What Is ESG Investing?
What is ESG investing? ESG investing looks at investments based on environmental, social, and governance criteria in order to determine what type of impact an investment might have on our society and our world.
Traditional Investing vs. ESG Investing
The main goal of traditional investing is strictly to make money. Investopedia defines investing as “the act of allocating resources, usually money, with the expectation of generating an income or profit“.
ESG investing seeks to generate a return on your money while making the world a better place. This method of investing allows people to prioritize their own values and incorporate these into their investing decisions. And there are a ton of different ways to invest according to your values.
The landscape of investing is changing. ESG investing isn’t just for hippies and tree huggers. No offense to any hippies out there. I like The Grateful Dead.
There really isn’t much difference between the old-school traditional investing philosophy and an ESG focused philosophy. ESG investing just builds upon traditional investing by incorporating additional information to allow you to focus on what you care about most.
ESG Investing Terms
There are a lot of different terms and acronyms used to describe ESG investing.
- Ethical Investing
- Green Investing
- Impact Investing
- Mission-Based Investing
- Program-Related Investing
- Responsible Investing
- Socially Responsible Investing
- Sustainable Investing
- Triple-Bottom-Line Investing
- Values-Based Investing
- and probably a dozen other terms and phrases
These terms aren’t all identical because each of these types of investments does have a different specific focus. That being said, all of these seek to incorporate some type of environmental, social, or governance factors into their investment practices. The ultimate goal is to generate a return on your investment and to improve the world we live in.
So let’s talk about ESG criteria. The “E” part of ESG is for “Environmental” and this considers a company’s impact on the environment and the physical world around them. This is probably the most straightforward of the three criteria but there are a lot of different issues that can fall under this category.
These are just a few:
- Climate Change
- Carbon Emissions
- Clean Technology
- Materials Sourcing
- Resource Management and Conservation
Let’s look at a real-world example of environmental impact as it relates to corporations.
The 2010 British Petroleum Oil Spill is one of the greatest environmental disasters in U.S. history. An explosion on the Deepwater Horizon oil rig killed eleven people and released over 200 million gallons of oil into the ocean over the course of 87 days.
Scientists are still researching the impact of this oil spill and even 10 years later they are still seeing an ongoing environmental impact on the local marine life.
One of the leading providers of ESG research during this time was GMI Ratings. GMI downgraded British Petroleum before the Deepwater Horizon tragedy ever occurred. BP was also removed from several ESG specific indices. This company had a previous history of accidents leading up to the 2010 oil spill that made it a poor ESG investment at the time.
We know how much impact the oil spill had on the environment but what kind of impact did the spill have on the company itself? Let’s take a look at the stock chart.
Source: Yahoo Finance
After the oil spill, BP lost half of its value in just 2 months. The stock went from trading at $60 per share to $27 per share. The company wound up paying more than 40 billion dollars in fines and other legal settlements. BP is now trading at a fraction of what it once was.
ESG investing looks for opportunities as well as risks that relate to environmental, social and governance criteria. This can save investors a lot of money by identifying companies engaging in risky behaviors early on.
The “Social” section of ESG criteria looks at how a company treats people. This is not strictly limited to a company’s employees. Social investing looks at how a company treats people in general; considering communities, and the impact it has on society as a whole.
- Labor Standards
- Health and Safety
- Human Rights Protections
- Community Engagement
- Equal Employment Opportunities
- Product Safety
- Data Privacy
We talked about British Petroleum in the context of environmental investing. Let’s talk about social investing and a movement that had an enormous positive impact on the people in our world.
South Africa had a long history of legal and institutional racial segregation. Apartheid, like a lot of you probably already know. White African citizens were considered the elite and held the highest statuses in South African society.
Black Africans were told where they could work, where they could live, and even who they could marry. This barely scratches the surface of Apartheid but I will include a link to more information in the references of this article.
This social injustice led to public outcry from many different groups and many different countries but it was ultimately “money” that had one of the biggest impacts in ending Apartheid in South Africa.
The social movement to end Apartheid began on American college campuses. In case you didn’t know, colleges and universities hold large sums of money in endowment funds. This money doesn’t just sit in savings accounts; it is invested.
Many colleges began restricting their investments and stopped investing in companies that did business in South Africa. This put pressure on these companies; not just from a financial standpoint but from a negative publicity standpoint.
This movement may have started on college campuses but it spread to cities, then to states, and eventually led to companies changing their behaviors and divesting money from South Africa.
Over 155 colleges, 26 states, and 200 U.S. companies divested away from South Africa. This created a $1 billion dollar loss for South Africa and left the country with no other option than to end their long practice of racial segregation.
Let’s just take that in for a moment. I think we’ve all heard money being described as the route of all evil. But the truth is, money can create positive change and be a substantial force for good.
Lastly, let’s talk about corporate governance. Governance has to do with how a company is run. This investment criterion looks at:
- Board Diversity
- Executive Compensation
- Shareholder Protections and Rights
- Business Ethics
- Ant-Corruption Policies
- Corporate Disclosure and Transparency
Governance is typically the main ESG focus for institutional investors. These are the big guys; banks, hedge funds, financial advisors, mutual funds, and the rest.
The main reason for this emphasis is because governance data is more quantitative and it is easier to put a number to something like board diversity than it is to quantify community engagement.
Corporate governance practices vary significantly from company to company. Even today, gender and racial inequality are still significant workplace issues.
