Environmental, Social and Governance: All About ESG Investing

September 23, 2022

Socially responsible investing has grown rapidly in recent years, and providers and investors alike are jumping on sustainable investment opportunities.

ESG investing is an institutionalized attempt to clarify sustainable investment strategy by using particular criteria to grade investments, making it simple to compare companies and sustainable finance investment products.

Criteria to measure ESG investments create a framework for helping investors who want to incorporate personal values and passions into their investment process.

What is ESG Investing?

“ESG” stands for environmental, social, and governance. It’s a way of investing in companies based on their commitment to one or more ESG factors. It is often also conflated with sustainable investing, socially responsible investing, or impact investing, but all terms have slight differences.

Environmental, social, and governance are non-financial factors investors can use to measure an investment or company’s sustainability. 

Environmental factors examine the conservation of the natural world, social factors examine how a company treats employees and people outside the company, and governance factors consider how a company is run and managed.

How Does ESG Investing Work?

ESG investing is a form of sustainable investing that considers non-financial factors to judge an investment’s financial returns and its overall impact. An investment’s ESG score measures the sustainability of an investment decision in those specific categories.

Many companies measure their own performance regarding ESG metrics and tout those performances in annual reports and other documents. ESG performance for individual companies is also measured and reported by third-party providers such as Morningstar, Bloomberg and MSCI, as well as the media.

According to the US SIF Foundation’s 2020 trends report, U.S. assets under management using ESG strategies grew to $17.1 trillion at the beginning of 2020. That’s a 42% increase from $12 trillion at the beginning of 2018.

What Are ESG Criteria?

ESG criteria allow investors insight into a company’s adherence (or lack of) to ethical practices. Investors can research companies to find out how they score on ESG criteria by using websites such as Sustainalytics, a division of Morningstar, which reports companies’ ESG rank and compares it to other companies in that industry.

The three components are defined in the following ways:

Environmental Criteria

A company’s impact on the environment and its ability to mitigate various risks that could contribute to climate change. This may include:

  • Climate change policies including carbon footprint and carbon intensity, deforestation, greenhouse gas emissions, water usage and conservation, overfishing, and waste management
  • Renewable energy usage
  • Publishing a sustainability report that tracks fund managers’ and companies’ ESG data

Social Criteria

Social factors assess issues affecting employees, customers, consumers, suppliers, and the local community. Examples of ESG issues include:

  • Employee treatment and compensation, training and development, and engagement and turnover
  • Employee safety policies and sexual harassment prevention
  • Diversity and inclusion in hiring, promotions, and pay increases
  • Ethical supply chain sourcing
  • Customer service performance
  • Consumer protection activity, including lawsuits, recalls, and regulatory penalties
  • Public stance on social justice issues

Corporate Governance

This factor assesses a company’s internal processes as they relate to transparency, independence, leadership effectiveness, and business ethics. Specific governance issues include:

  • Executive pay, bonuses, and perks
  • Policies that define and enforce ethical business practices
  • Diversity of the board and management team
  • Shareholders’ ability to nominate board candidates
  • Transparency of shareholder communications

Benefits of ESG Investing

Aside from having an investment portfolio that may better align with your own values, ESG has other potential compelling benefits.

Potential Higher Returns

A 2019 white paper from the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds with traditional funds and found that from 2004 to 2018, the total returns of sustainable mutual funds and ETFs (exchange-traded funds).

JUST Capital ranks companies based on factors such as whether they pay fair wages or take steps to protect the environment. It created the JUST U.S. Large Cap Diversified Index (JULCD), and ESG Index which includes the top 50% of companies in the Russell 1000 (a large-cap stock index) based on those rankings. 

Since its inception, the index has returned 15.94% on an annualized basis compared with the Russell 1000’s 14.76% return.

Portfolios incorporating ESG and sustainability also frequently performed better in the long term than those that don’t. For example, Morningstar found that over a period of 10 years, 80% of blend equity funds investing sustainably outperform traditional funds. 

They also found that 77% of ESG funds that existed 10 years ago have survived, compared to only 46% of traditional funds.

Can Help Lower Risk

The same Morgan Stanley study found that sustainable funds consistently showed a lower downside risk than traditional funds, regardless of asset class. 

The study found that during market corrections or crashes, such as in 2008, 2009, 2015, and 2018, traditional funds historically had significantly larger downside deviation than sustainable funds, meaning traditional funds had a higher potential for loss.

ESG funds have even managed to post strong performance since 2020. Of 26 sustainable index funds analyzed by investment research company Morningstar in April, 24 outperformed comparable traditional funds in the first quarter of 2020.

