work

Imagine a marketplace where companies buy and sell carbon credits like an auction; that’s how carbon markets work. Companies first need to measure how much carbon they emit. Whether they are under their limit or over their limit. Then, companies that are under their limit are the ones that have reduced emissions. As a reward, they get carbon credits, which can be sold to companies struggling to meet their emission targets. For Example, Companies like Tesla emit way less than traditional automakers. So, it earns carbon credits and sells them to companies like General Motors and Fiat ⁽⁹⁾. This acts as an additional source of income, and thus Tesla makes millions in revenue from sustainability.

Now, to ensure carbon credits aren’t just false promises, regulatory bodies verify that emissions reductions are real and are measured. Thus, carbon markets benefit companies as companies comply with regulations to reduce their carbon footprints and profit from eco-friendly initiatives.

Regulatory Landscape and Global Trends in ESG

Business is no longer just about profits- it's about accountability. Now, governments and investors demand higher transparency and sustainability. ESG regulations are reshaping investment strategies and flows. SEC’s ESG disclosure and Corporate Sustainability Reporting Directive (CSRD) depict that ESG is no longer just about ethics, but it’s a financial necessity now.

But how do these policies impact investors, corporations, and markets? ESG guidelines influence financial risk management, capital allocation, and corporate decision making. This determines which companies will succeed as the economy moves more towards climate awareness.

Key ESG Regulations Shaping Global Finance:

1.     US SEC’s ESG Disclosure Rules

The U.S. Securities and Exchange Commission (SEC) introduced a rule for public companies to disclose climate-related risks in their financial reports. This aims to provide investors with ESG data, ensuring that these companies are transparent about their environmental impact ⁽¹⁰⁾.

These companies are expected to quantify their climate risks, such as carbon emissions, regulatory fines, or climate-related disruptions. With this, investors have better visibility into ESG risks, allowing them to make more strategic and informed decisions. Investments will shift towards companies with strong ESG strategies as they are perceived to be more stable and financially viable in the long term.

2.     European Union’s Corporate Sustainability Reporting Directive (CSRD)

The European Union’s CSRD aims to transform ESG reporting by companies from optional sustainability claims to mandatory, data-driven accountability ⁽⁶⁾. Companies now operating in Europe must provide full disclosure about their sustainability risks, carbon footprints, and government practices followed, making ESG an integral part of their financial reporting. This directive ensures that businesses are not just claiming to be eco-friendly but are proving it with numbers.

Thus, companies must integrate EU climate targets with their strategies, gaining investors’ confidence and capital inflows. With ESG-compliant firms recognized for their transparency, investors can now rely on standardized benchmarks to assess corporate sustainability. With ESG, it's not just about good intentions — it's about data, accountability, and sound financial strategy.

3.     SEBI’s ESG Disclosure Framework in India

The Securities and Exchange Board of India has made it mandatory for the top 1,000 listed companies to disclose their ESG regulations, ensuring transparency. ⁽¹¹⁾ The Companies Act 2013 emphasizes board diversity by requiring companies to appoint at least one female director. ⁽¹²⁾ Thus, as investor interest in ESG frameworks grows, Indian companies are increasingly integrating ESG practices into their strategies, aligning with ethical standards.

Challenges and Future Prospects of ESG

As ESG investing gains momentum, it also faces significant risks and challenges that can change its future trajectory. Some challenges are-

1)     Greenwashing: The illusion of sustainability

Some companies claim their products to be eco-friendly while continuing harmful environmental practices. A recent survey by EY shows that 85% of investors see greenwashing as a growing problem ⁽¹³⁾.  This occurs when companies exaggerate their ESG reports to appear more sustainable to investors than they are. This undermines investor trust and creates skepticism in investors’ minds. There should be stricter regulations and independent ESG audits that can verify whether claims made by companies are true or not, ensuring companies are held accountable.

2)     Lack of standardization

There is no universal ESG reporting framework, making it difficult for investors to compare companies. Different countries use different criteria, leading to inconsistent assessments. For example, the EU’s CSRD aims to standardize ESG reporting, but universal acceptance is still lacking. Governments and financial institutions must set a standardized set of rules, ensuring transparency and comparability across markets.

3)     Evolving ESG policies

In this dynamic world where policies and political changes occur rapidly, it creates uncertainty for businesses and investors. Companies struggle to adapt to evolving ESG requirements. Thus, there should be clear guidelines that are long-term and sustainable, helping companies form their strategies accordingly.

Future Prospects: Will ESG Investing Become the Norm?

ESG assets are expected to surpass $50 trillion by 2025 ^(4), proving that ESG is here to stay and becoming a core factor for investment decisions. Major managers like BlackRock are integrating ESG into their portfolios, signalling a long-term shift towards sustainable investing. Thus, ESG is on track to become a mainstream financial strategy and will impact investor demand, regulatory pressure, and corporate accountability.

Carbon markets, on the other hand, are expanding rapidly, offering businesses new ways of generating income. More companies and investors are showing keen interest in ESG  investing to achieve net-zero goals. Carbon credits are also becoming tradable assets, allowing companies and investors to profit from sustainability initiatives. Banks are also offering green loans and sustainability-linked bonds, incentivizing companies to meet ESG targets.

Thus, while ESG faces challenges like greenwashing and regulatory uncertainties, its future remains promising. ESG has the potential to become a fundamental pillar of global finance.

Conclusion

The world is undergoing a fundamental transformation, with ESG no more a moral imperative but a strategic necessity. Over the years, it has become a new financial reality. Financial institutions play a key role in standardizing the market, making it more sustainable, cleaner and ethical. Companies that embrace ESG will thrive, while others will fall behind. Thus, the choice is clear- businesses, investors and policymakers must step up, adapt and invest in a world where finance fuels sustainability.

Notes:

1.     Deloitte, #1 What is ESG?, March 2, 2022

2.     ESG the Report, What is ESG and Why is it Important?, January 2, 2025

3.     Gartner, The ESG Imperative: 7 Factors for Finance Leaders to Consider, June 10, 2021

4.     Bloomberg, ESG Asset Rising to $50 Trillion Will Reshape $140.5 Trillion of Global AUM by 2025, Finds Bloomberg Intelligence, July 21,2021

5.     Key ESG, 50 sustainability statistics you need to know in 2025, April 28, 2025

6.     European Commission, Sustainability- related disclosure in the financial services sector, May 3, 2024

7.     Hindustan Unilever Limited, Sustainable Living

8.     Michigan Journal of Economics, Op-Ed: Patagonia Proves the Success of Sustainable Corporations,       November 22, 2023

9.     Business Insider, Tesla has made hundreds of millions of dollars selling tax credits to other automakers. Now we know who bought them, June 4, 2019

10.  U.S. Securities and Exchange Commission, SEC Proposes Rules to Enhance and Standardize Climate- Related Disclosures for Investors, July 14,2022

11.  India Briefing, ESG Reporting Mandates in India: Guidelines for Businesses, September 2, 2024

12.  Science Direct, On the side effects of mandatory gender diversity laws in corporate boards, June 2022

13.  ESG News, EY Survey: 85% of investors see greenwashing as a growing problem in ESG Reporting, December 11, 2024