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Guide to Environmental, Social, and Governance (ESG) Investing
Environmental, Social and Governance (ESG) investing involves considering a company’s environmental, social and governance practices when making investment decisions. It’s a strategy used by socially conscious investors looking to invest in companies whose values align with their own.
This article will help you understand ESG investing, how it works, and how adopting an ESG investment strategy can help you achieve your financial goals.
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What is ESG Investing?
Environmental, social, and governance (ESG) investing encourages investors to use their conscious when making investment decisions. Instead of looking at a company’s financial record alone, ESG investors look at a company’s environmental, social and governance record as well before deciding to invest.
Considering environmental factors involves examining the steps being taken by a company to protect the environment. Social factors examine how companies treat their employees, customers, suppliers and the communities in which they operate. Governance involves considering factors such as a company’s leadership structure, executive compensation, internal controls, and shareholder rights.
History and evolution of ESG investing
ESG investing began in the 1960s, as ‘socially responsible investing’, as investors began avoiding investing in companies associated with tobacco production or the South African apartheid regime. The practice was rebranded in the 1980s as ‘corporate social responsibility’ when companies began recognizing the importance of being transparent about their impact on society and the environment. It’s only since the 2000s that investors started commonly using the term ESG investing.
Once a niche concept, ESG investing is becoming more mainstream as investors increasingly look to invest in companies whose values align with their own. For investors with a social conscious, it’s no longer enough to consider a company’s finances alone when deciding whether or not to invest.
As demand for more information about a company’s ESG performance has grown, so has interest in greater standardization and transparency in ESG reporting.
In response to increasing demand, ESG Ratings have been established to provide investors with industry-specific assessments of ESG issues, risks and opportunities.
Importance of ESG Investing
ESG investing helps investors understand how a company treats its workers, managers, customers, communities, shareholders and the environment.
Well-run companies go out of their way to establish and achieve ESG goals. And well-run companies may align with investors goals.
ESG investing helps promote more ethical business practices. The more investors focus on ESG factors when making decisions, the more companies look to integrate ESG considerations into their business plans.
ESG Factors
Environmental
Environmental factors assess a company’s environmental impact and risks and opportunities presented by climate change and other environmental issues.
Environmental issues considered by ESG investors include:
- Energy efficiency and consumption
- Greenhouse gas emissions and carbon footprint
- Climate change mitigation and adaptation strategies
- Air and water pollution
- Natural resource conservation and depletion
- Deforestation
- Biodiversity loss
- Waste management
Social
Social factors consider how a company treats the people it interacts with. That includes their workers, suppliers, and customers, and the members of the communities in which they operate.
Social factors include:
- Employee compensation – including providing a living wage to employees
- Diversity, equity and inclusion (DEI) programs
- Community relations
- Funding of initiatives that serve poor and underserved communities
- Support for human rights and labour standards
- Employee experience and engagement
- Workplace health and safety
- Treatment of customers and suppliers
- Customer satisfaction
- Data protection and privacy policies
Governance
Governance deals with how a company is governed. Governance factors examine the policies and internal controls a company adopts to ensure compliance with regulations, industry best practices and corporate responsibility.
Governance factors include:
- Company leadership and management
- Board composition
- Executive diversity and structure
- Executive compensation policies
- Financial transparency and business integrity
- Regulatory compliance
- Whistleblower programs
- Rules on corruption, bribery, conflicts of interest, political donations and lobbying
- Risk management initiatives
- Adoption of ethical business practices
Opportunities and Challenges in ESG Investing
Opportunities
Potential for higher returns: ESG investing helps generate returns while supporting ethical business practices. Companies that focus on ESG considerations may be better positioned to capitalize on new opportunities that may lead to enhanced potential for growth and returns.
Positive impact: ESG investing lets you invest in companies who share your values and have a positive impact on society. ESG investing involves looking beyond a company’s financial performance alone to considers a company’s environmental, social, and governance performance as well. ESG investing has gained considerable attention over the last few years as investors increasingly look to invest in companies committed to making a positive contribution to the world.
