Many readers have come across the abbreviation ‘ESG’, but there is often confusion about what it is. As ESG investing gains a higher profile, it’s worthwhile explaining exactly what this term means, why it’s important and what benefits research suggests that it can bring to investors’ portfolios.
What is the meaning of ESG investing?
ESG stands for environmental, social, and governance. Broadly speaking, the concept covers a wide range of risks and opportunities that are indicative of a company’s performance, despite not being obviously linked to its finances.
Historically, these areas have not typically been accounted for by traditional financial analysis, but research undertaken in recent years shows that they are relevant to overall performance.
ESG also refers to a style of investing that integrates this concept into stock selection. An ESG investor looks at non-financial measurement factors during the decision-making process, instead of choosing investments based on monetary performance alone.
What issues come under the umbrella of ESG?
The three pillars of ESG each include a wide range of topics:
- Environmental – issues that affect the planet, such as climate change, pollution, biodiversity, waste, use of natural resources including water, forestry and mining.
- Social – issues that relate to people, such as human rights, labour standards, child labour, equal opportunities and food supply.
- Governance – issues relating to company management such as board structure, executive remuneration, bonuses, avoidance of bribery and corruption.
Is ESG the same as ethical investing?
ESG investing and ethical investing are two distinct investing styles that should not be confused. And while an ethical investor and an ESG investor might both choose not to invest in a company over the same issue – say, pollution or bribery – they will do so for fundamentally different reasons.
Ethical investing, sometimes also called socially responsible investing, is concerned with choosing investments that are in harmony with personal moral beliefs. An ethical investor ensures that shares of companies in an industry that they consider immoral are not included in their portfolio, regardless of performance. Typical topics of ethical concern include tobacco, armaments, pornography, alcohol, animal testing, and animal welfare.
In contrast, ESG investing is about more than morals (although they may still somewhat motivate many ESG investors). Its leading proposition is that companies that are sustainable, socially responsible, and well- governed are more likely to perform well in the long term; and this makes their shares a better choice for investors looking for sustainable returns in their portfolio.
Why is ESG investing gaining profile so quickly?
Over recent years, many events have pushed social, environmental and governance issues into the limelight, helping to increase awareness of the viability of ESG investing.
For instance, the COVID-19 pandemic has highlighted the need for people and companies to act in a more responsible and sustainable way. Similarly, social justice movements (such as Black Lives Matters) have increased awareness of societal imbalances in need of correction.
And if not for these high-profile news stories, one would imagine that the headlines would have been dominated by stories about the record-breaking number of global-warming-induced environmental changes taking place worldwide.
- This year saw the second time that the official alphabetical list of hurricane names has been used up, meaning forecasters have had to move to the supplementary list of Greek letter names
- Wildfires have burned millions of acres across the planet
- The weather station in the Siberian town Verkhoyansk measured a maximum temperature of 38 degrees Celsius in June this year
- The polar ice caps are melting 6 times faster than in the 90s resulting in rising sea levels
Why are ESG factors important for investing?
Over recent years, it has become increasingly clear that companies that operate unsustainably, behave socially irresponsibly, or are ill-governed tend to face challenges over the long- term. Pressures to adopt ESG-friendly practices are mounting, with critical implications for strategic investing.
Companies face environmental pressures from governments
According to the sixth assessment report of the UN Intergovernmental Panel on Climate Change, human influence is unequivocally the cause of global warming. Unsustainable practices will create catastrophic outcomes, unless deep reductions in greenhouse emissions and other key changes occur in the coming decades.
In response to the evidence, many countries are adopting ambitious goals to reduce their emissions in alignment with the net zero target set out at the COP26 UN Climate Change Conference in Glasgow.
As a result, large public companies now face demands to minimise their environmental impact throughout their supply chains, operations, products and services. In many countries, non-compliant companies will suffer financial consequences such as carbon taxes.
Similarly, the institutions that support these companies are under analogous mandates. UK financial institutions will have to set out detailed plans showing how they will decarbonise their assets, under proposed treasury rules. In response, banks and firms will have no choice but to integrate ESG factors into their commercial investing criteria.
The market is shifting toward ESG
Yet the pressure for companies to transition towards improving in ESG areas is not coming from governments and international institutions only.
Research has long shown that companies that effectively manage their corporate social responsibility perform better than those that don’t. And now, there is greater consumer demand for socially and environmentally responsible companies in the UK than ever before.
This is demonstrated by the continued growth of ethical consumer spending, which increased by almost 25% from 2019-20 to exceed £120 billion, as reported by the Ethical Consumer Markets Report.
There is a similarly high demand for high-ranking ESG companies among investors, too. Even though investors have been raising sustainability concerns for decades, more recent years have seen those concerns translated into investing strategy. According to data from Refinitiv Lipper, capital flowing into ESG funds worldwide has increased by over 200% from 2019-21.
By all appearances, environmental, social and governance issues are imperative for companies that want to survive in tomorrow’s market. From an investing perspective, ESG factors are key indicators of companies that will hold enduring value – making them an important part of the asset selection process.
How are ESG factors linked to investing performance?
Most of today's corporate leaders understand that businesses have a key role to play in tackling urgent environmental challenges. However, in the past, many have believed that pursuing a sustainability agenda could negatively impact the company’s profitability. The popularity of ESG investing reflected this.
This perception, however, is outdated. In flat contradiction, a study published in 2020 by the Institutional Shareholder Services showed that a positive correlation exists between ESG factors and financial performance.
What constitutes this connection isn’t explicitly clear. But regardless of whether more profitable companies have more resources to allocate towards improving ESG ratings, or whether better management of ESG risks leads to greater profitability – or both – the numbers show that ESG criteria should feature in the investing process.
Further to this point, research released by Merrill Lynch in 2017 and published by Principles for Responsible Investment revealed that stocks that ranked within the top third for ESG factors outperformed those in the bottom third by 18 percentage points between 2005-15.
It should be noted that data also shows that besides signalling positive performance, ESG metrics have also been strong indicators of future volatility, earnings risk, price declines and bankruptcies.
According to another study produced by Merrill Lynch in 2017, ESG could have helped investors mitigate their losses. An investor who only held stocks with above-average ESG score would have avoided 15 of the 17 bankruptcies that took place after 2008.
ESG investing is not a ‘nice to have’. Nor is it a popular moral stance that is detrimental to returns. It can be a prudent way to safeguard your portfolio against future risk and improve its chances of outperforming the market.
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