ESG investing is one of several trends that have gathered momentum in the investing world over the past two decades. Various events and movements have resulted in people becoming more conscious of their impact on the world around them.
One of the results of changing values has been the emergence of a range of investment products which allow investors to control or limit their impact on the world around them. This post explores the evolution of ESG investing, the different areas of focus and the types of products available to socially and environmentally conscious investors.
- What is ESG investing?
- Why is ESG investing growing?
- ESG factors for sustainable investing
- ESG investing vs. traditional investing
- Pros and cons of ESG investing
- Outlook for ESG investing
What is ESG investing?
Various terms are used interchangeably with the term ESG investing. These include responsible investing, SRI investing, sustainable investing and impact investing. While there is a lot of overlap between these themes, they are different. Responsible investing and SRI (Socially Responsible Investing) generally refers to the exclusion of certain industries or companies from a portfolio. This can be based on values, beliefs or religion. The terms sustainable investing and ethical investing are often used to refer to the same concept.
Impact investing takes things further by investing in companies that are actively trying to solve social and environmental problems. Recently, Beyond Meat listed on the New York Stock Exchange with market value of over $10 billion. The company produces meat substitute products made from vegetable protein. The objective is to produce a high-quality meat substitute with less environmental impact. Before the IPO the company was funded with $122 million over several rounds. This illustrates the potential returns impact investing can generate.
While ESG investing covers the same themes, it focuses on how they can affect the economic value of an investment opportunity. ESG factors can create both risks and opportunities for companies. In this way they become as fundamental to analysis as compound interest, margins or growth. ESG scores are therefore used alongside traditional metrics to analyse investments.
A good example of the benefit of ESG analysis is the VW scandal that occurred in 2015. In the years leading up to the scandal, several ESG ratings firms had flagged the company on ethics related concerns. This allowed investors paying attention to limit their exposure to VW stock.
Areas of ESG investment analysis
ESG stands for environmental, social, and governance. Most of the principles for socially and environmentally responsible investment can be divided between these three areas.
Environmental issues that ESG investors look at include pollution and resource management. Companies can limit their negative impact on the environment by limiting emissions and reducing energy consumption and waste. Failing to do so can result in potential liabilities as well as higher costs.
Social issues concern the entire community a company interacts with, including customers and employees throughout the supply chain. Effective labour management, working conditions, training, and health and safety standards can improve the lives of employees. This can improve productivity and lower the potential for liabilities. Customers benefit from fair pricing and safe products. This too reduces the risks a company faces and improves a company’s brand value. Investing in local communities can create goodwill and a safer environment for a business.
Governance concerns the way a company’s board is structured, executive pay, accounting standards, transparency and other ethical considerations. This area covers a company’s relationship with shareholders, regulators and the financial system. Effective governance aligns the interests of executives with those of shareholders and reduces the financial and reputational risk.
Why is ESG investing growing?
Several trends over the past few decades have led to a growing awareness of the impact of businesses on the environment and society:
- Global warming is just one way in which the impact of industry on the environment has become apparent.
- There is growing awareness of the impact that industries like tobacco, alcohol and gambling can have on society.
- High profile corporate scandals have led to growing recognition of the ways corporate governance can affect financial markets, employees, shareholders and pension fund beneficiaries.
These issues have led to financial institutions seeing growing demand for products that invest in companies that consider their impact on society and the environment. While many people originally saw ESG or sustainable investing as just another way to market and differentiate investment products, attitudes are now changing. Responsible investment opportunities are now viewed as more likely to be sustainable in terms of profitability.
When ESG investing originally emerged it was assumed that investing responsibly would come at a cost. Many investors expected that they would have to give up some returns for investing ethically. However, in many cases ESG funds have performed in line, or even outperformed, more general funds. Empirical evidence is also beginning to suggest that companies that take their responsibilities seriously are more likely to succeed in the long run. There is growing acceptance now that ultimately values begin to affect the economic environment. Companies that align their values with those of society can build a competitive advantage.
Climate change has been the most visible catalyst for sustainable investing. Firstly, the impact of climate change has been witnessed around the world. And secondly, investors have seen the impact of investing in renewable energy. Renewable energy has become cheaper to produce due to the investments made in technology. This has become an example of the way in which impact investing can simultaneously be profitable and solve problems.
Most large asset management firms have offered some form of sustainable investing product for some time. Institutional investors are now beginning to incorporate ESG factors in their process too. What began as a niche opportunity is now becoming a component of mainstream investing.
ESG factors for sustainable investing
Various frameworks have been developed for managing ESG funds. These tend to vary from one firm to the next, but ESG data is expensive to gather. This has prompted several rating agencies and research firms to publish ESG rating scores. ESG data is gathered from company reports and from external publications. For the most part ESG data is focussed on equities and fixed income, and not on other asset classes.
