Over the years, more and more investors have shown a growing interest in putting their money where their values align. If you’re a socially responsible investor, using ESG criteria to screen your investments is an integral part of your decision-making. Here’s everything you need to know about this earth-friendly and socially aware investment indicator.
ESG Investing definition: What is Environmental, Social, and Governance (ESG) Investing?
In a nutshell, ESG is used to measure the ethical and sustainable impact of an investment in a company or business. Today, socially responsible investors use ESG criteria to screen investments, as it allows them to evaluate the behavior of companies while determining their future financial performance.
As its name suggests, ESG considers three factors: environmental, social, and governance issues. Imagine, for example, a socially responsible investor looking for a company to put his money in.
Before he decides to invest, the investor does his research on the company’s ESG to answer several questions:
- Is the company taking steps to reduce greenhouse gas emissions?
- How is the company promoting employee diversity?
- Does the corporation have a history of abusing animals?
- Does it have accurate and transparent accounting methods?
Through thorough ESG screening, investors can safely put their money in earth-friendly and socially aware companies that align with their values, and they’re not just doing this as a mere act of virtue signaling.
Research has proven that investors who select ESG-screened investments receive a ‘double dividend’: a better rate of return with a lower risk. ESG investments are also constantly shown to outperform traditional investments.
The history of ESG
How old is the Environment, Social, and Governance standard?
The term itself is more than a decade and a half old. In 2004, former UN Secretary-General Kofi Annan invited over 50 CEOs of major financial institutions to cooperate under the auspices of the UN Global Compact.
The initiative’s purpose was to find creative ways to integrate ESG into capital markets.
Reports backed up its effectiveness
In 2005, the initiative birthed a landmark study entitled “Who Cares Wins”, and the term ‘ESG’ investing was coined for the first time.
The report made a strong case: integrating environmental, social, and governance factors in capital markets lead to better sustainability, generates positive social impact, and makes good business sense.
During the same time, the ‘Freshfield Report’ was also drafted by the UNEP/Fi, which displayed how ESG issues are integral in financial valuation.
Two of these reports spurred the 2006 launch of the Principles for Responsible Investment (PRI) at the New York Stock Exchange and the establishment of the Sustainable Stock Exchange Initiative the following year.
Steady growth through good results
The continuous growth of ESG investing accelerated between 2013 and 2014 when studies based on ESG investments showed that good corporate sustainability performance led to stellar financial results.
Today, ESG investing has boomed to over $20 trillion in assets under management and is still expected to rise over the decade to come. Even before ESG’s inception, however, Socially Responsible Investments, or SRI, has been a solid movement.
However, unlike SRI which focuses on moral and ethical criteria with a set of negative screens like not investing in firearms, tobacco, or alcohol, ESG investing is based on the notion that ESG factors have strong financial relevance.
In 2018, ESG grew even more in popularity when thousands of professionals held the job title ‘ESG Analyst’. Suddenly, the investment performance indicator turned into a major specialty, and ESG investing became the topic of news articles in some of the world’s leading newspapers.
Today, established investors know that determining a corporation’s ESG information is important in understanding its strategy, purpose, and management quality.
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A deeper look at ESG factors
To properly assess a company based on ESG criteria, investors need to investigate a company through different lenses. Asset management companies who want to know how to write an ESG policy must fully understand these ESG factors to develop responsible investment processes.
Here’s everything you need to know about it.
When screening for ESG, investors look deeply into the company’s environmental impact. This may include the company’s treatment of animals, waste, pollution, natural resource conservation, and energy use.
Several questions investors ask themselves before investing are the following:
- Does the company own contaminated land?
- How does it dispose of its hazardous waste?
- Does it manage toxic emissions well?
- How does it comply with government environmental regulations?
- Where does it source its raw materials, and do they contribute to deforestation?
- What are the company’s attitudes toward climate change?
Case in point: Disney
Disney utilizes zero-net direct greenhouse gas emission policies in all its established facilities while working hard to reduce indirect greenhouse gas emissions by reducing electrical consumption.
With a company policy of having a net positive environmental impact, this multinational mass media conglomerate also has a zero-waste policy and uses technology to save water, while lower the footprint of its product distribution and manufacturing.
The social criteria bring to light a vast range of potential issues. While there are many social aspects of ESG, all of them are connected to social relationships. Most vital among these social relationships is the company’s relationship with its employees.
Here are some questions investors may ask themselves when screening for ESG.
- Are employees paid fairly, and how does their compensation fare when compared to other companies and positions throughout the industry?
- What perks and benefits are employees provided with?
- What are the company’s policies regarding inclusion, diversity, and the prevention of sexual harassment?
- Does the company offer training and education programs? Does it offer financial support for higher education, and are employees offered flexible hours to pursue further education?
- How much power are employees given within their respective departments? Are their inputs considered valuable?
- What are the company’s attitudes toward human rights issues? Do they donate to charitable causes?
