**2.1 Environmental factors**

The "E" in ESG investing considers how a company takes care of the natural or physical environment. Environmental factors (**Table 1**) consider a company's utilization of natural resources and impacts of its direct operations and supply chains on the environment. The environmental factors examine a company's environmental disclosure, impact and efforts to reduce carbon emissions, issues which represent risks and opportunities for a company [22]. Conservation of biodiversity, pollution, waste generation and community health are common environmental factors that pose risks and opportunities. For example, companies that violate waste disposal regulations are prone to costly litigation and criminal prosecution while those implicated in biodiversity loss may experience negative publicity and customer backlash. The 2010 BP oil spill in the Gulf of Mexico brought a record fine and furious negative publicity to the company. Investors may choose to avoid oil and gas companies altogether because of such environmental risks associated with their operations.

Reduction of greenhouse gas emissions is becoming a significant positive screening environmental factor in light of the current climate change. Climate change is expected to increase the occurrence of catastrophic events and, therefore, it imposes a realistic financial risk, especially to companies that are inadequately prepared and poorly resourced [22]. Carbon emissions have been categorized into scopes 1–3. Scope 1 are carbon emissions directly linked to the activities of a company and they mostly occur at premises of the company [23]. For example, carbon emissions resulting from baking of bread at a bakery or burning of coal at a power plant constitute scope 1 emissions for the bakery and power plant. Emissions associated with the supply of electricity are scope 2. All other indirect emissions not associated with electricity constitute scope 3 [23]. Scope 3 may emanate from downstream (consumers) and or upstream activities (suppliers). Since on average more than 75% of an industry sector's carbon footprint is from scope 3 sources, companies are now being encouraged to target this scope across their supply chain [24]. Overall, a company's strategy to reduce carbon emission depends on the targeted scope.

### **2.2 Social factors**

Social factors (**Table 1**) relate to how a company manages relationships with its workforce, suppliers, customers, communities and political environment it operates under. Human rights, community outreach, diversity policies, modern slavery, child labor, working conditions and racial disparities are some of the social factors important to a company's long-term performance [25]. Investors may be influenced by whether a company provides safe and healthy working conditions, or if it donates time, money or other resources to communities where it operates. Unsafe working conditions or a disregard for community or customer concerns are potential grave financial risks. In contrast, companies that treat employees well and donate to communities are judged as less risky and they can benefit from higher productivity and attraction of top talent.

The UN's International Bill of Human Rights (IBHR) and the International Labor Organization (ILO) Core Conventions set out social factors that are important for long-term financial performance. The United Nations Declaration on the Rights of Indigenous Peoples (UNDRIP) helps companies to avoid conflict with indigenous populations. The seemingly unending birth pangs of the Keystone XL pipeline in the US and the incessant negative publicity directed at Rio Tinto after the company blew up ancient caves in western Australia despite opposition from Aboriginal communities may be consequences of overlooking indigenous peoples' rights. Such disregard of social factors may turn out to be financially costly to investors.

*The Increasing Importance of Environmental, Social and Governance (ESG) Investing… DOI: http://dx.doi.org/10.5772/intechopen.98345*

#### **2.3 Governance factors**

Governance factors (**Table 1**) are concerned with a company's decision-making, from policymaking to the distribution of rights and responsibilities among different participants, including the board of directors, managers and shareholders. Governance factors indicate the rules and procedures for companies, and allow investors to screen for appropriate governance practices as they would for environmental and social factors. A corporation's purpose, the role and makeup of boards of directors, shareholder rights and how corporate performance is measured are core elements of corporate governance structures [26]. Gender diversity and equity are becoming important to investors who are increasingly demanding better representation of women and people of color on corporate boards and in executive ranks, as well as equal compensation and promotion prospects.

A company that has robust governance structures is transparent and fair, and it operates within regulations and policies. Good governance mitigates risks of mismanagement, corruption and regulatory penalties. The Volkswagen emission cheating scandal that was revealed in 2015 in the US may be a result of governance failure. Volkswagen installed a software that was programmed to allow their vehicles to pass testing performed by the Environmental Protection Agency (EPA) but pollute up to 40x the federal maximum when on the road [27]. The governance failure of the company potentially had a negative effect on its stock price and financial performance, on top of reputational damage [28].
