ESG Investing: What You Need to Know

ESG Investing, an acronym for Environmental, Social, and Governance, pertains to evaluating companies based on their performance in these areas to determine their suitability for investment. Environmental criteria assess a company's efforts in environmental preservation. Social criteria scrutinise its handling of relationships with stakeholders like employees, suppliers, customers, and communities. Governance evaluates aspects such as leadership quality, executive compensation, audit practices, internal controls, and shareholder rights.

ESG investing, also known as sustainable investing, responsible investing, impact investing, or socially responsible investing (SRI), involves assessing companies based on a spectrum of behaviours and policies. Investors examine various factors to ensure that the companies they support are environmentally conscious, socially responsible, and governed accountably. Here's how it works:

1. Environmental: Investors scrutinise corporate practices concerning climate policies, energy consumption, waste management, pollution control, natural resource preservation, and animal welfare. This includes evaluating greenhouse gas emissions, toxic waste management, and adherence to environmental regulations.

2. Social: The company's interactions with both internal and external stakeholders are evaluated. This involves assessing initiatives such as community contributions, employee volunteering programs, and workplace conditions to ensure health and safety standards are met.

3. Governance: Investors ensure that companies maintain accurate and transparent accounting practices, prioritise integrity and diversity in leadership selection, and remain accountable to shareholders. This includes scrutinising board member and executive selection processes to avoid conflicts of interest and unethical behaviour.

Why ESG investing?

ESG investors play a crucial role in guiding the investment decisions of large institutional investors like public pension funds. ESG-specific financial products, such as mutual funds and exchange-traded funds (ETFs), have seen significant growth, reaching a record $480 billion in assets under management (AUM) in 2023. Brokerage firms and mutual fund companies offer these ESG-themed products, while robo-advisors like Betterment and Wealthfront actively promote them to younger investors.

ESG Metrics

ESG metrics serve as crucial evaluation tools for investment firms like Trillium Asset Management, based in Boston, aiding in the identification of companies poised for sustainable long-term growth. Analysts at Trillium establish criteria tailored to sectors, industries, and specific companies, reflecting pertinent environmental, social, and governance concerns.

Trillium's ESG criteria guide investment decisions, steering clear of companies involved in high-risk sectors or with ties to coal or hard rock mining, nuclear or coal power, private prisons, agricultural biotechnology, tobacco, tar sands, or weapons and firearms. Moreover, they avoid companies embroiled in significant controversies surrounding human rights, animal welfare, environmental issues, governance matters, or product safety.

Their metrics encompass investments in companies championing environmental stewardship through renewable energy initiatives and transparent sustainability reporting. Socially, they favour companies maintaining ethical supply chains and eschewing overseas labour with dubious workplace or child labour practices. Governance metrics prioritise board diversity and corporate transparency.

What are ESG Funds?

An ESG fund encompasses various sustainable investing strategies aimed at delivering financial returns while contributing to societal well-being. This broad definition includes approaches that range from excluding certain "bad actor" companies from investment portfolios to actively investing in firms aligned with specific environmental goals, such as promoting clean water access.

There's a call for greater clarity in defining these funds, with suggestions for asset managers to be more intentional in their branding to aid investor understanding. Proposed SEC regulations aim to enforce stricter rules on sustainability fund names, potentially simplifying investors' comprehension of fund holdings.

In practice, sustainable funds typically fall into three main categories:

1. Socially Responsible Funds:

These funds have a history dating back to the 1950s and typically focus on what they exclude rather than what they include. They avoid investing in companies associated with controversial industries such as alcohol, gambling, tobacco, firearms, and fossil fuel production.

2. ESG Funds:

These funds prioritise investments in companies that score highly on environmental, social, and governance criteria. They seek to mitigate risks to a company's valuation by promoting practices that reduce environmental impact, prioritise employee and customer welfare, and align policies with shareholder interests.

3. Impact Funds: 

Unlike ESG funds, impact funds aim to generate tangible progress towards sustainable objectives. They target specific areas such as climate action, ecosystem health, resource scarcity, basic needs, and human development. For example, while an ESG fund might focus on companies with low carbon footprints, a climate impact fund might invest in firms manufacturing renewable energy technologies like solar panels or wind turbines.

Investors Embrace ESG: Shaping Financial Landscapes

As ESG practices gain traction, investment firms such as JPMorgan Chase, Wells Fargo, and Goldman Sachs actively monitor and report on their ESG strategies and outcomes. However, the ultimate impact of ESG investing hinges on whether it drives meaningful change or merely fosters checkbox compliance. Realising its potential depends on the adoption of realistic, measurable, and actionable ESG principles.

