Investors today are looking for assets that align with their values while generating strong returns. ESG investing is the best way to achieve that. It offers a chance to support sustainable companies while potentially boosting your portfolio’s performance.
This guide explores what is ESG investing. It enables you to make informed investments that benefit your bottom line and the world around you.
What is ESG?
ESG is an acronym. It stands for Environmental, Social, and Governance.
These three factors represent a series of standards you can use as a socially conscious investor to screen potential investments.
Factor | Definition | Examples |
Environmental factors | A company’s environmental impact. | Carbon emissions; pollution; waste management; resource use; renewable energy; toxic chemicals |
Social factors | How a company treats its employees, customers, and the communities in which it operates. | Labor standards; human rights; product safety; data security; employee relations; supply chain ethics; board diversity |
Governance factors | The quality of a company’s leadership, executive pay, audits, internal controls, and shareholder rights. | Executive compensation; board structure; business ethics; tax transparency; corruption policies; political lobbying |
While socially responsible investing (SRI) has existed for decades, ESG as a framework emerged in the early 2000s. The United Nations and a group of key financial leaders were the first to coin the term in the 2004 “Who Cares Wins” report.
The report is designed to encourage companies and analysts in the investment industry to:
“…better incorporate environmental, social and governance (ESG) factors in their research where appropriate and to further develop the necessary investment know-how, models and tools in a creative and thoughtful way.”
ESG has gained considerable traction in recent years. Many investors today incorporate ESG factors and criteria into their investment decisions.
What is ESG investing, and how does it work?
ESG investing is an approach that considers ESG factors in parallel with financial factors in the investment decision-making process. It involves investing in companies prioritizing sustainability, ethical practices, and strong corporate governance.
As such, you can see ESG investing as a form of conscious capitalism.
Here are a few examples of what ESG investing looks like:
- Investing in a renewable energy company committed to reducing carbon emissions.
- Choosing a company with a diverse board of directors and fair labor practices.
- Avoiding companies involved in fossil fuels or those with poor environmental records.
It’s important to note that ESG investing is not simply about excluding certain sectors or companies. It’s about understanding a company’s overall impact and how it manages ESG risks and opportunities.
ESG investing strategies
Several ESG investing strategies exist. They aim to align your portfolio with your values and financial goals. These strategies offer different approaches to incorporating ESG considerations into the investment process and include:
- ESG integration.
- Negative and positive screening.
- Thematic ESG investing.
- Impact investing.
ESG integration
ESG integration involves systematically incorporating ESG factors into traditional financial analysis. The strategy considers ESG risks and opportunities alongside financial metrics when evaluating potential investments.
Negative screening
Negative screening means excluding companies or sectors based on specific ESG criteria. For example, investors might avoid companies involved in tobacco, weapons manufacturing, or fossil fuels.
Positive screening
Positive screening is the opposite. It focuses on identifying investment choices with strong ESG performance.
Thematic ESG investing
Thematic investing focuses on specific ESG-related themes or trends. For example, it may focus on climate change, clean technology, or gender equality.
Impact investing
Impact investing seeks to generate financial gains while simultaneously creating a positive social or environmental impact.
What is ESG investing? — ESG ratings and metrics
A key question in ESG investing is how to measure a company’s performance around ESG factors. ESG ratings and metrics provide a standardized way to assess a company’s ESG performance. They help ESG investors compare companies and identify those leading in sustainability and ethical practices.
Here are some examples of popular metrics to rate companies on ESG factors.
Metric | Description | ESG Factors |
Carbon emissions | Amount of greenhouse gas emissions as CO2 equivalents produced by a company. | E |
Water usage | Amount of water consumed by a company. | E |
Waste generation | Amount of waste produced by a company. | E |
Employee turnover | The rate at which employees leave a company. | S |
Gender pay gap | Difference in pay between men and women. | S |
Board diversity | Representation of women and minorities on the board of directors. | G |
Executive compensation | Pay packages for top executives. | G |
Political lobbying | Company’s involvement in political activities. | G |
How do they measure ratings?
You can calculate ESG ratings and metrics using a variety of data sources, including:
- Company disclosures such as sustainability reports.
- Third-party data providers.
- News articles and media reports.
- NGO and government reports with data on environmental and social issues.
ESG rating agencies
The easiest way to get information on a company’s ESG is through a third-party data provider. Several prominent agencies specialize in providing environmental, social, and governance ratings and data to guide responsible investment:
- MSCI
- Reprisk
- Sustainalytics
- Refinitiv
- ISS ESG
- Bloomberg ESG investing
- SPGlobal
These agencies use different methodologies and data sources. Some may align more or less with your ESG principles. Therefore, it’s important to understand each agency’s approach when comparing ratings.
