What is ESG Investing?
Investors are using environmental, social, and governance information to choose their investments. Find out how you can do the same.
By Asiyah Choudry
UPDATED: August 1, 2024
ORIGINALLY PUBLISHED: February 24, 2021
What ESG investing is, and what it’s not.
As awareness of sustainability issues increases, individuals are seeking financial products that are aligned with their environmental values. ESG investing refers to an investment strategy that incorporates environmental, social, and governance factors into investment decisions. Investors examine ESG information to augment traditional financial analysis, by analyzing the risks and opportunities associated with these factors.
ESG investing is also referred to as sustainable investing. Other investment strategies that fall under the sustainable investing umbrella include socially responsible investing (SRI) and impact investing. Although the terms ESG investing, socially responsible investing (SRI), and impact investing are often used interchangeably, ESG is a distinct form of investing. The primary focus of impact investing is producing positive measurable environmental and social impacts, sometimes at the expense of financial returns. In contrast, ESG looks at company performance across various ESG factors to try and determine how that will affect a company’s long-term success.
Key considerations for ESG investors
Let’s take a look at some of the information that an ESG investor might examine to determine whether or not a company is ESG compliant:
- Environmental factors might include climate change policies, GHG emissions, compliance with environmental regulations, and treatment of animals.
- Social factors include employee working conditions, support for social causes, and business relationships.
- Governance factors look at a company’s board of directors, transparency, relationships with stakeholders, and diversity in leadership.
Investing in an ESG fund does not always mean that you are investing in climate-positive companies. Given that ESG funds consider a broad range of factors, including social and governance aspects, not all companies within these funds have strong environmental credentials. For investors particularly interested in carbon emissions, industry experts are now starting to look specifically at environmental factors such as the company's carbon footprint, waste management practices, and overall impact on natural resources.
Indeed, there are many different views on how to invest to reduce one’s carbon footprint or to slow climate change. S&P Global splits sustainability into many different indices looking at categories like ESG, carbon efficiency, and alignment with various climate objectives. Many institutional investors use specialist rating firms, like Morningstar’s Sustainalytics, to determine the carbon risk rating of different investments, without a focus on social and governance factors. GreenPortfolio aims to provide this type of clarity to anyone interested in greening their investments by scoring publicly traded stocks and funds for climate impact. To see if your money is funding fossil fuel, sign up for GreenPortfolio’s free platform today.
How are ESG criteria applied?
Two of the most common strategies for applying ESG criteria are negative screening and ESG integration. The Principles for Responsible Investment (PRI) defines negative screening “as the exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria.” Using a negative screening approach, an investment fund might choose to exclude the tobacco and fossil fuel sectors due to negative social and environmental impacts. The effort to divest personal, pension or endowment assets from oil and gas companies would fall into this bucket.
ESG integration is a profit-oriented strategy that analyzes traditional factors such as cash flow and capital allocation in addition to financial analysis. ESG integration has steadily gained popularity amongst individual investors. PwC surveyed asset managers and institutional investors, and estimates that $4.5 trillion was managed under an ESG strategy in 2021 in the US, and is projected to grow to $10.5 trillion in 2026.
Investment funds employ a wide variety of ESG strategies. As a result, ESG-compliant companies can be found across all sectors. For example, many ESG funds hold companies like Amazon, Alphabet, Apple, and Microsoft. There is no requirement that companies held in ESG funds have a positive environmental or social impact. For example, although Amazon decreased greenhouse gas emissions by 3% from 2022 to 2023, it has increased emissions by 34.5% since 2019, when it initially made its net-zero commitment. Nonetheless, the company complies with most ESG filters. Despite a lack of meaningful change, Amazon’s historical climate commitments have been reason enough for ESG funds to include it.
Additional considerations when researching ESG funds
Performance can exceed traditional funds
A 2023 report from Morgan Stanley Institute for Sustainable Investing found that U.S. sustainable equity funds outperformed traditional funds that year, with a median return of 12.6% compared to 8.6%. While there are nuances to these performance results – not to mention keeping in mind that past performance doesn’t guarantee future results – there’s reason to believe that sustainability and profit need not be mutually exclusive.
The ESG style of investing is growing in popularity
In the US, Morgan Stanley reports that the percentage of total assets under management that employs sustainable investment strategies increased by 15% between 2022 and 2023 (see footnote). The popularity of these funds is on the rise, even with mounting criticism.
Lacking a single industry standard for measurement
A central issue in ESG investing is the absence of a standard methodology for applying ESG criteria. While there have been significant advancements in ESG standards and reporting frameworks, the absence of a universally accepted methodology for applying ESG criteria continues to be a challenge. Companies might be classified as ESG compliant in some cases and noncompliant in others depending on the methodology that is used. In an effort to increase transparency, the EU is in the process of developing performance thresholds across the entire industry that will require ESG portfolio managers to provide evidence to support the claim that they have invested sustainability. Increased regulatory oversight could help to reduce greenwashing in the US and could reduce some of the uncertainty associated with ESG ratings.
The future of ESG
Overall, ESG investing is a promising starting point for individuals interested in sustainable investments. However, as ESG investing gains mainstream traction, it has also become a target of significant political backlash and controversy. Critics argue that ESG criteria can be vague and inconsistently applied, leading to accusations of “greenwashing” and political bias.
Despite these challenges, efforts to improve transparency are underway. For instance, Refinitiv has recently made company ESG scores freely available to consumers, a significant step towards increasing transparency and facilitating investments in socially and environmentally responsible organizations.
With Bloomberg Intelligence predicting that global ESG assets will reach $40 trillion by 2030, ESG investing is here to stay. It’s crucial to ensure that your values are accurately represented by your investments. While considering ESG funds for your portfolio, thorough research is essential to navigate the complex and often politicized landscape of sustainable investing.
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Footnote
A note on methodology
It is important to note that the findings reported in Morgan Stanley’s 2023 Sustainable Reality are based on a specific methodology and dataset (see p2 of the report for details). These factors should be considered when interpreting the report's findings.
In summary, the analysis covers the performance of approximately 97,000 global funds between January 1, 2023 and December 31, 2023. Funds analyzed met Morningstar’s “sustainable” classification, which includes but is not synonymous with an ESG classification, see here for more information.
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