ESG is essentially an acronym which stands for Environmental, Social and Governance.

According to Wikipedia, ESG investing refers to the application of these three factors to assess the sustainability and social impact of an investment in a company.

Historically investment decisions have often been based on financial factors. But, in recent years, there is a growing emphasis on non- financial factors as well – to ensures that the environment, society and minority shareholders are protected too. In other words, ESG investing involves considering Environmental, Social and Governance factors along with financial factors when making investment decisions.

More on ESG

Let’s start with E - Environment.

It includes taking into account factors like climate change risk, carbon emission, resource depletion, clean water, energy efficiency, waste and pollution, recycling and deforestation – just to name a few factors - before investing in a company

S - Social - will include factors like working conditions, child labour, slavery, the impact of a company’s business on local communities including indigenous communities, health and safety issues, employee relations, gender equality, human rights and diversity issues.

Finally, G or Governance will include factors like shareholders’ rights, voting procedures, board independence, board diversity, transparency, executive compensation, corruption, political lobbying and donations.

Source: BlackRock

ESG vs socially responsible & sustainable investing

Taken loosely, ESG investing, sustainable investing and socially responsible investing are one and the same.

The key idea is basically to invest in companies with sustainable businesses. In other words, adopting an investment approach that aims to achieve a better and more sustainable future for our society.

Going mainstream

ESG highlights big problems that requires big solutions – global climate change being a case in point.

Policies and laws need to change, and greater global co-ordination is needed. But even as these problems appear insurmountable, that has not stopped people from trying to make a difference. Investors are no different. They want to help. After all, a healthy, more equitable society is good for the longevity of businesses and overall prosperity. The hope is that through the voting power of their dollar, investors are able to help steer economic activity in the right direction.

What is heartening is that more and more companies are embracing ESG and making business decisions based on them.

This is because companies recognise that they must play their part in improving the world and ensuring a more sustainable future for our society.

Traditionally, little regard is given to the sustainability of a company’s actions beyond the bottom line. Sustainability mattered where dividend payments or profits were concerned. The environmental or social consequences of corporate actions mattered less in valuing investment opportunities. But this is not the case today. The call for social responsibility and collective action has triggered a movement. Socially responsible investing has taken root. It is slowly moving out of a niche territory into the mainstream.

Good concept, but how to execute?

ESG sounds good as a concept, but how would one systematically incorporate ESG factors in the investment process? Fortunately, a great deal of work and research through the years have gone into creating a variety of ESG scoring frameworks to identify companies with better ESG profiles. As mentioned earlier, sustainable businesses tend to be companies with better environmental standards, employee relations and higher proportion of institutional ownership and outside directors.

Global financial data providers such as Bloomberg, Refinitiv, MSCI, FTSE and S&P Dow Jones Indices have progressively offered more refined ESG securities ratings and benchmarks to screen good ESG names from the bad. This has helped to improve and expand investors’ ability to integrate ESG criteria into their investment process.

Doing well by doing good

Clearly, the transition to a more environmentally friendly, socially responsible and climate-resilient global economy will introduce new opportunities for investment and growth.

Companies that adapt successfully to this transition are increasingly likely to benefit from evolving consumer preferences and regulations on the back of a reshaped economic landscape.

As higher-quality ESG metrics and industry standards are developed and more ESG-focused products are introduced, we see increasingly greater opportunities for investors to align their portfolios more closely with their own sustainability preferences and goals.

Does doing the right thing cost money?

At its most rudimentary, investing is about earning financial returns over time. Narrowing one’s investment opportunity set to just companies that do well on the ESG scale necessarily invites the question if investors are unnecessarily sacrificing returns just to do good.

A 2018 review of academic research by the NYU Stern School of Business and quantitative investment firm QMA suggests that the answer is an unequivocal no. There is no strong evidence of a significant difference in the returns earned by firms with high or low ESG ratings. Instead, their research shows that companies with better ESG profiles tend to be able to borrow more cheaply and enjoy higher credit rankings and lower cost of equity capital. Essentially, companies with better ESG scores are better quality assets.

Research from MSCI corroborates this. They show that companies with the strongest ESG practices relative to their peers are more profitable, have less volatile earnings and are better at mitigating serious business risk that can lead to large financial losses as a result of careless judgment or regulatory malfeasance and even bankruptcies. Such quality assets can provide some downside protection to portfolios in times of market stress.

ESG - An investment theme that cannot be ignored

There is a growing realisation that more and more global fund managers will shun companies that do not embrace ESG.

A useful signpost of the growing acceptance of sustainable investing in the world today is the steady rise in the number of signatories committing to the UN-led Principles for Responsible Investment.

Nearly 2,400 asset owners and managers representing US$86.3 trillion in assets under management (AUM) globally have signed up so far. This is a marked improvement from 2006, where only 63 asset owners and managers with US$6.5 trillion worth of AUM endorsed the UN principles.

So ESG is becoming a key driver for investment decisions by international portfolio managers, who control billions and even trillions of dollars.

According to Pensions & Investments, the value of global assets applying ESG has doubled over the past four years, and tripled over the past eight years, to more than US$40 trillion in 2020.

So, clearly, ESG is a fast-emerging theme that investors cannot ignore.