What is ESG investing?

While Environment, Social, Governance investing has been around for a long time, it has recently gained momentum as companies focus more on climate change, social equality, and health.  Historically, ESG investing became popular with investors who sought to make a social impact, or simply make socially responsible investments.  Investors would choose the best investment opportunities constrained by a socially conscious agenda.  An example would be avoiding investments that are involved in fossil fuels.  Those types of decisions would often eliminate many investment opportunities, positioning a portfolio for sub-optimal results.  Recently however, companies as well as investors are recognizing that ESG sensitivity is not necessarily a burden, but rather an opportunity.  Let’s take a closer look at the ESG framework from a more current perspective.

The factors

While there is a growing list of critical ESG factors, they can all be classified in three primary categories.  Environment, Social, and Governance as its name implies.

Environment

Environmental factors are concerned with how companies deal with waste, energy consumption, toxic materials, pollution, and depletion of natural resources.  For example, a company may burn fossil fuels as part of its manufacturing process, however it may employ technology to minimize the release of carbon into the atmosphere.  Further, it may have longer term initiatives to completely wean itself off of fossil fuel burning over time.  Companies may additionally offset carbon emissions by investing in processes that remove carbon from the atmosphere.  Sustainability is a popular initiative that fits in this category in which companies strive to have negative net effects on the environment.  An example of this might be a lumber producer planting new trees to make up for the ones used in production.

Social

Social factors deal with how a company interacts with its customers, suppliers, competitors, and employees.  Social also covers how a company connects with local communities.  An example of how a company has socially responsible interactions with its customers may be as simple as its commitment to providing safe products.  A recent example of failure was Peloton’s non-action to recall its high-end treadmill despite the fact that the company knew that the product was potentially harmful.  The company’s lack of action led to an unfortunate death.  Another less extreme example would be a gambling website warning potential users of gambling addiction.

Diversity is another aspect of the social category.  Though the practice of gender or race bias may not have been intentional, many companies have policies that have prevented them from better representing the race and gender makeup of society.  Inclusion has become a major focus for all companies wishing to be socially responsible.  Not surprising, companies are recognizing that diverse workforces have had positive impact on innovation and business success. 

Animal welfare is an area of social awareness which historically included the humane treatment of animals in testing of pharmaceutical and cosmetic products.  More recently, animal welfare commitment has found its way into the food industry where consumers have access to meatless products or meat-based products in which animals are humanely treated.  Examples of this may be free-range, or cageless chickens or eggs.

Governance

Governance covers the way in which a company manages its internal behaviors.  Companies focused on high governance standards are critical about the makeup of its workforce, equality, and transparency.  An example of strong governance would be a board removing a CEO for inappropriate behavior.  Good governance would also include wage equality over not only gender but also race.  Governance may additionally examine how companies treat their employees whether through fair wages (living wage) or quality of life benefits such as generous paid maternal leave or childcare accommodations. 

Following the rules

The examples given above are only a very small set compared to quickly growing list of ESG factors.  By now, you might have guessed that, despite best intentions, not all companies can cover all of these ESG factors.  Airplanes must still fly using fossil fuel driven jet engines until cost effective alternatives can be developed.  Using that example, an airline can invest in solar cell installations on all of its buildings and transition to hydrogen powered land vehicles in order to partially offset its carbon emissions.  Electric utilities investing in sustainable energy sources such as solar and wind power to offset emissions by its older coal-fired plants is another example of how a company can still conduct business while being environmentally friendly.  

When it comes to social awareness, companies must simply set policies which prevent bias in hiring, compensation, and upward mobility.  They must further, set strict governance-based audits and remediation for failures.  While many companies have enacted equality policies and procedures, it is still up to management to ensure that the policies are put into practice, despite challenges.

How can an investor tell how well a company adheres to ESG practices?  The good news is that there are many third-party services that will rate a company based on its relevant ESG factors.  Some examples are:

  • S&P Global ESG Rank – companies are given a percentile rank between 0 and 100 on ESG compliance.
  • MSCI Rating – Global indexing leader ranks companies’ ESG risks and assigns a rating between CCC – AAA, worst to best. 
  • Bloomberg – ranks companies on numerous ESG factors, comparing performance to its history and its peers.  Examples include:
    • Environmental – Global Greenhouse Gas Emissions, Water Recycled %, Carbon Reserves, and Sulphur Oxide Emissions
    • Social – Employee Turnover, Women Employee %, Women Management %, Minority Employee %, and Total Incident Rate
    • Governance – Independent Board Member %, Women Board Member %, total CEO Compensation

In conclusion

So, we know that we can now simply look up most companies ESG scores just as we would any fundamental indicator or rating, and factor those into our investment decisions.  What exactly should we do with this knowledge?

Many people incorrectly assume that investors wishing to invest in high ESG performers do so at a cost to market performance.  The famous economist Milton Friedman argued that the costs of ethical behavior would outweigh its benefits.  Of course, he argued this on an academic basis in 1970s.  We now know today that companies who embrace ESG guidelines, in many cases, are simply more competitive.  How can we be certain of this?  Over the past 10 years, the S&P 500 ESG Index has outperformed the Wilshire 5000 Total Market Index, gaining +280.14% versus +273.26% respectively.  Many analysts are also coming to recognize that companies who invest in ESG initiatives today will be better positioned as market leaders in the future.  ESG investing is no longer simply a socially conscious effort.  Today it is a way to ensure that companies are putting themselves in the best possible position to be successful not just today, but in the future as well.

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