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
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.
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 mean that you are investing in renewable energy. For investors who are specifically interested in carbon emissions, industry experts are starting to look specifically at environmental factors. Investors interested in funds that directly support renewable energy production can find some options on GreenPortfolio’s Funds page.
Indeed, there are many different views on how to invest to reduce one’s carbon footprint or to slow climate change. The S&P Dow Jones Index splits sustainability into three categories: ESG, carbon efficiency, and alignment with various climate objectives. Many institutional investors use specialist rating firms, like 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 investing in renewable energy by identifying all the ways that your capital can fund renewable energy development.
How are ESG criteria applied?
Two of the most common strategies for applying ESG criteria are negative screening and ESG integration. The Global Sustainable Investment Alliance 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 environmental, social, and governance factors in financial analysis. ESG integration is the most popular sustainable investment strategy in the US, with an estimated $9.5 trillion in assets managed under this strategy.
Norms-based screening is another commonly used approach, which measures compliance with international guidelines developed by organizations such as UNICEF, the UN, or the OECD. Positive screening is the practice of including investments in certain sectors or companies based on positive ESG performance.
There are a wide variety of ESG strategies that are employed by investment funds. 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. Amazon, for example, increased its carbon emissions by 15% in 2019 yet is still compliant with most ESG filters. Although Amazon has not reduced its carbon emissions yet, simply its commitment to reduce emissions is reason enough for ESG funds to include it.
Why you should consider investing in an ESG fund
Performance is comparable to traditional funds
A 2004-2018 study of 11,000 mutual funds, conducted by Morgan Stanley, found that there was no statistically significant difference in the total returns of traditional funds and sustainable funds. The same study found that sustainable funds had a 20% smaller downside deviation, indicating that sustainable funds may offer lower market risk and greater stability.
Aligning your investments with your values
By choosing to invest in an ESG fund, you are using your money to support companies that share your values. By screening out companies that are large polluters or that don’t invest in worker safety, you avoid supporting harmful practices and help create a culture of conscious investment and corporate social responsibility.
The ESG style of investing is growing in popularity
In the US, the percentage of total assets under management that employs sustainable investment strategies increased by 38% between 2016 and 2018. ESG investing is entering into the mainstream, with ESG-focused ETFs and mutual funds are launching in record numbers. The popularity of these funds means that they are now having to compete more and provide more options and accountability to consumers.
Shortcomings of ESG
While ESG investing is a promising alternative to traditional, profit-driven investment strategies, it can fail to fully account for a company’s environmental, social, and governance performance.
A central issue in ESG investing is the absence of a standard methodology for applying ESG criteria. 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 sustainably. This type of regulatory oversight could help to reduce greenwashing in the US and could remove the uncertainty associated with ESG ratings.
Another issue is that ESG investing often fails to fully account for the environmental performance of companies. ESG funds might include oil companies, or tech companies that have poor environmental performance on the basis that they have a strong social impact. For example, the Kensho Clean Power ETF has significant oil and gas holdings in addition to a variety of utilities which distribute electricity produced from coal. An ESG title still requires the holder to perform thorough due diligence before purchasing as there is no external agency ensuring the fund met any sort of standard.
The future of ESG
Overall, ESG investing is a great starting point for individuals who are interested in investing their money sustainably. As ESG investing moves into the mainstream, more work needs to be done to improve transparency and ensure that ESG criteria accurately capture the performance of different companies. Refinitiv has recently made company ESG scores freely available to consumers. This is a highly welcome, significant industry development to increase consumer transparency and to facilitate investment into socially responsible organizations.
As the number of ESG investment options on the market grows, now is the time to make sure that your values are accurately represented by your investments. Consider adding ESG funds to your portfolio, but make sure to research them thoroughly first.
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