ESG investing is increasingly woven into corporate America’s fabric even as the rules are still being written. While the term ESG was first coined in 2005, it has only been in recent years that changes in corporate and government behavior have become evident. ESG policies are not only built into the mission statements of businesses but have also begun to shape the way that governments raise funds and investors choose assets.
ESG investing is a strategy in which sustainable standards drive the decision-making process. While stocks are a major component of it, as investors cherry-pick companies that check all the right ESG boxes, sustainable investing is not limited to stocks.
Increasingly, the fixed-income asset class is also making its way into ESG investing, where corporations and governments issue debt tied to the development of some sustainable project or endeavor. In addition, ESG investments have made their way into various types of funds, where portfolio managers are increasingly using ESG as one of the thresholds by which they evaluate an asset, in addition to potential returns, of course.
As sustainability continues to gain popularity, ESG investing has never been more important in today’s financial landscape, especially after the health crisis. ESG issues have been thrust into the spotlight as investors seek assets with the risk/return profile associated with ESG. A 2020 EY survey reveals that 98% of investors polled are more rigorously evaluating companies based on features other than just financial returns.
Investors have begun holding companies and governments accountable for their impact on the environment and society as a whole. They are using ESG as a criterion for assets in which they choose to invest, like climate fintech, and shunning those assets whose practices are deemed harmful to society or the human race.
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The rules on ESG are still being written, including a classification system that defines ESG criteria. However, there are ways to evaluate ESG investments, chief among which are ESG ratings assigned to individual companies. These ratings weigh how resilient a business is to long-term financial risks and opportunities that ESG can present.
Meanwhile, the industry is mature enough that we can make some determinations about what comprises an ESG-compliant asset. Let’s start with the acronym itself — ESG.
- Environmental criteria reflect the impact that a company or government’s endeavors are having on the environment. Some of the themes around “Environmental” include tackling greenhouse gas emissions, other air pollution, water/wastewater management, hazardous materials, and biodiversity. The environmental component of ESG is the primary driver of demand in this market segment.
- Social criteria reflect the company or government’s impact on the community or society as a whole. These themes include labor practices, health and safety issues, community engagement, and more.
- Governance criteria reflect how a company approaches corporate governance, such as diversity on the board or among the staff, mission statement, relationship management, etc.
The ways that these criteria are affecting companies and entire industries have only begun to scratch the surface. Sustainability is now branded into the consciousness of management teams as big and small investors alike demand this from leaders across sectors of the economy and regions around the world.
Several years ago, these criteria weren’t nearly as influential on investors’ decisions. However, the tide has begun to turn, as evidenced by a fivefold increase in web searches for ESG in the four years leading up to 2022. Companies across sectors of the economy are directing more of their balance sheets toward sustainable initiatives. One sign of this is with companies that are members of the S&P 500 index, 90% of which now provide ESG reports.
Prior to this fundamental shift taking place, you could still find traces of sustainability in traditional investing. Before ESG, sustainability was more a defensive play in which investors and portfolio managers avoided sectors of the economy that they deemed harmful, like tobacco, defense, and gambling, to name a few.
When an investor decides to make ESG part of their strategy, this doesn’t mean that they must sacrifice returns. On the contrary, there are a host of benefits related to ESG investing, ranging from financial performance to staying true to one’s core belief system.
Let’s start with returns. According to a McKinsey report, including ESG in the evaluation of investments does not interfere with returns. In fact, based on the results of thousands of studies, ESG-related financial performance is positively more than two-thirds of the time, with negative findings emerging 8% of the time.
A Thomson Reuters report agrees, saying companies that have achieved higher ESG scores have a tendency to perform better in the stock market and other financial metrics vs. companies with low scores in this area. As businesses take steps to move toward lowering their carbon footprints, these measures are “strongly correlated” to their financial performance, another study reveals.
Beyond performance, another benefit of ESG investing is the positive effect it can have on an investor’s reputation and brand image. With so much emphasis being placed on ESG themes, the investment landscape is clearly moving in this direction. Businesses and investors alike are taking pride in the way that sustainability is being reflected within their own structures and also choosing projects that are designed to have positive social results.
As investors engage in ESG-related issues, they are empowered to take a more active role in their investments. Not only are they taking responsibility for the assets they own, but they are holding companies and issuers accountable for how they weigh ESG opportunities and risks.
With ESG gaining so much traction in the financial services industry, there’s no shortage of ways to gain exposure to this niche in your investment portfolio. One way is by choosing ESG funds and ETFs.
Exchange-traded funds are passive investment funds that track the performance of some index. Therefore ESG ETFs specifically track the performance of ESG-related companies or fixed-income instruments. If you’re wondering how popular they are, consider the size of the assets.
There are over four dozen equity ESG-related ETFs available to invest in across $194 billion-plus. In addition to stocks, there are also ESG ETFs dedicated to the fixed-income asset class. However, these funds lagged behind the broader market in the 12 months leading up to September 2022.
Another way to invest in ESG is by selecting individual companies in which to invest, which requires doing your own research. This is where ESG scores can work in your favor. MSCI ratings are designed to identify the leaders and the laggards when it comes to ESG criteria. They rate stocks, bonds, loans, mutual funds, and entire countries. MSCI’s rating system is as follows:
- Leaders = AAA-AA
- Average = A, BBB, BB
- Laggard = B, CCC
MSCI explains that ESG risks and opportunities vary based on the sector, and they find the most relevant criteria by which to evaluate a company or entity based on these metrics. For example, they consider the voluntary disclosures that a company makes as it relates to ESG reporting and product risks around things like emissions intensity, hazardous substances, and water intensity at a company by which these standards are relevant.
When investing in ESG, it’s important to understand what to expect. For example, you might not experience immediate profits when selecting ESG investments. That could be said of traditional investing, too, as there’s no crystal ball. But when you are focusing on a specific niche, like ESG, it helps to be patient. If you are prepared to invest in the long haul, then ESG investing has proven to deliver positive financial results to investors over time.
The key is to strike a balance between your personal values and the returns that an asset has the potential to deliver. After all, you’re investing to protect and grow your wealth. At the moment, companies are increasingly making ESG disclosures voluntarily, but this trend is expected to become a mandatory requirement.
There’s no single reporting standard for ESG. As a result, the onus is on investors to determine whether a company is truly seeking to benefit society and the human race or is merely attempting to pull the wool over their eyes, a practice dubbed greenwashing.
However, in the meantime, the Sustainability Accounting Standards Board (SASB) has created an ESG guidance framework to help investors. It establishes standards for sustainability reporting by corporations.
ESG is an exciting asset class for which demand is only getting stronger. As ESG criteria become more defined, investors will have even more transparency on the companies and other assets that they want to own. For investors with sustainability goals of net-zero emissions, ESG investing is a surefire way to support that mission while also setting yourself up for financial returns over the long term.
However, the regulatory framework for ESG investments is still being formalized. In the meantime, there could be some shakeout in the industry as companies and fund managers alike reassess to meet new standards, especially as the field of climate fintech grows. ESG as an investment category is still evolving, and there is greater clarity ahead as it becomes more mature. As an investor, you are encouraged to continue to do your own research on ESG-related assets, including the benefits and risks that they involve.