ESG vs. Socially Responsible Investing vs CSR

Another common term for the process of creating a sustainable investment portfolio is socially responsible investing, or SRI. While SRI and ESG both seek to build more responsible portfolios, there are a few differences between the two terms.

ESG is a system for measuring the sustainability of a company or investment in three specific categories: environmental, social and governance. Socially responsible investing, ethical investing, sustainable investing and impact investing are more general umbrella terms.

Historically, certain forms of sustainable investing varied in how they created their portfolios. For example, SRI used an exclusionary-only approach to filter out investments referred to as “sin stocks,” like tobacco, alcohol, or weapons. ESG investing excluded those same investments, but also included companies deemed to be creating a positive impact.

CSR, or corporate social responsibility, is a business practice taken on by a company to improve a local community, the environment, or society at large. Beyond helping their cause, CSR initiatives can improve a company’s public opinion. CSR initiative planners may take ESG factors into consideration when detailing their CSR strategy.

Types of ESG Investments

There are many ways to invest in ESG, but here’s a short list of well-known methods.

For help in finding specific investment products, there are financial advisors and financial institutions that offer investment management for investors with a focus on ESG.

ESG Stocks

Some companies offer an impact report, which highlights any sustainable or cultural initiatives they’ve implemented and how they handle issues such as carbon emissions. 

ESG Funds

Funds can help to quickly provide diversification. The number of ESG funds has surged in recent years. According to Morningstar data, there were 303 open-end and exchange-traded funds in 2019, up from 270 in 2018.

Some of these funds focus on a particular issue, such as green energy, making it easy to personalize your portfolio’s area of impact. With a  mutual fund screening tool, you can compare different funds to see how their ESG ratings stack up.

To learn more about the specific details of a particular fund, such as what companies the fund invests in, you’ll want to look through its prospectus. This document should be available online, and will include other helpful information like the fund’s expense ratio.

History and Growth of ESG Investing

According to Commonfund Institute, an asset management firm that serves nonprofits and public pensions, responsible investing dates as far back as Colonial times when some religious groups refused to invest their endowment funds in the slave trade.

However, socially responsible investing didn’t emerge until the middle of the 20th century. It was driven in the 19660s by opposition to the Vietnam War and by the civil rights movement, and in the 1970s, by an increase in environmental awareness and broad opposition to apartheid in South Africa.

Recent Boom in ESG Investing

Recent years have seen a significant expansion of ESG investing around the globe as organizations and individuals increasingly recognize the interdependencies between social, environmental, and economic issues.

The COVID-19 pandemic stoked this trend greatly as market disruption and uncertainty led many investors to turn to ESG funds as more of the general public became more involved in social issues. In fact, in the first three months of the COVID-19 lockdown, we saw $45.6 billion USD flow into ESG funds globally.

$30.7 trillion currently sits in sustainable investment funds worldwide, and it is predicted that this could rise to $50 trillion in the next two decades. More investors are looking to fund organizations and products that support and promote sustainability, and comply with emerging regulations such as climate change and human rights regulations.

The boom in ESG investing can likely be attributed to a variety of factors. As supply chains become more complex, there is a wider awareness of social, labor, and human rights issues and risks to the business world. Growing concerns for environmental issues such as climate change also influence shareholder decisions.

Heightened engagement of groups previously less involved in traditional investing — younger generations and women, notably — is also thought to have contributed to the ESG investing boom. To reflect evolving societal values and norms, more companies have been compelled to adopt ESG practices to remain competitive in their industry and contribute to the common good.

Industries and companies that are slow to make these changes receive increasing criticism and pressure from shareholders, stakeholders, and concerned citizens alike. Legal obligations are also expected to progressively tighten for these industries.

In May 2021, a Dutch court ruled that Royal Dutch Shell cut greenhouse gas emissions by 45% by 2030. In the same week, ExxonMobil and Chevron faced pressure from their shareholders to reduce the companies’ contributions to fossil fuel emissions. It is likely these events could  spark further transformations in these industries.

Bottom Line

As issues like climate change and COVID-19 have demonstrated the fragility of business-as-usual methodology, they have also highlighted the importance of organizational resiliency. 

As investors’ sentiment changes, the investment world has to follow suit. The popularity of ESG investments has proved this. It’s now attracting more investment than any other area in the world. It’s predicted that ESG investments will reach over $50 trillion by 2025, or about a third of all money invested globally. 

Because of increasing interest, there are a growing number of funds and investment firms that cater to ESG investments. If you have a personal passion for climate change mitigation or social justice issues, it should not be difficult to invest in ESG products. 

This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.

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