Most fund managers use raw data from ratings agencies to construct their own ESG scores. These are then used to construct investment portfolios around specific objectives. To incorporate ESG issues with other forms of financial analysis, it helps to break them down to a set of ESG factors. These are grouped within the three ESG categories. A commonly cited framework is the SASB materiality map. Not all these factors are relevant to every company. This framework includes:
- CHG emissions and air quality
- Energy and fuel management
- Water and wastewater management
- Waste and hazardous materials management
- Ecological impacts
- Human rights and community relations
- Customer privacy
- Data security
- Access and affordability
- Product quality and safety
- Customer welfare
- Selling practices and product labelling
- Labour practices
- Employee health and safety
- Employee engagement, diversity and inclusion
- Product design and lifecycle management
- Business model resilience
- Supply chain management
- Materials sourcing and efficiency
- Physical impacts of climate change
- Business ethics
- Competitive behaviour
- Management of the legal and regulatory environment
- Critical incident risk management
- Systemic risk management
ESG investing vs. traditional investing
The primary difference between the various forms of sustainable investing and traditional investing is the objective. Traditional investing is focussed on profitability and financial returns first and foremost. SRI investing puts socially responsibility first, and then considers the factors that contribute to profitability. Impact investing considers the environmental or social impacts an investment can have first. While these outcomes come first, impact investing does aim to make businesses economically sustainable too.
The more sustainable a business model is, the more impact it can have in time. ESG investing combines sustainable investing with traditional investing, although that is not necessarily the objective. ESG factors are used to identify ESG related opportunities and risks that may affect returns. It is therefore not that far removed from well-established investing practices. Increasingly ESG factors are being used alongside other factors.
Pros and cons of ESG investments
Like any investing style, ESG investing comes with several advantages and disadvantages. For this reason, ESG considerations are best included as a component of an investing plan, rather than in place of other approaches.
- Perhaps the biggest advantage of sustainable investing is that investors do not have to make a choice between being ethical and generating returns. ESG investing allows one to be a responsible investor and make financial returns.
- ESG factors can now be easily combined with other factors like value, growth, quality and size. This even makes sustainable investing easily compatible with ETF investing.
- The effectiveness of ethical investing should improve. As more data becomes available, decision can become better informed. Growing awareness of ESG issues should also make them more important for any business to consider.
- A wide range of ESG investment funds, including ETFs and mutual funds is now available. This has made it easy for the financial advice industry to incorporate ESG products in the asset allocation process.
- Sustainable investing is a long-term process. In the short term sustainable investing strategies are just as vulnerable to market sentiment as any other. To reduce volatility, a portfolio still requires diversification across other asset classes like hedge funds or real estate.
- Larger companies have more resources to devote to ESG reporting. The result is that larger companies often receive better ESG ratings when that may not reflect reality.
- Sustainability data is now widely available for companies in the United States and other developed economies. In developing economies data is not readily available. This makes ranking and scoring companies around the world challenging.
- ESG analysis considers the way in which SRI issues affect economic value. In many cases this results in more responsible investing. However, it can result in important factors being ignored if they don’t affect value.
Outlook for ESG investing
It is now widely accepted that ESG factors affect the economic value of a company. As such it is likely that ESG principles will become a standard part of many investment processes. The challenge for quantitative investing firms has been a lack of ESG related data. But we are now reaching a point where relevant data has been collected for long enough to be useful. In addition, new sources of big data are becoming available. All this data can be analysed using artificial intelligence and machine learning techniques.
Over the next decade we can expect quant managers to take the lead in determining how ESG factors affect investment returns. This will strengthen the case for including ESG factors in traditional analysis. SRI investing and impact investing may become more fragmented. Responsible investing will be driven by market demand. This may result in more products that allow investors to customise portfolios based on their own values.
Impact investing is becoming increasingly associated with technology. Often the biggest impact can be made by solving problems with new technologies. This tends to be the domain of venture capital firms, and many are now launching funds targeting impact investing opportunities.
The other growing arena for impact investing is crowd funding campaigns. These allow large groups of people to contribute small amounts to empower small businesses, farmers and cooperatives. Often these investments are made without the expectation of a return. The opportunity in this space will be to offer tangible returns for these investments. The growth of sustainable investing is and will continue to lead more companies to become mission driven rather than profit driven.
Patagonia, the outdoor clothing brand is focussed around its mission which states: “Build the best product, cause no unnecessary harm, use business to inspire and implement solutions to the environmental crisis.” The company has built a large and loyal following by adhering to this mission. Numerous other companies are doing the same.
Conclusion: ESG factors leading the way to responsible investing
ESG investing has grown rapidly to the point where it is becoming a component of mainstream investing. However, there is probably a long way to go. Investors should keep an open mind to the industry. On the one hand it provides opportunities to be a responsible investor and possibly improve returns. On the other hand, ESG strategies are not a replacement for a well-balanced portfolio of assets and strategies.