Environmental, Social and Governance (ESG) investing
With so many buzz words surrounding sustainable investing, it can be difficult to understand the actual investment strategies. Throughout the recent rise in responsible investing, ESG has become the standard term. But what does it mean and what does it involve?
What is ESG Investing?
ESG Investing is the practice of incorporating environmental, social and governance factors into investment decisions. There are many reasons to do this, both ethical and practical, but the main reason is to generate sustainable, long-term rewards. It is very similar to Socially Responsible Investing (SRI) but with a more universal strategy and factors that are adopted by the majority, as opposed to tailoring guidelines per individual’s values.
Again, with all sustainable investing, there is never going to be one perfect company, so it is a case of researching and weighing up the different factors: while a company might actively fight climate change, it may not have an overtly diverse board. The main key is intention and transparency; if a company is falling behind in one area of ESG, it may already have policies and plans in place to improve that area. As with everything else investment-wise, research is key.
There are many examples of ESG factors that can be taken into account during the decision-making process. When looking at ESG funds, they will usually stipulate the areas that they focus on and sometimes their ESG screening process.
Environmental factors are focused on the impact on the Earth, including:
- Climate change
- Waste and pollution
- Water-related issues such as usage and waste disposal
- Resource depletion
- Renewable energy
Social factors are based around human rights, animal welfare and companies’ societal impact. This area can include:
- Employee relations and diversity
- Health and safety
- Local community
- Child labour and slavery
- Human rights
- Stakeholder relations
Corporate Governance looks into the management of companies, from its board to shareholders and stakeholders. Other factors include:
- Executive pay
- Board diversity and structure
- Bribery and corruption
- Shareholder rights
- Transparency and disclosure
- Political lobbying and donations
It isn’t just the overall ESG factors and company direction that are taken into account; controversies play a big part in whether a fund will invest in a company. A lot of ESG rating systems and fund screening processes assess any and all company controversies, and weigh up what each controversy means for their ESG impact. The main reason for this is that a controversy can indicate structural problems within a business and with their risk management capabilities. Ultimately though, depending on the controversy, it could have a directly negative environmental, social and/or governance impact.
Each controversy is reviewed and often placed on a scale, such as with the MSCI ESG rating. MSCI rate each controversy as minor, moderate, severe or very severe, based on how minimal or egregious the controversy was and how big the impact was, from low to extremely widespread. Controversies can range from oil spills and regulatory actions to multiple allegations of anti-competitive behaviour.
The importance of ESG investments
With the rise of ESG investing over the years, there has been an inevitable surge in studies as to whether this form of ethical investing is better or worse for the investor. Just a few years ago, the main argument against ESG investments was that by limiting your investment options, you limit your potential profit, thus sacrificing financial gain in favour of being ethical. However this has been disproved numerous times over the years.
In fact, with an increasing global interest in environmental and social issues, ethical investing is now being seen as having practical purpose. As the world moves towards cleaner, greener technologies and practices, sustainable products and companies could become more in demand than ever before. Companies that don’t fit with the ESG criteria may also signal future risk factors as they can sometimes be more prone to controversies and major incidents, such as oil spills and workforce strikes. Bear in mind, though, that every investment has an element of risk and there is always a chance for incidents and controversies within businesses, it may just be more likely for certain companies as we head towards a more sustainable future.