Reduced risk: Companies that pollute the environment or act unethically may be unsustainable. By focusing on ESG, companies demonstrate their commitment to sustainable business practices and thereby, mitigate emerging risks. As a result, investing in these companies may present fewer risks for investors.
Improved corporate behaviour: Investing in companies committed to ESG encourages more ethical business practices. When investors prioritize ESG factors, companies prioritize them as well. ESG investing sends a strong signal to corporations that a commitment to ethical behaviour is actually good for business.
Challenges
Limited investment opportunities: Some companies aren’t as committed to ESG factors as others. As a result, ESG investing can limit the number of investment opportunities available to you. For example, companies that produce high-levels of greenhouse gas emissions wouldn’t be considered ESG-focused companies. In addition, smaller companies often don’t have the resources required to meet ESG standards.
Potential for lower returns: While ESG-focused companies may be more sustainable over the long term, and provides a return on your values and have a positive impact on society they may not be as profitable in the short term.
Subjectivity: Evaluating a company’s commitment to ESG factors can be subjective. Investors may have different standards for what they consider to be ethical corporate behaviour. For example, some investors may place a higher priority on a company’s environmental practices. Others may think a company’s social, or governance practices are more important. As a result, deciding which companies are most ethical, or what constitutes ethical business behaviour, can be dependent on an investor’s particular values and beliefs.
Lack of standardization: There are multiple ESG frameworks and benchmarks available for companies to choose from for their reporting, which means companies within same industry may use same or different frameworks. Hence, there’s no standard benchmark for evaluating a company’s commitment to ESG considerations. This can make it hard for investors to compare one company’s business practices to another. It can also be particularly difficult to compare ESG factors across companies that operate in different industries and geographic regions. This lack of standardization can make it hard for ESG investors to make informed investment decisions.
How are ESG Scores Determined
ESG scores provide a qualitative assessment of a company’s commitment to ESG factors. Some companies use a standardized framework to assess their ESG performance. These frameworks may be developed by third-party groups such as the Global Reporting Initiative or the Task Force on Climate-Related Financial Disclosure. ESG ratings can also be obtained from third-party ratings agencies.
Examples of ESG rating systems include:
MSCI ESG rating
S&P Global Corporate Sustainable Assessment
Institutional Shareholder Services ESG
Bloomberg ESG data
Ratings are developed by collecting as much information about a company’s ESG initiatives as possible and assessing it against a standard assessment framework. This information is then used to rate a company’s ESG performance. The MSCI ESG rating system, for example, assigns companies with an ESG rating based on a numerical score of between 0 and 10 and a letter grade:
Leader: 7.143-10.000; AA or AAA.
Average: 2.857-7.143; BB, BBB, or A.
Laggard: Less than 2.857; CCC or B.
How to Start ESG Investing
Start investing in ESG-focused companies by following these three steps.
- Open a brokerage account. You need to open a brokerage account to buy and sell investments. You can review features and tools provided by some of the most popular brokerages here.
- Determine ESG criteria: Determine which ESG factors are most important to you. This will help you decide what to focus on when researching companies’ ESG practices and making investment decisions.
- Research investments and buy: Research different companies based on the ESG criteria that’s most important to you. Some brokerage platforms let you screen companies based on specific ESG criteria and minimum ESG scores.
You can choose to invest in individual ESG stocks or ESG mutual funds and ETFs. Investing in an ESG mutual fund or ETF avoids having to research individual stocks and lets you benefit from the expertise of a professional money manager. There are several online tools available to help you research and buy ESG mutual funds and ETFs.
Conclusion
ESG investing helps you invest in companies whose values align with your own. ESG investing is becoming increasingly popular among socially conscious investors and encourages companies to adopt more socially minded business practices. While investing has historically focused on generating returns alone, it doesn’t have to. Feel good about the investment decisions you’re making by adding ESG focused investments to your portfolio.
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