What Is ESG?
ESG, which stands for environmental, social, and governance factors, refers to non-financial criteria that investors can use to determine whether companies are socially and environmentally responsible.
ESG investing is considered a form of sustainable or impact investing, but the term itself is more specific to emphasize that companies must focus on positive results in these three areas.
There is, however, no universally shared set of ESG criteria used by all investors or financial firms to evaluate a company’s soundness or risk along these lines. Rather, investors must learn which standards a certain fund or stock adheres to before choosing to invest.
Even so, there has been growing interest in ESG strategies in the last decade, as many of these funds have shown themselves to offer competitive returns vs. traditional strategies.
Breaking Down the 3 ESG Factors
The following are some of the common factors that investors consider when evaluating the three different ESG areas.
The environmental component of ESG criteria might include metrics on a company’s energy emissions, waste, and water usage. Investors may also focus on the risks and opportunities associated with the impacts of climate change on the company and its industry.
Some company information that environmentally conscious investors may evaluate include:
• Pollution and carbon footprint
• Water usage and conservation
• Renewable energy integration (such as solar and wind)
• Climate change policies
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The social component of ESG generally describes the impact of a company’s relationships with people and society. Factors as varied as corporate culture, commitment to diversity, and how much a company invests in local organizations or communities can impact socially conscious investors’ decisions on buying into a specific corporation.
Some other social factors can include:
• Employee pay, benefits, and perks
• Diversity, equity, and inclusion
• Commitment to social justice causes
• Ethical supply chains (e.g., no sweatshops, conflict-free minerals, etc.)
The governance component of ESG generally focuses on how the company is run. Investors want to know how the board of directors, company, and shareholders relate to one another.
Some additional governance factors that investors evaluate include:
• Executive compensation, bonuses, and perks
• Diversity of the board of directors and management team
• Transparency in communications with shareholders
• Rights and roles guaranteed to shareholders
What Is ESG Investing?
As discussed, investors use ESG criteria to screen potential investments; if a business’s operations don’t follow ESG standards, investors may avoid putting money into the company. In that sense, ESG investing can be seen as a type of socially responsible investing.
But, as mentioned above, there is no universal set of standards for what makes a company ESG friendly. Companies committed to ESG operations may publish sustainability reports to give investors some insights into the firm. Additionally, third-party organizations have stepped in to create ESG scores for companies and funds based on their adherence to various ESG factors.
How ESG Scores Work
ESG scores — sometimes called ESG ratings — are designed to measure a company’s performance based on specific environmental, social, and governance criteria. Investors can use them to assess a company’s success, risks, and opportunities concerning these three areas.
An ESG score is typically calculated by analyzing a company’s available data on environmental, social, and governance policies and practices using various sources, like SEC filings, government databases, and media reports.
A high ESG score means a company manages ESG risks better than its peers, while a low ESG score means the company has more unmanaged ESG risks. Evaluating a company’s ESG score, along with financial analysis, can give investors a better idea of the company’s long-term prospects.
Some of the most prominent ESG score providers are MSCI, Morningstar Sustainalytics, and S&P Global. But some financial firms conduct their own ESG evaluations and provide proprietary scores. Transparency into how the scores are calculated can vary.
ESG vs SRI vs Impact Investing
ESG investing is sometimes called sustainable investing, impact investing, or socially responsible investing (SRI). However, impact investing and socially responsible investing are often viewed differently than ESG investing.
Some of the differences between the three investment strategies are:
• ESG investing focuses on a company or fund’s environmental, social, and governance practices and traditional financial analysis.
• Socially responsible investing eliminates or selects investments according to specific ethical guidelines. Investors following an SRI strategy may avoid investing in companies related to gambling and other sin stocks, or they may avoid companies that cause damage to the natural environment — or both.
• Impact investing is generally done by institutional investors and foundations. Impact investing focuses on making investments in companies or projects specifically designed to generate positive social or environmental impact.
In addition there is another designation investors may want to know, green investing refers to strategies that are purely focused on benefiting the environment.
Last, corporate social responsibility initiatives, or CSR refers to programs and initiatives that organizations may establish on their own. Often, these business decisions support socially responsible movements, like environmental sustainability, ethical labor practices, and social justice initiatives.
