What is ESG?
ESG investing is the consideration of environmental, social and governance (ESG) factors, alongside financial factors, when making investment decisions. Many socially responsible investors have taken these factors into consideration, as part of their investment process for many years, but an ever-increasing focus from people, governments and regulators on the broader impact that companies are having on the world that we live in means that companies and investors are now being asked (and in some cases required) to measure and report the way in which they do this, and acknowledge and provide explanations in instances where they do not. It seems like it should be easy, but ESG factors actually cover a broad range of issues, from avoiding investing in oil and tobacco companies, to financing green energy initiatives. At its core, ESG investing is about influencing positive changes in society through better investing.
Here’s a closer look at the three criteria used to evaluate companies for ESG investing:
Environmental
Examines the way in which a company’s operations impact on our natural environment, focusing on:
- waste and pollution
- resource depletion
- greenhouse gas emission
- deforestation
- climate change
Social
Looks at how companies give due consideration for the treat people and relationships, and focuses on the following:
- employee relations and diversity
- working conditions
- local communities: funding projects or institutions that will serve poor and underserved communities
- health and safety
- conflict
Governance
Addresses the rules, practices and process employed to run the company, and highlights concerns such as:
- tax strategy
- executive remuneration
- donations and political lobbying
- corruption and bribery
- board diversity and structure
- ESG limitations
How Does ESG Investing Work?
At its simplest level, the evaluation of companies using ESG criteria can be used to screen investments that fail to meet a certain required standard. However, as we have seen these factors are wide-ranging, and in many cases are not black and white. Adopting an ESG strategy means investing more in companies that score highly on environmental and societal responsibility scales third-party, independent companies and research firms such as MSCI, Sustainalytics, Bloomberg, FTSE Russel and S&P. These firm provide clear and helpful metrices for comparing different investments. These firms’ ratings tend to rely on multiple criteria to evaluate each of the individual E, S and G components. Scores generally work on a 100-point scale: The higher the score, the better a company performs in fulfilling different ESG criteria. Scores may vary between firms, which may employ different metrics and weighting schemes.
Pros of ESG Investing
1. Investing in line with your Beliefs
Socially responsible investing is one way people can make a difference in the world if they are looking to do so. Also, for investors who are concerned about war, racism, deforestation, and pollution, they have the option to invest in companies or funds that tackle these issues and more.
2. A way to De-Risk your Portfolio
More companies have started to realise the need for ESG strategies as an important part of their strategy for long term survival and not simply a way to look good in the eyes of investors. For this reason, the future might include more companies investing in socially responsible activities. And if this happens, making socially responsible ESG investments now might help you avoid the risk of losing money in the future.
3. An Opportunity to Reward Ethical Companies
The more investment ethical companies receive from investors, the stronger they grow and the more initiatives they can implement to handle contentious issues. If investment is redirected away from unethical companies, they become deprived of needed capital to grow and expand. In the long run, more companies will join the sustainable route which will have a bigger positive impact on the planet by doing so.
Cons of ESG Investing
1. Missing out on lucrative Investment Opportunities
Concentrating your investment approach on ESG investments can lead to missed opportunities with better returns from companies and funds which don’t currently have an ESG focus. Eliminating lucrative investment opportunities because of their lack of an ESG focus can negatively impact the potential returns of your investment portfolio. Careful consideration must be given to striking a balance between your ESG values and your required investment portfolio returns.
2. Ethics Vs. Performance
When investing your money, many people’s primary objective is to make returns. It is important to give consideration to whether you have any specific objectives when considering ESG investing, and to introduce a way of prioritising and ideally measuring these, within your investment assessment framework. If a company is too focused on specific non-commercial objectives, such as social responsibility, financial performance may suffer, causing investors to lose out, at least over the short term.
3. Greenwashing is a Problem
Unfortunately, many companies will claim to be acting in socially responsible, environmentally friendly ways, and many investment fund managers claim to take ESG factors into account as part of their investment decision making processes but their social responsibility / ESG / impact investing activities are just marketing stunts, or ‘green-washing’, to look good, avoid scrutiny or criticism, and attract investment from investors who are too busy or not sufficiently well informed or advised to be able to tell the difference.
Conclusion
When investing your money, it is important to understand that approaches to ESG responsible investing can vary from company to company. Some may align with your attitude to risk and personal ethics, while other may not. ESG investments carry can carry risks and might not be suitable for all investors. They should be considered as part of an overall diversified portfolio.