Case in point: Accenture
Accenture, a multinational consulting and processing company, has one of the world’s most admirable workplaces which consistently earns it a spot on Fortune’s Best Companies to Work For.
With a focus on diversity and inclusion, Accenture continues to improve its workplace gender ratios, with the goal of having an equal amount of male and female employees by 2025. It also pledged to have at least 35% female managing directors.
In the context of ESG, the governance factor measures how a company is managed by its higher-ups. Accounting and financial transparency are also considered to be integral aspects of great corporate governance. Here are some questions investors may ask themselves when screening for governance.
- Do the board of directors and executive management consider the interests of the company’s stakeholders, including the shareholders, employees, and customers?
- What are the company’s advocacies on giving back to the community where they are located?
- Are board members acting in a genuine fiduciary relationship with their stockholders to avoid conflicts of interest?
- Are the members of the board of directors an inclusive and diverse group?
- For many ESG investors, executive compensation is a primary focus. Are executives given million-dollar bonuses while their employees are in a salary freeze? Or are executives offered extra compensation to increase the viability and profitability of the business?
Case in point: Xerox and Advanced Micro Devices
American printing corporation Xerox features a 90%-independent board of directors and a comprehensive list of corporate governance guidelines. The board of directors is tasked to serve on no more than four other boards while holding meaningful equity ownership in the company.
Advanced Micro Devices has a long list of governance principles, which states that directors need to be reelected every year with no more than two employees as directors at the same time. Members of the Compensation Committee and the Audit and Finance Committee are also expected to serve on only one public board, while directors are expected not to overcommit themselves on too many boards.
Putting them all together
Of course, no company will pass every test in all categories, so investors need to focus on values that are important to them. A good example of this is Trillium Asset Management – a Boston-based company that uses a selection of ESG factors to determine which companies are poised for long-term performance.
Trillium follows ESG criteria that avoid companies that derive a certain percentage of their revenues from weapons or nuclear power, or those that dabble in coal mining. The company also avoids putting its money in institutions with ongoing controversies related to animal abuse, workplace discrimination, and corporate governance, among others.
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Why do investors care about ESG?
More and more investors are realizing the value of ESG investing and how it delivers what everyone longs for: great, risk-adjusted performance in the long run.
While assets under management in EST investments are on a steady rise, some investors are still clueless: why should I care about making investments that generate a positive impact? Here are some reasons to consider.
1. Millennials are in on it
According to popular opinion, millennials are a great fit for impact investing. ESG is aligned with virtually all the aspects of a millennial’s decision-making, from consumer habits to jobs and finances, millennials often prioritize the environmental and social impact of everything they do.
According to a 2018 US Trust survey, 87% of millennial investors believe that ESG investing should play a strong role in deciding which companies to invest in. Millennials have a generational wealth amounting to $30 trillion – their passion for impact investing could be largely transformative.
2. ESG may improve company financials
According to research, employing ESG criteria in your investment decisions has a positive impact on financial performance. In one meta-study, ESG performance was measured in over 2000 individual analyses across regions and asset classes between 1970 and 2014.
The study discovered that nearly 50% showed a positive relationship between corporate financial performance and ESG (only 11 found a negative relationship). This is, however, a study done at the company level, which is more likely to find a positive relationship between financial performance and ESG.
3. There’s a positive relationship between ESG and financial performance in emerging markets
There’s a growing number of studies finding a positive relationship between corporate financial performance and ESG in emerging markets than in developed markets. This is mainly because of lower ESG standards across the board in these markets which resulted in larger potential gains.
4. The trade-off between fund performance and sustainability is a myth
Some investors believe that doing the right thing with their money will sacrifice the performance of their funds, but studies say otherwise. A study conducted by Morningstar found that ESG funds have successfully outperformed the wider market over the long term.
Out of 4,900 funds analyzed in the research, over 77.3% of sustainable funds which were made available to investors more than a decade ago are still around today, compared to just 46.4% of traditional funds.
Experts attribute this performance to several reasons, but most believe it could be because ESG funds are typically biased towards higher-quality companies that operate with more efficiency and sustainability.
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What’s in it for you?
A contribution to the global good. Investors put their money in ESG companies that do good for the world. If values are important to you, then ESG investing allows you to talk the talk and walk the walk.
An opportunity to invest in better-performing companies. A growing amount of research proves this. ESG companies are showing annualized returns of 5.46%, a slightly better performance than the S&P 500’s 5.43% over the same period.
A lower risk. By following ESG criteria when choosing your investments, you may be able to avoid companies with practices that could signal a risk factor. Investors know how much a scandal or controversy can rock stock prices, therefore resulting in losses.
Starting an ESG portfolio can be challenging for the uninitiated, but it doesn’t have to be difficult. Since building an investment portfolio takes time, investors can seek the help of robo or in-person advisors to build and manage investment portfolios based on their goals and risk tolerance.
While it’s good to rely on advisors when choosing companies to invest in, it also pays to conduct your own research, especially if you’re an investor that puts huge importance on values and ethical practices.