While sectors like tobacco and defence historically yield above-average returns, they clash with ESG values, prompting some investors to accept potential financial trade-offs for ethical alignment. According to a survey, a significant portion of ESG investors prioritise values over returns, underscoring the importance of aligning investments with personal principles.

ESG investing, often conflated with sustainable investing, revolves around scrutinising companies based on their pro-social, environmentally conscious, and well-governed practices. Embracing ESG principles entails a strategic shift towards environmental preservation, social responsibility, and transparent governance.

Various financial institutions that offer ESG ratings and scoring systems make it easier to identify ESG-friendly investments. MSCI, for instance, rates over 8,500 companies based on their adherence to ESG standards, providing investors with valuable insights into a company's sustainability efforts.

Businesses embracing the ESG Investing and implementing  Sustainable Investing

A growing understanding of the intricate connections between social, environmental, and economic factors is what is driving the surge in ESG investing, which represents a seismic shift in the global financial landscape. The onset of the COVID-19 pandemic in 2020 acted as a catalyst, prompting investors to seek refuge in ESG funds amidst market turmoil. In just the first quarter of that year, a staggering USD 45.6 billion flooded into these funds worldwide. Currently, sustainable investment funds hold a formidable $30.7 trillion, with projections indicating potential growth to $50 trillion within the next two decades. This mounting investor appetite for sustainability reflects a broader trend towards supporting organisations and products aligned with emerging regulations, particularly in areas like climate change mitigation.

This heightened demand has spurred action within the business sphere, with companies increasingly prioritising ESG initiatives. Notably, ESG funds have exhibited remarkable resilience in the face of market disruptions, often outperforming their traditional counterparts in the long run. For instance, studies show that over the past decade, a significant majority of sustainably-focused equity funds have surpassed their conventional counterparts. Furthermore, a substantial proportion of ESG funds established a decade ago continue to thrive compared to their traditional counterparts, underscoring the sustained appeal and durability of ESG investing.

Several factors underpin this ESG investing boom. As global supply chains become more intricate, awareness of social, labour, and human rights issues has heightened, prompting investors to scrutinize corporate behaviour more closely. Concurrently, mounting concerns over environmental challenges such as climate change are shaping investor decisions. Moreover, the growing involvement of demographics traditionally less engaged in conventional investing, such as younger individuals and women, has fueled the momentum behind ESG investing.

However, industries slow to embrace these shifts face mounting scrutiny and pressure from various stakeholders, including investors and concerned citizens. Recent court rulings requiring significant greenhouse gas emissions reductions for major corporations are evidence that legal obligations will also tighten. Such events are likely to catalyse further transformations across industries, reinforcing the imperative for organisations to adopt forward-thinking ESG practices to remain competitive and contribute positively to society's well-being.

Essential Insights into ESG Investing: Here are the top 5 things to remember

• At the heart of ESG investing lies the belief that influential investors can compel large corporations to adopt responsible practices across social, environmental, and governance dimensions. With the escalating threats of climate change and the consequential harm to natural ecosystems and human lives, corporations can no longer afford to overlook the adverse impacts of their operations. The "E" in ESG signifies investing in companies actively transitioning towards environmentally sustainable practices.

• Another key criterion in ESG investments revolves around a company's values and its treatment of various stakeholders, including employees, contractors, customers, and suppliers. Socially responsible policies, transparent management practices, and commitments to stakeholder well-being, both within and beyond the organization, are paramount.

• The governance aspect evaluates companies based on their management structures, business ethics, and ability to manage long-term risks and opportunities. Factors such as transparency in accounting, regulatory frameworks to prevent corruption, and adherence to legal practices are considered. Investing in companies with strong corporate governance can mitigate risks associated with malpractices and safeguard investments.

• Despite initial hesitations due to concerns about potentially lower returns, evidence suggests otherwise. A 2015 study by the University of Oxford and Arabesque Partners found that good ESG performance is positively correlated with stock performance, debunking the notion of sacrificing profits for ethical investments.

• Previously, there were no standardised criteria for assessing ESG investments, leading fund houses to develop their methodologies. However, in response to the growing investor interest in ESG funds, regulatory bodies like the Securities and Exchange Board of India (SEBI) have introduced new disclosure norms. The SEBI circular issued in May 2021 mandates sustainability-related reporting for the top 1,000 listed companies by market capitalization by FY23, under a new Business Responsibility and Sustainability Report (BRSR) format.

Conclusion

In conclusion, ESG investing focuses on companies committed to positive environmental, social, and governance principles, reflecting a growing investor desire to align portfolios with socially responsible entities. This burgeoning trend not only promises financial returns but also fosters positive societal and environmental impacts.

Our Directors’ Institute- World Council of Directors can help you accelerate your board journey by training you on your roles and responsibilities to be carried out efficiently, helping you make a significant contribution to the board and raise corporate governance standards within the organization.