What is ESG Investing?
ESG (Environmental, Social and Governance) investing refers to a class of investing that is also known as “sustainable investing.” This is an umbrella term for investments that seek positive returns and long-term impact on society, environment and the performance of the business. There are several different categories of sustainable investing. They include impact investing, socially responsible investing (SRI), ESG and values-based investing. Another school of thought puts ESG under the umbrella term of SRI. Under SRI are ethical investing, ESG investing and impact investing.
The Financial Times Lexicon defines ESG as “a generic term used in capital markets and used by investors to evaluate corporate behavior and to determine the future financial performance of companies.” It is used by investors to evaluate corporations and determine the future financial performance of companies. It adds that ESG “are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing a company’s carbon footprint and ensuring there are systems in place to ensure accountability.” They are factors in investment considerations, used in risk assessment strategies incorporated into both investment decisions and risk management processes.
According to Environmental, Social and Governance Issues in Investing: A Guide for Investment Professionals, “There is…a lingering misperception that the body of empirical evidence shows that ESG considerations adversely affect financial performance.” It adds that, “For investment professionals, a key idea in the discussion of ESG issues is that systematically considering ESG issues will likely lead to more complete investment analyses and better-informed investment decisions.”
ESG also refers to environmental, social and governance issues that an investor may consider when making an investment. Following are examples of ESG issues.
- Environmental risks created by business activities have actual or potential negative impact on air, land, water, ecosystems and human health. Company environmental activities considered ESG factors include managing resources and preventing pollution, reducing emissions and climate impact, and executing environmental reporting or disclosure. Environmental positive outcomes include avoiding or minimizing environmental liabilities, lowering costs and increasing profitability through energy and other efficiencies, and reducing regulatory, litigation and reputational risk.
- Social risks refer to the impact that companies can have on society. They are addressed by company social activities such as promoting health and safety, encouraging labor-management relations, protecting human rights and focusing on product integrity. Social positive outcomes include increasing productivity and morale, reducing turnover and absenteeism, and improving brand loyalty.
- Governance risks concern the way companies are run. It addresses areas such as corporate brand independence and diversity, corporate risk management and excessive executive compensation, through company governance activities such as increasing diversity and accountability of the board, protecting shareholders and their rights, and reporting and disclosing information. Governance positive outcomes include aligning interests of shareowners and management, and avoiding unpleasant financial surprises.
What is the Appeal of ESG Investing?
Many investors are not only interested in the financial outcomes of investments. They are also interested in the impact of their investments and the role their assets can have in promoting global issues such as climate action. One demographic that is particularly attracted to ESG investing is millennials. According to a 2006 study called Cone Millennial Cause Study, millennials are more likely to trust a company or purchase a company’s products when the company has a reputation of being socially or environmentally responsible. Half of those surveyed are more likely to turn down a product or service from a company perceived to be socially or environmentally irresponsible.
ESG Investing Factors
ESG investing looks at “extra-financial” variables or factors. Responsible investors evaluate companies using ESG criteria as a framework to screen investments or to assess risks in investment decision-making. Environmental factors determine a company’s stewardship of environment and focus on waste and pollution, resource depletion, greenhouse gas emissions, deforestation, and climate change. Social factors look at how a company treats people and focuses on employee relations and diversity, working conditions, local communities, health and safety, and conflict. Governance factors take a look at corporate policies and how a company is governed. They focus on tax strategy, executive remuneration, donations and political lobbying, corruption and bribery, and board diversity and structure.
ESG investing can take various forms. The S&P Dow Jones Index splits sustainability into two categories: ESG and green or low carbon. The ESG framework of investing tends to capture more factors, while green is more focused. Environmental factors include waste management, water management, environmental resource use, environmental disclosure, environmental impact, and reduction of pollution and emissions. Social factors include stakeholder analysis, workplace mentality, human rights, diversity community relationships, corporate citizenship, and philanthropy. Governance factors include board structure, management compensation, stakeholder impact, stakeholder rights and the relationship between management and stakeholders.
The Difference Between SRI, ESG and Impact Investing
Socially Responsible Investing (SRI) started in the 1970s as investors mostly used negative screening methods to exclude investments in guns, tobacco, gambling, adult entertainment and other vices. Investing in these stocks was seen as supporting morally “bad” or socially irresponsible businesses. The philosophy behind this practice was that capital should be used for morally “good” industries. This basis for perceiving companies within SRI is criticized as a narrow view of the investment universe, thus an impediment to building an optimal investment portfolio.
ESG investing, though sometimes considered synonymous with SRI, is its own class of investing. ESG investing is the integration of environmental, social and governance factors into the fundamental investment process. Using ESG factors or an ESG framework, investors can select companies in which to invest. ESG factors such as environmental friendliness are considered factors in the longevity of a company. In other words, companies that follow high quality environmental, social and governance standards are more likely to outperform their peers in the long-run.
Why do ESG investments work? According to Gitterman Wealth Management, “A successful ESG money manager typically engages in the following strategy: First, he will identify a set of compelling investments, based on his traditional investment selection criteria. Subsequent to doing so, he will apply an ESG lens to this set of viable investments. Last, but not least, he selects those investments that are anticipated to generate a scalable, profitable impact. The reason why impact and returns need not be mutually exclusive is because the ESG lens is only applied to profitable investments that have been identified pre-lens.”
Impact investing is considered the most advanced of the three kinds of sustainable investing. It involves generating a measurable environmental and social impact alongside financial returns. The two are not mutually exclusive. Though profit and impact may conflict and contradict, impact investing rests on finding a way of implementing both financial profitability and creating a positive environmental and social impact.
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