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What Are ESG Standards?
As noted, ESG standards vary depending on the entity or organization who has established the standards. As an example, here is a breakdown of the types of standards being used to evaluate companies in the ESG space.
A company may:
• Publish reports detailing pollution emissions, energy use, management of harmful or toxic chemicals.
• State criteria or benchmarks for emissions and pollutants
• Uses renewable energy sources
• Reduces waste
• Maintains clean water standards
A company may:
• Embrace policies around fair wages
• Work toward an ethical supply chain
• Encourage all forms of diversity
• Has policies to prevent and address sexual misconduct
• Avoids vendors with questionable workplace safety or that employ child labor, especially from partners abroad
• Adheres to data privacy
• Supports the local community
A company may:
• Establish a code of ethics for its leadership
• Adhere to diversity standards for its board of directors
• Foster corporate transparency around political contributions and more
• Embrace policies that prevent fraud
Why Is ESG Investing Important?
ESG investing is important because it offers investors a way of putting their money into causes that are significant to them, with the hope of having a genuine impact via their investments in certain companies or funds. This is why ESG is often called impact investing, although true impact investing is a broader term, and refers to a range of companies that may or may not be focused on sustainable issues.
Whether or not companies or funds that embrace ESG strategies deliver on the promised goals is a matter for investors to decide via due diligence. As noted above, without a commonly agreed-upon set of standards and some form of accountability, it’s difficult to ascertain which companies are truly having an impact.
Are ESG Strategies Profitable?
Nonetheless, investors have continued to be interested in ESG strategies. In 2021, socially responsible U.S. mutual funds saw record inflows of some $70 billion — a 36% increase over 2020. ESG funds saw substantial outflows through 2021 and most of 2022. But sustainable funds still managed to outperform non-sustainable funds through Q3 of 2022, despite challenging market conditions, according to Morningstar research as of September 30, 2022.
During the third quarter of 2022, sustainable large-cap funds netted $525 million, versus their unsustainable equity peers, who lost $25 billion that period.
Two other studies from Morningstar added to the evidence that funds which embrace socially responsible investing strategies tend to outperform conventional mutual funds.
Their “Sustainable Funds U.S. Landscape Report” from February 2022 found that “two thirds of sustainable offerings in the large-blend category topped the U.S. market index last year compared with 54% of all funds in the category.”
According to the report: “There are 5 times as many sustainable funds in the U.S. today than a decade ago, and 3 times more than five years ago.”
Types of ESG Investments
Investors can make ESG investments in the stocks and bonds of companies that adhere to ESG criteria or have high ESG scores. Other potential investment vehicles are mutual funds and exchange-traded funds (ETFs) with an ESG strategy.
Buying stocks of companies with environmental, social, and governance commitments can be one way to start ESG investing. However, investors will often need to research companies that have ESG credibility or rely on third-party agencies that release ESG scores.
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The bonds of corporations involved in ESG-friendly business practices can be a good option for investors interested in fixed-income securities. Green and climate bonds are bonds issued by companies to finance various environmentally-friendly projects and business operations.
Additionally, government bonds used to fund green energy projects can be an option for fixed-income investors. These bonds may come with tax incentives, making them a more attractive investment than traditional bonds.
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Mutual Funds and ETFs
Investors who don’t want to pick individual stocks to invest in can always look to mutual funds and exchange-traded funds (ETFs) that provide exposure to ESG companies and investments.
A growing number of index funds invest in a basket of sustainable stocks and bonds. These funds allow investors to diversify their holdings by investing in one security.
However, not all ESG funds follow the same criteria and may focus on different aspects of environmental, social, and governance issues. Interested investors would do well to look under the hood of specific funds to evaluate their holdings and other criteria.
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Identifying ESG Companies
What is the best way to find an ESG company? There are a number of resources available for ESG investors, including proprietary tools that allow investors to search and/or evaluate different stocks based on specific criteria.
There are also a number of lists published by financial media companies that evaluate companies and funds according to ESG criteria.
Financial ratings firms like Morningstar publish regular research reports on different aspects of the ESG sector.
