There comes a time when you want your personal values about the environment to be reflected in the investment choices you make. Making a decision to integrate Environmental, Social, and Governance (ESG) factors into your investment strategy is a great first step. However, that’s only the beginning, as there are many aspects of ESG-based investment decisions to consider in developing a sustainable investment strategy.
First and foremost, it’s important to define ESG investing so you can spot truly sustainable assets from the posers. The precise definition varies, but it could entail allocating your capital to a bond issuer behind a wind farm project or a high-tech company that’s dedicated to impacting society in a positive way. ESG investing factors in sustainability criteria with the goal of also generating a profit.
Unfortunately, there are also bad actors out there who would have you believe that their mission statement aligns with your objectives. However, just because they talk the talk doesn’t mean they walk the walk on ESG. So, you must be selective.
ESG investing is a form of responsible investing that incorporates ESG standards into the decision-making process. In addition to evaluating financial returns, it also considers assets based on their sustainability track record, whether it’s an ESG rating on a company or some other metric.
To understand how important ESG investing has become in the financial world, all you have to do is consider some statistics. ESG assets set a fresh record in 2021 of about $35 trillion and are poised to reach $50 trillion by 2025, according to Bloomberg Intelligence data.
When it comes to sustainable investing, there’s no shortage of information out there. We’ve narrowed it down, and in this article, we’ll explore some of the key factors to consider when making ESG-based investment decisions.
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While an official sustainability classification system has yet to be established, there are ESG criteria you could look out for when making ESG-based investment decisions. You can choose to focus on the factors that mostly align with your own personal values around sustainability.
Whether you are considering investing in a company or another asset, like a government bond whose proceeds will be directed toward a solar power farm, for example, keep ESG in mind:
- Environmental: Ask yourself, are the decisions and actions of a company, government or project affecting the environment in a positive way? Is this entity focused on shrinking its carbon footprint alongside the UN’s carbon neutrality goal of net-zero emissions by 2050?
- Social: How is this company (or other entity) impacting the community in which they exist? Does their mission statement reflect a focus on issues like diversity (gender, race, etc.), healthcare or human safety that will make the community stronger?
- Governance: How a company’s hiring history or its behavior around the board of directors and ESG reporting reflect similar goals around diversity, risks, anti-corruption behavior, compensation/bonus incentives, etc.
Companies and entire sectors of the economy have a heightened awareness of ESG criteria these days. As investors continue to hold companies accountable for their sustainability efforts, the degree to which ESG is reflected in corporate America’s activities should only grow stronger.
The importance of considering ESG factors in investment decisions has never been more apparent. It is being seen and heard in many ways. As an example in financial services, Bank of America in 2021 upped its promise to support community-driven efforts toward racial equality and economic opportunity to $1.25 billion.
Think about all the natural disasters you’ve heard about lately, whether it’s flooding in South Asia or drought conditions in California, unbearable heat with temperatures soaring to almost 50 degrees Celsius or food crises like the egg shortage that the United States is experiencing at the moment. These situations play into the environmental risks and could serve as catalysts to consider ESG-based investment decisions.
When it comes to developing an ESG investment strategy, the first step is to define what your investment goals might be, both on sustainability and returns. Not all ESG investing looks the same, and your strategy should align with your own personal values and morals. Let’s take a few examples inspired by Harvard Business School.
- Exclusionary Screening: This involves avoiding companies to invest in whose activities do not line up with your ESG standards. If it’s the environment, you might avoid companies that participate in the exploration and production of fossil fuels.
- Positive Screening: The flip side of negative screening is positive screening, whereby you measure companies based on how they rate your ESG criteria. You might decide to invest in the leading companies in a given sector, such as retail, with the smallest carbon footprints.
- ESG Integration: This model is where you select companies that have strong ESG ratings attached. One of the ways to measure this is through the MSCI ESG ratings, through which you can learn which companies are effectively managing their ESG-related opportunities and risk. According to JPMorgan, companies with strong ESG ratings have a habit of being more competitive and profitable, leading to solid financial returns.
Speaking of risk, just because you are investing in assets that are designed to bring positive change to society and humanity doesn’t mean there aren’t risks involved. Therefore, in addition to considering an asset’s ESG-related risks, it’s wise to establish your personal risk tolerance level before making ESG-based investment decisions.
In general, you can expect companies that rate well for ESG to expose investors to lesser risk for issues like litigation and fraud. This is because of their commitment to risk management in their behaviors as it relates to sustainability matters, whether it’s around the climate, energy, wastewater, corporate ethics, or something else.
As an example, the technology company Taiwan Semiconductor operates in the water-intensive business of making chips for electronics. However, it also operates in areas of Taiwan where there is “water stress.” As a result, this company has become proactive about the conservation and recycling of water, which has had a positive effect on its water withdrawal intensity.
When making ESG-based investment decisions, there are some steps you can take to ensure you stay on the right path. Among them is to evaluate the ESG performance of the companies and industries you are researching as investments. There’s no single metric to come to this conclusion, and you’ll have to weigh a variety of factors. For example, you can ask yourself a set of questions:
- How sustainable is it? To answer this, you might consider the ESG rating or certification on this asset, if available.
- Are the company’s values aligned with mine? For example, if they operate in sectors like defense/weapons or fossil fuels, how does that align with your ESG values? If it’s a consumer product-oriented company, what kind of greenhouse gas emissions does it cause?
- How do this company’s ESG behaviors compare with its competitors? One way to measure this performance is by its ESG rating or score, also taking into account financial performance over a period of time.
It’s important to strike a balance between ESG criteria and financial performance. After all, you are investing for a reason — to protect and grow your wealth. In addition to doing good for the environment, you want an asset to do good for your investment portfolio.
A Reuters report reveals that a positive ESG showing has a tendency to strengthen financial performance. In the five years leading up to 2022, stock funds that were skewed toward companies with strong ESG scores outperformed global benchmarks, especially in Europe. In this particular study, companies with high scores on governance did better than those that scored the best on the social component.
On a shorter-term basis, you might not always see the same results. While 2022 was a tough year for the broader stock market, ESG funds struggled more than their conventional counterparts. Where you begin to see ESG funds outperform is over three-year or five-year time frames, experts say.
It’s okay to set ESG-related investment goals. However, just make sure they are attainable. One way to do this is to consider the past performance of the assets you are considering buying over a five-year or 10-year time frame. If the asset’s mission and performance meet your return profile, it could be a good candidate.
You should have a good basis for making ESG-based investment decisions. Whether it’s knowing what to look for in a company or defining an ESG strategy, you can be on your way to building a portfolio that reflects your sustainability standards. In some ways, you’ll have less risk exposure with ESG assets by the nature of these very companies to have a positive impact on communities and society.
Remember, this process involves sidestepping companies with questionable activities as much as it does identify ones focused on themes like carbon neutrality, for example. Decide which aspects of ESG are most important to you, and lean on ratings and certifications where you need to. Nothing’s perfect, so don’t forget to do your own research.
The size of assets being directed into this category is only expected to grow in the coming years, and you don’t want to be left behind. The sooner you can integrate ESG criteria into your decision-making process, the sooner you will be able to see your investments, and potential financial performance, aligned with your personal goals.