Also known as “sustainable investing”, Environmental, Social, and Governance (ESG) is a class of investing and an umbrella term for investments that looks for positive returns and long-term effects on society, environment, and business performance. There are various categories of sustainable investing and they are impact investing, socially responsible investing (SRI), ESG and values-based investing. Sometimes ESG falls under the umbrella term of SRI which includes ethical investing, ESG investing, and impact investing.
According to the Financial Times Lexicon, ESG is a generic term used in capital markets and is applied by investors to investigate corporate behavior and to figure out the financial standing of the company in the future. In addition, ESG is a subset of non-financial performance indicators which involves sustainable, ethical and corporate governance issues like looking after a company’s carbon footprint and making sure that there are systems establish to ensure accountability. When investments are considered, these factors are used as well as in risk assessment strategies combined into both investment decisions and processes that involves risk management.
There is a lingering misinterpretation about the body of empirical evidence showing that ESG considerations negatively affect financial performance, according to Environmental, Social and Governance Issues in Investing: A Guide for Investment Professionals. Furthermore, investment professionals must know that the main purpose of the ESG issues discussions is that when they are considered systematically, it will likely result in a more complete investment analysis and well-informed investment decisions.
What are ESG Issues?
Here are the following ESG issues:
Environmental risks - Business activities that causes environmental risks that have actual or can be potentially harmful to air, land, water, ecosystems, and human health. The environmental activities of a company involve consideration of ESG factors such as managing resources and preventing pollution, reduction of emissions and climate impact and executing environmental reporting or disclosure. Environmental positive outcomes, on the other hand, involve avoiding or minimizing environmental liabilities, lessening costs and bringing up profitability through energy and other efficiencies and lowering regulatory, litigation, and reputational risk.
Social risks - the effect of companies to the society. Companies address these risks through conducting social activities like health and safety promotion, labor-management relations encouragement, human rights protection and focus on product integrity. The positive outcomes of them socially are the increased productivity and morale, less turnover and absenteeism, brand loyalty improvement.
Governance risk - involves how companies are run. It takes a closer look at corporate brand independence and diversity, risk management of the corporate office and out of control executive compensation. Governance activities are made by the company such as diversity awareness and board accountability, protecting the rights and of shareholders, and opening up information. The positive outcome of governance includes incorporating the interests of shareowners and management, and unexpected financial surprises prevention.
The Appeal of ESG Investing
Most investors do not only focus on the financial outcomes of investments but also on the impact of their investments and their assets role towards promoting global issues such as climate action. Millennials are one specific demographic attracted to ESG investing. A study made in 2006 named Cone Millennial Cause Study showed millennials having more trust in a company or patronize the product of a company that has a good reputation when it comes to social and environmental issues. The survey showed half of them were more likely to refuse a product or service from a company that appears to be irresponsible towards social and environmental issues.
Factors to Consider in ESG Investing
It’s important for ESG investing to take a closer look at “extra-financial” variables or factors. If you’re a responsible investor, you will evaluate companies through ESG criteria as a basis to screen investments or investigate the risks when making investment decisions. Factors like environmental, social, and governance just like what was discussed above needs to be considered. Does the company focus on environmental issues like waste and pollution, resource depletion, and greenhouse gas emissions? How do the company treat people and employee relations and diversity? Are the corporate policies and the way the company is run fair and just? In addition to the governance risks, there must be a focus on tax strategy, executive remuneration, donations and political lobbying, corruption, and bribery. These factors need to be evaluated properly to make correct investment decisions.