Making investment decisions based on ESG ratings
ESG ratings are a valuable tool for making investment decisions. That said, it’s important to use them along with other financial and non-financial information during the investment process. Consider the following:
- Compare ratings from different agencies to get a holistic view.
- Look beyond the overall score and investigate the factors driving the rating.
- Consider the company’s industry and its specific ESG risks and opportunities.
- Integrate ESG metrics with your overall investment strategy and risk tolerance.
As always, due diligence is paramount when assessing ESG issues related to future investments.
Finding when investing ESG investments
Finding ESG investments requires research and due diligence. Here are some resources and strategies:
ESG-focused mutual funds and ETFs
Unlike traditional funds, ESG funds invest in companies with strong ESG performance. Some focus more on corporate governance investing, others on climate change, and others on social sustainability. One example is the iShares ESG Aware MSCI USA ETF (ESGU).
Scouring ESG research platforms
Online tools like Sustainalytics or MSCI provide ESG data and ratings on hundreds of companies in developed markets and developing countries. By looking around their databases, you can find different investments worth looking into.
Assessing company sustainability reports
Look for companies that disclose their ESG performance transparently. Microsoft, for example, issues annual reports on its environmental sustainability.
Financial advisors with ESG expertise
If all else fails, you can always seek guidance from professionals specializing in sustainable investing. A few examples include:
- Certified Financial Planner (CFP) with a specialization in ESG investing.
- Registered Investment Advisors (RIAs) focused on ESG.
- Chartered SRI Counselor (CSRIC).
ESG investing and robo-advisors
Robo-advisors are automated investment platforms that help you build and manage your portfolio. Some robo-advisors offer specific ESG portfolios or allow you to customize your investments based on your values. Popular robo-advisors with ESG options include:
- Betterment
- Wealthfront
- M1 Finance
- Acorns
Impact of ESG on financial performance
A growing body of evidence points to companies with strong ESG performance outperforming their peers in the long term. Examples include a study from Ahmad and coworkers, another by Patrick Velte from the Institute of Finance and Accounting of Leuphana University, Germany), and many more.
Authors attribute the positive impact of ESG to several factors, including enhanced brand image, better appeal to employees, and improved customer trust.
ESG’s impact on risk mitigation
ESG factors are also crucial in mitigating investment risks. Companies with robust ESG practices are less likely to face environmental liabilities, social controversies, or governance issues. These benefits can significantly impact their financial performance.
For example, one large-scale study on 24,076 companies by a team from Macau University of Science and Technology showed that ESG had a stronger impact on high-risk companies than on lower-risk ones.
By incorporating ESG considerations, investors can identify companies that are better prepared to navigate long-term challenges and create sustainable value. This lower risk profile can lead to more stable and predictable returns.
What are the returns of ESG investing?
While past performance doesn’t guarantee future results, ESG investing generally delivers competitive returns.
A recent study by the MIT Sloan School of Management used data from six major ESG rating agencies to create a series of ESG portfolios with different investment choices. They measured the true excess return of long/short portfolios ranked by ESG scores. The portfolios take a long position on companies with a high ESG score and are short on the bottom performers.
The results showed that the returns of ESG investment can range from 2% to as much as 10% annually above non-ESG benchmark portfolios.
Navigating the controversies of ESG investing
While ESG investing offers numerous potential benefits, it’s essential to acknowledge the controversies and criticisms surrounding it:
- Data quality and standardization issues: ESG metrics can be subjective and lack standardization, making comparing companies across different sectors and regions challenging.
- Greenwashing: Some companies exaggerate their ESG efforts in an attempt to attract many investors without genuinely committing to sustainable business practices.
- State-level restrictions: Certain states have implemented restrictions on ESG investing in public retirement funds, citing concerns about political bias or potential harm to certain industries.
- “Woke” investing accusations: ESG investing has been labeled as “woke capitalism” by some critics, who argue that it pushes a leftist liberal agenda.
Concluding remarks about ESG investing
ESG investing presents a compelling opportunity for business owners and investors to align their financial goals with their values. By considering environmental issues, social responsibility, and governance factors, investors can potentially enhance returns by 2% to 10% compared to traditional investment products.
Besides contributing to a more sustainable future, investing based on ESG standards also helps businesses mitigate risks. While controversies exist, understanding the complexities of ESG investing empowers individuals to make informed decisions and navigate the evolving landscape of responsible investing.