Women continue to earn less than men for the same jobs. The latest data from the U.S. Bureau of Labor Statistics found that women earn 81 cents for every dollar that men make. That is almost a 20% difference in pay. That is HUGE! While this pay gap has definitely narrowed over the last 40 years, there has seemed to be some leveling off in this progress. For context; this data goes back to 1979 when women were earning just 62% of what men were. While progress has definitely been made, the pay gap has been stuck around 81 – 82% for more than 15 years now.
Source: U.S. Bureau of Labor Statistics
The gender pay gap falls more into the social criterion for ESG investing. But one major focus of governance investing has been the promotion of greater diversity among board members and company executives. Many states, organizations, and even companies themselves have made commitments to support and improve diversity among the leaders at the top.
Institutional Shareholder Services recently analyzed the boards of over 2,100 public companies and found that the percentage of women joining company boards is at a record high. Today, women make up about 19% of board members. In 2008 this number was 9%. So there continues to be steady progress in this area.
Ethnic board diversity still lags behind gender diversity, with non-caucasian board members making up only 13% of the 2,100 companies analyzed.
Source: ISS Analytics
Ethnic and gender diversity aren’t just good practices for the sake of our society. Diversity is good business.
There have been plenty of studies showing that companies with higher diversity in their leadership tend to outperform their peers. This makes sense because greater diversity brings more skills, experience, and perspectives to companies and allows these organizations to better understand their consumers and run better.
How to Invest Using ESG Criteria
So how do you actually go about ESG investing? I know I’ve already said it but there really isn’t all that much difference between traditional investing and ESG investing. So there really isn’t much difference in how you go about investing with ESG in mind.
You can invest in stocks, bonds, mutual funds, and exchange-traded funds through the same process as traditional investing. You just need to decide what is most important to you and which investments align best with your values.
That being said, there are a few different ESG investing methods you can use to get started. I’m just going to briefly touch on each one.
Negative Screening tends to be the ESG investing style that people think of first. That’s probably because negative screening goes back thousands of years. If there is a company or an industry you strongly disagree with, you can simply choose not to invest in those areas by screening these out of your portfolio.
The example I use a lot is the tobacco industry. My grandfather died of lung cancer. I, like I think a lot of other people, don’t want to support an industry that profits from killing its customers.
And I think it’s important to remember that when you invest your money into a company you are supporting that company. I think it can sometimes be very easy to forget this when you’re focused on charts and stock tickers.
Positive Screening is the process of investing in companies with high ESG ratings compared to their peers. This screening method is often called best-in-class because it seeks to identify companies that are the ESG leaders in their industries.
Basically, all other things being equal, if you are choosing between two similar companies within a specific sector, you’d choose the company with the best ESG rating. That’s best-in-class.
ESG Integration incorporates environmental, social, and governance factors into traditional investment analysis. Basically, when someone is analyzing a company they are looking at ESG criteria to determine a company’s strengths and weakness but this research continues to look at financial factors like sales growth, price to earnings, company valuation, and other financial metrics.
Thematic investing isn’t specific to ESG. Thematic investing focuses on a particular category or topic in investing. The idea is that companies that fit within a particular theme are included within that specific portfolio or index.
Themes could be anything from artificial intelligence to robotics. There are a number of different ESG specific themes including climate change, solar power, wind energy, and clean water.
Active vs. Passive Investing
ESG investing allows you to invest actively or passively. There are thousands of ESG-specific mutual funds and exchange-traded funds to choose from. Some funds are actively managed while others are passive funds.
If you want a set-it-and-forget-it style of investment, you just need to identify what is most important to you and then choose the fund that best suits both your goals and your values.
Why You Should Consider ESG Investing
There is a human tendency to believe that there is a trade-off to everything. So what’s the catch with ESG investing? Are you ready? There is none!
For a long time, the main argument against ESG investing was that people were sacrificing financial returns all for that warm fuzzy feeling of doing something good.
So let’s be clear. ESG investing does not have a negative impact on financial performance. This has been studied extensively throughout the years. Morgan Stanley analyzed the performance of almost 11,000 mutual funds and exchange-traded funds and this was their conclusion:
“The returns of sustainable funds are in line with those of traditional funds, while also offering lower downside risk for investors. What’s more, in an uncertain market, sustainable funds may offer a layer of stability for investors looking to reduce volatility.“
To add onto this, more and more studies are now showing that ESG investing actually outperforms traditional investing over time. This makes a lot of sense. Companies that score highest in their ESG ratings tend to be the leaders in their industries. That’s because they are forward-thinking, well-run companies.
The advantage of ESG investing is that it looks at additional information and risk factors that may be overlooked with traditional investing. After all, when is having MORE information ever a bad thing? This could save you from investing in a company that is demonstrating questionable or unethical behavior.
If we go back to the British Petroleum example we can see that there were several incidents that turned BP into a poor ESG investment prior to the oil rig disaster. ESG investing can save investors a lot of money over time.
The Future of ESG Investing
ESG investing has grown substantially over the years and there’s going to come a time, much sooner rather than later, when there won’t even be a question of traditional investing versus ESG investing. It will all just be investing.
Environmental, social, and governance criteria will be a fundamental part of all investment analysis. People are going to look back and wonder why we would ever choose to ignore information about a company just because the information is related to the environment or social or governance topics.
Tell me what you think in the comments below. Have you started to include ESG criteria into your investment research? What are some of the experiences you’ve had with ESG investing?