The Significance of ESG Policies on Externalities

by Electra Radioti

Environmental, Social, and Corporate Governance (ESG) is a term used to describe the core aspects that should be considered, alongside financial metrics, as good practice in evaluating the ethical impact and sustainability of an investment in a company. Assessing a company’s business practices and performance based on ESG as a subset of non-financial performance indicators involves measuring the environmental, social, and ethical impact, as well as sustainability in corporate governance issues. It identifies business risks, potential opportunities, and future returns based on these aspects (European Parliament, 2023). The increased awareness and concern for sustainability characterize modern consumers and investors, while climate change, social welfare, and corporate governance scandals have turned public attention towards companies with strong ESG profiles (McKinsey & Company, 2023). Governments and regulatory bodies worldwide increasingly recognize the importance of sustainable practices, enacting policies that require greater transparency regarding ESG issues. Market studies and performances over time have begun to show that companies with strong ESG practices may outperform their less sustainable competitors, thus making good business sense not only for the environment and society (Matos, 2020). In the era of social media, companies can easily be exposed for their poor practices. A failure in environmental management, social responsibility, or governance can lead to significant reputational damage and, consequently, financial performance (Boffo & Patalano, 2020).

ESG policies aim to regulate externalities, which are involuntary side effects of economic activities affecting third parties not directly involved in these activities (Mankiw & Taylor, 2010). These can be positive or negative. Businesses often emit pollutants or degrade natural resources as part of their activities, which can have negative external effects on society causing environmental damages, such as air and water pollution, deforestation, and climate change. The environmental criterion examines how a company acts as a steward of the natural environment it exploits, including a company’s energy use, waste, pollution, conservation of natural resources, and treatment of animals (Boffo & Patalano, 2020). These criteria can also be used to assess any environmental risks a company may face and manage them, as well as the significant financial impacts that future regulatory changes (e.g., carbon emissions limits) could have. ESG policies encourage businesses to reduce their negative environmental impacts and invest in sustainable practices, which can lead to the internalization of environmental costs. This, in turn, benefits society by reducing the overall environmental burden (Brock, 2023; OECD, 2021).

Social external effects arise when a company’s actions affect the well-being of society at large. For example, labor exploitation, discrimination, or unsafe working conditions can create negative social external effects. The social criterion examines how a company manages relationships with its employees, suppliers, customers, and the communities where it operates (Boffo & Patalano, 2020). Social criteria consider the company’s business relationships and its contribution to society. It may include how the company handles health and safety concerns, manages its supply chains, protects customer privacy, invests or donates to communities, or supports employee welfare and development. ESG policies promote ethical labor practices, diversity, and worker welfare, mitigating these negative impacts and contributing to overall societal well-being (Brock, 2023; OECD, 2021).

In corporate governance, issues such as the company’s leadership structure, relationships with employees, executive compensation, employee remuneration, conflict of interest management, internal control systems, and shareholder rights are evaluated—issues that could directly impact a company’s performance (Matos, 2020). Investors, for example, may want to know that a company uses accurate and transparent accounting methods, avoiding companies with unethical practices. Poor corporate governance can lead to inappropriate behavior, fraud, and subsequent market instability from a financial perspective, negatively affecting not only shareholders but also the broader financial system and economy. ESG governance standards encourage transparency, accountability, and responsible management practices. In this way, they contribute to reducing the risk of external impacts related to governance and contribute to the stability of financial markets (Brock, 2023; OECD, 2021).

Indeed, ESG (Environmental, Social, and Governance) policies have gained significant prominence in recent years, becoming a cornerstone in evaluating business practices and guiding investment decisions. With an increasing trend towards socially responsible investment, many investors use ESG criteria to screen potential investments for sustainability and ethical practices, believing that these factors can significantly affect a company’s performance and market value. The general perception is that, in the long term, companies that adhere to good ESG practices are more profitable and financially stable, thereby presenting a lower investment risk. This can lead to positive external effects on competition, providing incentives for other businesses to adopt similar practices to remain competitive in the market. As more companies prioritize ESG, a competitive climate may be created where businesses aim to achieve higher sustainable and ethical standards, ultimately leading to a more efficient and socially beneficial market system.


Bibliographical References

Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris. Retrieved October 29, 2023, from

Brock, T. (2023, March 22). What Is Environmental, Social, and Governance (ESG) Investing? Investopedia. Retrieved October 29, 2023, from

European Parliament. (2023, October 20). Environmental, Social and Governance (ESG) rating activities: Commission proposal for a Regulation on their transparency and integrity | Legislative Train Schedule. European Parliament. Retrieved October 29, 2023, from

Mankiw G. N. & Taylor M.P. (2010, μετάφραση), «Αρχές Οικονομικής Θεωρίας», Τόμος Α’ – Μικροοικονομική, εκδόσεις Gutenberg

Matos, P. (2020). ESG and Responsible Institutional Investing Around the World: A Critical Review. CFA Institute Research Foundation.

McKinsey & Company. (2023, February 6). Consumers care about sustainability—and back it up with their wallets. McKinsey & Company. Retrieved October 29, 2023, from

OECD (2021), ESG Investing and Climate Transition: Market Practices, Issues and Policy Considerations, OECD Paris. Retrieved October 29, 2023, from

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