Understanding ESG Investing: Meaning, Types, and What Lies Ahead
ESG investing is the idea of incorporating non-financial variables into investing - to bring notice to a variety of world issues to stakeholders and stockholders alike. Itâs a concept that has grown in popularity over the past few years as physical evidence of anthropogenic climate change has become incontestably visible. The overarching premise is that we must radically alter the way we measure value in our economic systems, away from the extractive and acquisitive, towards the sustainable and regenerative.
From an investment perspective, this means supporting companies that follow ESG principles and that are measurably trying to improve the way they operate their business. And while ESG is still evolving, and there are some simple investment rules we can follow, itâs important to start with some basic aspects of ESG investing that will help remove any confusion and provide clarity.
ESG stands for âenvironmental, social and governanceâ. When investors are assessing companies, ESG evaluation is based on how well a given business performs, via transparent reporting and assessment, within these three âpillarsâ. The aim, then, is to understand what all the non-financial risks are in a companyâs operations, relating to ESG.
Environmental focuses on resources and how effectively a company uses them. Are there opportunities to reconsider how water, packaging, plastic, or fossil fuels are currently used? Does this signal a switch to renewable energy sources to power company operations, supply chains, or workplace climatic conditions? While these criteria will differ hugely from company to company, the point is to start quantifying how energy and resources are used, identify how to improve this, and put a plan into action.
Social looks at how the company manages relationships with employees, labour regulations, and the communities within which it operates. Where can current inequalities be identified in hiring practices, gender, racial diversity, pay gaps, working conditions, health and safety standards, and access to benefits?
Governance considers leadership and administrative aspects, shareholder rights, executive pay, board behaviour and performance-aligned benefits, and diversity in management. From the regulatory standpoint, it seeks to assess potential corruption and unfair corporate practices.
However, it is important not to confuse ESG and sustainable investing. Both are pretty much the same concept, but there are some differences. So, let's understand the meaning of the latter.
What Is Sustainable Investing?
By and large, investing means using your money to buy somethingâlike shares, property or assetsâwith the hope that it will grow in value over time and give you a return. Traditionally, investors mainly focused on two things: how risky the investment is and how much money it could earn.
But now, many investors also consider environmental, social, and governance (ESG) issues as these factors turn into real economic factors in the long term.
So, sustainable investing is an approach that takes into account risk, reward, and ESG factors together when making investment decisions.
Sustainable investing includes ESG integration, impact investing, investing based on themes like clean energy, being active in company decisions (stewardship), and avoiding certain industries or companies (screening).
Difference Between ESG and Sustainable Investing
ESG investment focuses on ESG factors â for example, how a company deals with climate change, labour practices, executive compensation, etc. In the meantime, sustainable investment prioritises investments with a positive environmental or social impact.
The former (narrower) is one method within sustainable investing, while the latter (broader) includes ESG investing, impact investing, thematic investing, etc.
ESG uses data to manage risks and improve performance; sustainable investments are aligned with values and impact objectives.
ESG is financially driven; sustainable investing can be ethical or mission-driven.
ESG investment is based on ESG scores, ESG data and ESG risks; sustainable investment includes areas such as renewable energy, social housing, and gender equity funds.
Institutional investors and asset managers are more commonly linked to ESG investing, whereas values-based investors, impact funds, and ethical portfolios are typically associated with sustainable investments.
ESG reporting for ESG investing; sustainability reports for sustainable investing.
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Discover more at the 2nd World ESG & Sustainability Reporting Summit.
Now that we have understood their difference, it is also important to know more related terms.
Responsible investing focuses on aligning investment decisions with ethical or moral values by avoiding companies or sectors considered harmful, such as tobacco, weapons, or gambling.
It often uses negative screening to exclude these sectors from portfolios. The approach is primarily values-based and aims to prevent negative impact. Responsible investing is narrower in scope compared to sustainable investing and typically appeals to individuals or institutions with specific ethical guidelines. It serves as an early foundation for more advanced sustainable strategies like ESG and impact investing.
Impact investing involves investing in businesses or projects that aim to deliver measurable positive social or environmental outcomes with financial returns. It is often used in affordable housing, clean energy, education, and healthcare.
Investors typically assess performance using impact metrics, including carbon savings or the number of jobs created in a region or country. This approach appeals to those who want their capital to directly contribute to solving real-world problems. Unlike ESG investing, impact investing targets outcomes as opposed to just managing risk.
