Environmental, Social, and Governance, or ESG investing, is a form of sustainable investing that considers an investment’s financial returns and its overall impact.
ESG investors examine criteria within these three categories to identify investments that perform well using ESG-related metrics. The motivating factors driving investor interest in ESG are varied; however, the most common themes center around a desire to have one’s investments reflect personal values while ideally making a positive impact on the world. Make no mistake, it’s not all altruistic, there are also very real investment performance and downside protection risk benefits associated with ESG investing. However, the driving force behind ESG investing for many investors is predominantly the desire to exact change in the world by leveraging the power of the investment dollar to send a message regarding priorities.
ESG Defined
“ESG” simply defines the three general categories upon which a company or investment is evaluated. The reality is that there are countless factors upon which to conduct an evaluation, ESG exists to help corral and delineate those factors.
Environmental
When assessing a company from an environmental standpoint, the attempt is to assess that company’s impact on the planet, considering a variety of both positive and negative factors. Areas for consideration often include:
- Carbon footprint, pollution, and emissions considerations.
- Climate change and applicable policies and plans.
- Greenhouse gas emissions and related reduction goals.
- Renewable energy usage goals and plans to reduce reliance on fossil fuels.
- Deforestation concerns and the company’s potential impact.
- Water considerations such as usage levels, conservation, and the water profile of the surrounding community (i.e., is water a scarce resource where the company is located).
- Recycling and other waste disposal policies.
Social
The social component of ESG focuses on the direct human element and evaluates topics such as employee treatment, company culture, customer facing policies, the local community, and more broadly, society as a whole. Areas for consideration often include:
- Human rights considerations and violations.
- Ethical supply chain souring and responsibly sourced materials and supplies.
- Employee treatment and overall job satisfaction.
- Employee training, development and available resources.
- Employee working conditions.
- Diversity and inclusion policies.
- Customer-facing responsiveness and considerations.
- Regulatory infractions, lawsuits, etc.
- Local community involvement.
- Larger social purpose and outreach.
Governance
The governance component of ESG focuses on how a company polices itself and how the company is governed. In practice, more often than not, a company with positive corporate governance and quality leadership often operates more effectively and profitably. Areas for consideration often include:
- Executive and management compensation structure and incentives.
- Compensation alignment with company performance.
- Composition and strength of the Board of Directors or governing body.
- Separation of roles between the Board and executive management.
- Diversity of the Board and management team.
- Corporate structure and investor share classes and rights.
- Relationships with regulatory agencies.
Why Care About ESG?
Improved Performance
In addition to the benefits associated with creating a more ethical and conscientious portfolio, there is significant evidence demonstrating that ESG investments often perform on par with, or outperform benchmarks, all while typically reducing risk. In short, strong performance in ESG categories is often correlated with high-quality management teams and strong company performance. The rationale behind this assertion is simple, when management is paying attention to ESG factors, they are typically also paying attention to the long-term strength and viability of the company. This is in stark contrast to the CEOs that prioritize short-term, quarterly profits, often at the expense of long-term performance.
Worldwide, ESG-focused companies have seen not only higher returns, but stronger earnings growth and dividends. The graphic below presents performance vs. benchmarks for companies in the MSCI ACWI Index during the period May 2013 through November 2020.
Lower Risk
A 2019 white paper produced by the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds with traditional funds and found that sustainable funds consistently showed a lower downside risk than traditional funds, regardless of asset class. The study found that during turbulent markets, such as in 2008, 2009, 2015 and 2018, traditional funds had significantly larger downside deviation than sustainable funds, meaning traditional funds had a higher potential for loss.
There are a variety of reasons why risk falls with adherence to ESG principles, to name just a few:
Environmental: Climate change and other environmental factors can cause scarcity of resources, natural disasters that are more frequent and of greater magnitude, and increased global poverty, as well as political unrest and instability. All of these factors pose substantial risks to a company’s profitability. Environmentally responsible entities are not immune to these risks, but they are likely going to be positioned to fare better than their non-ESG peers.
Social: It’s common knowledge that companies suffer when they become social pariahs. Companies that ignore social issues, how they are viewed and their impact on their community and society as a whole typically underperform and represent a higher level of risk.
Furthermore, poor employee policies and treatment result in unhappy, unhealthy and uncommitted employees who are less likely to perform, especially in times of stress and difficulty. They're also more likely to quit their jobs, leading to high rates of employee turnover that force the company to spend more money on hiring, training, and onboarding new employees. All of these factors add up to more risk from an investment perspective.
Governance: Strong corporate governance policies, combined with the accountability created by separating the Board of Directors from management, often lead to stronger performing, long-term focused companies that are positioned to adapt to change and face challenges. As such, governance plays a vital role in reducing the risk profile of a company.
Summary
Ethical investing has come a long way since its origins as a small investing niche, known at first only as socially responsible investing. ESG investing and other related investment approaches are increasingly gaining traction with both financial institutions and everyday investors, all of whom are seeking to do good with their investing dollars while doing well for themselves.