Read reviews from independent research firms to determine how a company or funds score in the ESG department. Be in the know of the ESG Investing Trends, so you won’t be left behind.
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How to understand an ESG score
Trying to make sense of an ESG score, especially when around 10 to 15 major ESG rating agencies have their own rating scales and reporting formats can be very challenging. For investors, there’s a lot of research to do, especially if you choose to create an ESG-style investment portfolio by yourself.
When portfolio managers develop an Environmental, Social, and Governance investing strategy, they typically consider ESG ratings from over three different agencies in the process of creating their models.
The report a portfolio manager chooses to base his research on is entirely based on his own preference. Here are just some of the most popular third-party ESG reports and rating providers.
1. Bloomberg ESG Data Service
Bloomberg offers a rating scale out of 100, while also providing scores from third-party rating agencies including Sustainalytics, RobecoSam, and ISS Quality Score.
The company evaluates companies on an annual basis while collecting public ESG information companies disclose to them through CSR reports, websites, annual reports, public sources, and company direct contact.
The company’s ESG data covers over 120 ESG indications including carbon emissions, pollution, community relations, human rights, executive compensation, and shareholder’s rights. Bloomberg had over 12,200 ESG customers in the past year.
2. Corporate Knights Global 100
This Toronto-based company is responsible for publishing the Corporate Knights magazine, which includes a list of the 100 most sustainable companies in the world. Corporate Knights are the largest magazine on sustainability and responsible business in the world.
Corporate Knights updates their ESG scores annually and rates on a 0 to 100 scale against other companies in the same industry.
Rankings, which consider 14 key performance indicators including employee management, financial management, and supplier performance, are based on publicly disclosed data with all geographies and industries considered.
3. DowJones Sustainability Index (DJSI)
This is the first global index to ever track down a company’s sustainability. DJSI partners with RobecoSAM for the calculation and publication of ESG indices. With a rating scale out of 100, DJSI annually ranks companies with their peers in the same industry.
The DJSI World Index represents the top 10% of the largest companies in 60 industries. Industry-specific questionnaires which cover ESG factors are sent to all participants.
4. Institutional Shareholder Services (ISS)
This company offers institutional investors a myriad of ESG solutions to help them integrate and develop responsible investment practices in their investment decisions.
The ISS Quality Score rating scale ranks from 1st to 10th decile, analyzing 200 factors that are divided into four pillars: shareholder rights, board structure, audit & risk oversight, and compensation or remuneration.
Scores in the 1st decile show higher quality governance practices and lower governance risk, while scores in the 10th decile show higher governance risk.
See Related: Corporate Governance: Reasons for Effective Management
Frequently Asked Questions
What does ESG stand for?
ESG stands for Environmental, Social, and Governance criteria. Simply put, ESG is an established set of standards that socially conscious investors measure to screen good investments.
The environmental criteria measure how a company’s business practices and initiatives respect the environment. The social criteria examine a company’s relationships with its suppliers, customers, employees, and its community. The governance criteria measure a company’s leadership, audits, executive pay, shareholder rights, and internal controls.
Is ESG Investing Good?
ESG investing is good, and in more ways than one. Aside from having a more ethical portfolio that contributes to a positive impact, there’s growing evidence that ESG investments can deliver similar (if not higher) returns than traditional investments while carrying less risk.
According to a study by the Morgan Stanley Institute for Sustainable investing, the total returns of sustainable ETFs and mutual funds were similar to traditional funds from 2004 to 2018.
The same study also discovered that sustainable funds carried lower risk compared to traditional funds, regardless of the asset class.
What is the difference between ESG and SRI?
Among those creating a sustainable investment portfolio, the terms socially responsible investing (SRI), ESG, ethical investing, and impact investing are often used interchangeably. In reality, there are a few differences you should know about.
Both ESG and SRI’s goals are to create more responsible portfolios. Historically, however, SRI developed a more exclusionary-only approach with goal of filtering out negative investments like alcohol or tobacco. ESG investing, on the other hand, also excludes the same investments, but also considers and includes companies that create a positive impact.
While you’ll still find providers who follow an exclusionary approach in creating socially responsible portfolios, you’ll find providers who will not only exclude certain investments but include ESG funds as well.
So you already know the difference between ESG and SRI, but how about Impact Investing? One must also learn about it. One must also learn about the history of Impact investing and know its importance of it.
Why is ESG so important?
ESG is important to investors as it offers several financial benefits. Companies that display a good ESG score often perform well financially. Socially responsible investors and green investment funds are more likely to support companies with good ESG standings.
According to MSCI, high-ESG companies experience less volatile earnings, lower cost of capital, and smaller risks compared to companies with poor ESG standings.
What is an ESG strategy?
An ESG strategy is a company’s overall game plan of building an ESG policy while developing actionable guides to achieve sustainable operations. When a company creates an ESG strategy, it assesses and identifies the ESG factors it considers aspirational presently and in the future, both from a financial and non-financial standpoint. This may include understanding ESG risks and how to amend them while developing a program with measurable targets.