Ethical investing is guided by an investorâs personal, religious, or moral beliefs, shaping the decision to include or exclude certain companies or sectors.
For example, an ethical investor might avoid industries like gambling, alcohol, or weapons manufacturing. It often overlaps with responsible investing, but can be more personal, and here the investment decision-making process is based on one's values and ideals.
Why ESG Is Such A Big Deal
ESG investing may feel ânewâ, but we just experienced an evolution in the structure of what was, since the 1960s, called âsocially responsible investingâ. It gained traction in the late 1990s and it has evolved into corporate social responsibility (CSR) at the turn of the century, and now the impact investing and ESG we see today.
ESG was coined in 2004 and is closely intertwined with impact investing. But why ESG is taking centre stage right now has a lot to do with the current state of the world. Looking around, people are worried about various things such as:
Visible effects of anthropogenic climate change
National security weakened through those impacts
Supply chain dependence and diversity
All these factors naturally affect the economic systems we have in place. The narrative of the past several decades has been the relatively unfettered forward march of capitalist policy-driven globalisation and corporate deregulation, both of which have contributed to a resource use expansion that now strains the carrying capacity limits of our planet.
However, investing, however well intentioned, must be a pragmatic business decision. Acceptance of ESG has thus expanded as investors realise that focussing on ESG initiatives generally doesnât affect their portfolio, ROI or bottom line at all - which was the main reason for initial investor hesitancy. ESG is, ever more, turning out to be a âwin-winâ, since while even pro-ESG investors may be ok with lower returns on certain companies that operate responsibly, even those who generally oppose ESG policies come out positively as they are investing in stocks that, generally, provide higher returns in the long-run.
As investors continue, they realise that ESG investing offers certain benefits that âtraditionalâ investment pathways did not:
It provides satisfaction. Akin to the idea of donating money to a charity, ESG investing means youâre providing financial support to a company that wants to make a bigger difference in the world. And unlike a charity, youâre getting dividends by investing.
Supporting companies that share your values. Do you care about the environment? How about workers or the community you live in? Values guide our actions and thoughts and ESG investing taps into that and provides companies that hold similar values to you.
You donât need to pay constant attention to it. ESG investing has a bit of built-in consistency to it. In other words, once youâve done your research - or as much of it as you want - you can invest in the company without worry. So long as the business doesnât think destroying forests is a good idea you can take a hands-off approach.
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There are several firms out there that measure ESG and provide a score to companies. The larger ones are Sustainalytics, MSCI and Refinitiv. Each site has its own measurement or âgradeâ they assign to each company, and these differ since they are more or less relevant for differing company circumstances. There is, at present, no âuniversalâ measurement for ESG, and this is fine because ESG promotes diversity and variation in business thinking. Differing requirements are natural and there is no single, top-down, mandated approach.
How ESG is measured is based on a companyâs research into specific categories of ESG. For example, Refinitiv looks into the performance, commitment and effectiveness of 10 main themes. How ESG is measured to them would be based on their own internal views of those 10 themes and how they specifically relate to the companyâs circumstances.
How To Invest With ESG In Mind
As mentioned before, ESG is putting non-financial variables into a financial decision. Companies are supplying this through policies, milestones, and hard data. As a result, and as with any âtraditionalâ investment opportunity, investing with ESG in mind comes down to screening each investment option and understanding the company thoroughly before investing.
The level of research varies depending on which financial instrument youâre choosing. Investing in individual stocks requires the most research, whereas investing in mutual funds or ETFs will give you narrower selections or someone investing in an ESG company for you. Overall, itâs best to talk to a financial advisor if you are thinking of investing with ESG in mind.
Letâs stand back from the acronym and look at the bigger picture. Weâve had other acronyms before, so you may be forgiven for being hesitant. Larger firms today are looking to have ESG-focused financial instruments or apply these standards to existing products. So far itâs not the standard yet, but it does show promise and progress. Currently, 79% of US individual investors and 99% of millennial investors are interested in ESG investing. And thatâs just it, this is the current model we are exploring that will become, in some form or another, the new âstandardâ. We are looking at a framework for the implementation of business change that could prove restorative to our planetâs future, rather than simply destructive. This is a necessary shift in the way we do business.
But this article is about investing. So, for one, we can see that companies are paying attention to investors and will care more and more about their ESG ratings as a result. Such behaviour shows that companies are starting to understand that focus on the betterment of society, communities, and the world, can be a central premise of their business operations, and that simply underlines the companies that are future-proofing their interests, which in turn make them a better opportunity for investors.
