By Leonel Chapa Mata
The term Environmental, Social, and Governance (ESG) was first used in a 2005 article, “Who Cares Wins”, authored by twenty financial institutions from nine countries with total assets under management of over $6 trillion. The report suggested a direct connection between how companies manage their environmental, social, and governance issues with the quality of its management.
However, even after more than 16 years, confusion reigns on use of the term. According to a survey of 475 institutional investors by State Street, 56% of the institutions which have adopted ESG investing cite a lack of clarity over what the term means. A wide variety of labels -- sustainable investing, socially responsible investing, ethical investing, impact investing -- describe the same, or similar, fields.
To some extent, ESG replaces CSR, short for Corporate Social Responsibility, adding the environmental and governance dimensions. ESG Investing is focused on the noun, not the adjective, reflecting the use of such non-financial information to analyse and evaluate potential investments. It looks at ESG from the investor’s point of view. In other words, ESG factors qualify and quantify both risk and reward factors that should be considered in a potential investment.
ESG investing differs substantially from the use of ESG factors to evaluate sustainability. In the latter case, the goal is to judge whether and to what extent a company is sustainable. In the former case, the focus is on using ESG ratings to determine whether a company is likely to provide an attractive financial return.
The UN Principles for Responsible Investment (PRI) defines ESG Investing as a strategy and practice to incorporate environmental, social, and governance factors in investment decisions and active ownership. These factors cover a wide spectrum of ESG considerations which may impact a company’s performance and value.
Environmental risk factors are concerned with impacts coming from carbon emissions, waste, pollution, or other harmful climate effects.
Social risk factors include Diversity, Equity & Inclusion (DEI) factors, labor issues, and community relations.
Governance factors involve how the company manages its business, including board diversity, compensation, disclosures, oversight, and shareholder policies.
It is important and relevant for individual investors and the investment community to understand the various ESG investing approaches. In recent years additional strategies segmenting the ESG investing realm have been offered:
Exclusion and/or norms-based screening: avoiding investments that don’t match social values. Investors can choose to exclude sectors or companies in controversial business areas, such as cannabis or weapons
Thematic investing: social, economic, industrial, and demographic trends, or themes, that drive positive performance of a portfolio of securities
Impact investing: capital allocation with the explicit intention of having a positive and measurable social or environmental impact, in addition to financial returns
Engagement: the use of shareholder power to influence corporate behavior, including the filing of shareholder proposals according to ESG guidelines
Best-in-class screening: investment in sectors, companies, or projects selected for positive ESG performance relative to industry peers
With the appearance of diverse ESG investment strategies over the last decade, there has been an increase in their adoption. The US Sustainable Investment Forum (SIF) reports that total US-domiciled assets under management using ESG strategies grew from $12T to $17.1T between 2018 and 2020. The 42% increase in investments which applied ESG strategies over the past two years resulted in 33% of total professionally managed assets in the US with ESG strategies. In the eyes of investors, the need for reporting and compliance is greater than ever.
Full transparency and a strategy for ESG risk mitigation have become key criteria for investment decisions. Decisions about where to put funds, and due diligence, require careful consideration of ESG factors and ratings. There also are options to invest in ESG index funds, ETFs and mutual funds comprising firms with positive ESG ratings. Hundreds of such funds are available for investors’ consideration.
On the other side of the investment coin, company managers seeking investment should place the management of ESG risks and reporting of ESG accomplishments at the forefront of their business models and strategies. This makes their companies more attractive to investors, and beneficial to the planet.