In addition, many industry firms and fund-providers have their own proprietary evaluation methods that investors might consider. Here are five of the biggest companies that provide ESG ratings, according to Fortune.com.
• FTSE Russell: Publishes ESG ratings on 7,200 securities
• ISS ESG: Provides ratings on 11,800 issuers and 25,000 funds
• MSCI: Publishes ESG ratings for over 8,000 companies worldwide
• Refinitiv: Calculates ESG scores on 11,800 companies
• Sustainalytics: Publishes ESG ratings on more than 13,000 companies
Benefits of ESG Investing
ESG investing has several benefits, including:
• Improving long-term financial performance: A growing body of evidence suggests that companies with solid ESG ratings may be good investments. They tend to outperform those with weaker ratings, both in share price performance and earnings growth.
• Mitigating risk: ESG factors can help identify companies with poor governance practices or exposure to environmental and social risks, leading to financial losses.
• Creating social and environmental impact: By investing in companies that are leading the way on environmental, social, and governance issues, investors can help drive positive change and make a positive impact on society.
These potential benefits are increasing the popularity of ESG investing. According to Bloomberg, global ESG assets may surpass $41 trillion by the end of 2022 and reach $50 trillion by 2025, up from $22.8 trillion in 2016.
Risks of ESG Investing
The main disadvantage of ESG strategies is that they limit the number of investments that people can consider. Thus, some investors may end up trading potential returns for the ability to invest according to their values.
In addition, ESG investments can sometimes come with higher costs, for example an ESG fund may have a higher expense ration vs. a traditional counterpart.
While there is a growing body of data regarding the performance of ESG indices and securities, it’s still a relatively new sector relative to more traditional investments.
Starting an ESG Investment Portfolio
If you’re interested in creating an ESG portfolio, you can start by contacting a financial advisor who can help you shape your investment strategy.
However, if you are ready to start investing and want to build a portfolio on your own, you can follow these steps:
• Open a brokerage account: You will need to open a brokerage account and deposit money into it. Once your account is funded, you will be able to buy and sell stocks, mutual funds, and other securities.
• Pick your assets: Decide what type of investment you want to make, whether in a stock of a company, an ESG-focused ETF or mutual fund, or bonds.
• Do your research: It’s important to research the different companies and funds and find a diversified selection that fits your desires and priorities.
• Invest: Once you’re ready, make your investment and then monitor your portfolio to ensure that the assets in your portfolio have a positive social and financial impact.
It is important to remember that you should diversify your portfolio by investing in various asset classes. Diversification will help to reduce your risk and maximize your returns.
ESG Investing Strategies
ESG investing can be different based on values and financial goals. It’s therefore essential to start with your investment goals and objectives when crafting an ESG investing strategy. Consider how ESG factors can help you achieve these goals.
It’s also crucial to understand the data and information available on ESG factors; this will vary by company and industry. When researching potential ESG investments, you want to make sure a company has a clear and publicly-available ESG policy and regularly discloses its ESG performance. Additionally, it can be helpful to look at third-party scores to determine a company’s ESG performance.
In recent years, investor interest in sustainable investing strategies like ESG has grown. In addition, there is some data that suggests that ESG strategies may be just as effective as traditional strategies in terms of performance.
This is despite the fact that ESG criteria are inconsistent throughout the industry. There are a myriad different ways that companies can provide ESG-centered investments, but there aren’t industry-wide benchmarks for different criteria or success metrics.
Thus, it’s fair to say that there is no “right” way to invest in ESG companies. What matters most is that you have done your own research; you are comfortable with the companies you are investing in; and you believe in their ability to create long-term value.
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What are the three pillars of ESG?
ESG stands for three areas that some companies strive to embrace by being proactive about the environment, supportive of social structures, and transparent and ethical in corporate leadership.
What are some examples of ESG investing?
There are countless ways to add ESG strategies to your portfolio: You can consider investing in green bonds, in companies that focus on environmentally supportive technologies, in funds that invest in a multitude of renewable energy companies, clean water initiatives, carbon sequestration, and more.
What is the difference between ESG and sustainability?
Sustainability is a broader term. Environmental, social, and governance factors may support sustainability in different ways: by limiting air or water pollution, by supporting fair labor practices, by insisting on transparency in corporate governance.
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