Last month in Invested, we got into “impact investing.” This month, we tackle ESG investing. These terms are often used interchangeably, but they have a few notable differences that we will explore, along with the ins and outs of what ESG investing is and why it is experiencing pushback.
Understanding ESG Investing
ESG investing is a strategy that considers a company's performance in three key areas (Moynihan, 2023):
- Environmental: This encompasses a company's impact on the environment, including its carbon emissions, energy efficiency, waste management, and water usage. Investors evaluate whether the company is taking measures to reduce its ecological footprint and promote sustainability.
- Social: Social factors relate to a company's treatment of its employees, customers, and the communities in which it operates. This includes diversity and inclusion policies, labour practices, consumer protection, and contributions to community development.
- Governance: Governance refers to a company's internal structure, leadership, and transparency. Investors assess factors like board composition, executive compensation, audit quality, and anti-corruption practices. Strong governance ensures that a company is well-managed and accountable and that business practices remain ethical.
And, in a world where environmental, social, and governance concerns are becoming increasingly critical, investors are discovering ways to align them with their financial goals, as investors who prioritize ESG factors believe those companies to be more sustainable and better positioned for long-term success. This is encapsulated perfectly by a survey that was conducted by Edelman (2022) with 14,000 participants from 14 countries that found 77% of respondents saw improving societal issues as a primary business function, and 59% considered addressing geopolitics to be a top priority for business. As of 2021, the ESG market was valued between $18 trillion (Moynihan, 2023) and $35 trillion (Alexander, 2023) in assets under management.
The key difference between ESG investing and impact investing lies in their objectives. ESG focuses on integrating ESG factors into investment decisions, primarily to manage risks and align investments with companies that exhibit better sustainability practices. While impact investing goes a step further by intentionally seeking out investments that can generate measurable positive impacts that align with the investment firm’s values. These investments are designed to make a difference to specific societal or environmental issues, such as poverty alleviation or renewable energy, while still trying to achieve financial returns. (Bildner, 2023)
The Benefits of ESG Investing (Alexander, 2023)
Investing in companies with ESG practices offers several key advantages. Firstly, these companies are better prepared to mitigate various risks, including those stemming from environmental disasters, legal actions, damage to reputation, and shifts in regulations. By allocating funds to such companies, investors have the potential to decrease their vulnerability to these risks. Additionally, research has demonstrated that businesses with elevated ESG ratings frequently surpass their counterparts in terms of long-term performance. Their commitment to sustainability, innovative approaches, and ethical conduct contributes to the company’s improved financial outcomes.
ESG investing also builds trust and loyalty among stakeholders, including customers, employees, and shareholders. Companies that demonstrate their commitment to responsible business methods are more likely to both attract and retain customers and talent. Furthermore, by channeling investments toward companies that prioritize environmental preservation and social responsibility, investors can actively contribute to driving positive societal impact. This involvement can facilitate the advancement of technologies and strategies that tackle pressing global predicaments, including climate change and inequality.
Lastly, following ESG strategies helps to position companies favourably for regulatory compliance, as governments across the world intensify regulations concerning environmental and social concerns. This adaptability allows them to navigate evolving requirements more effectively.
Challenges & Considerations
While ESG investing presents numerous benefits, it's important to acknowledge that it also comes with its share of challenges.
One major challenge is the lack of standardized metrics for assessing ESG performance, or even a lack of data altogether. This lack of consistent data makes it difficult for investors to effectively compare companies and may not show the whole picture. In the last five years alone, there has been a rapid proliferation of standards, standard bodies, data analytics, and assessment scores to assist investors in their analysis of ESG issues. And, while these developments have produced more information for investors, they have also resulted in information that is not globally coherent. This has led to growing criticism of the idea of ESG investing as it can conflate distinct issues and mislead portfolio construction and fund marketing. However, organizations – like the International Sustainability Standards Board – are making significant efforts to improve the quality and consistency of reporting standards. (Moynihan, 2023)
Another challenge is that there can be trade-offs within ESG categories. For example, a company that excels in environmental standards could have a disappointing human rights score. For some investment firms, ESG investing evolved into the process of only assessing ESG factors that are financially material – and, in doing so, ignoring those that are not. To combat this, investors should look at how five stakeholders – the communities of people and natural environment in the company’s vicinity, the employees and supply chain workers, as well as the customers – are impacted. (Sherman & Olazabel, 2022)
A third concern is "greenwashing," where some companies may exaggerate their ESG efforts and/or the impact of their efforts to attract investors without making significant changes. Greenwashing is way more prevalent than you would think and it occurs in corporations both big and small. To avoid supporting greenwashing organizations as an investor and consumer alike, thorough research and due diligence are necessary. (Sherman & Olazabel, 2022) The link above provides a list of companies that have been found guilty of greenwashing and provides information on how to spot other examples.
Finally, there is also consternation from people at both ends of the political spectrum. Some U.S. politicians, like Governor Ron DeSantis, oppose the ESG investment trend, going so far as to sign a bill that bans ESG investing in Florida. Likewise, some figures, such as Tariq Fancy, former CIO for Sustainable Investing at BlackRock, criticize ESG efforts for not being as effective as needed for substantial change. (Sherman & Olazabel, 2022)
Up until this past decade, ESG considerations were commonly treated as a superficial checklist for investors – a mere formality where companies would selectively adopt ESG practices that bolstered their profits and appeased shareholders. However, a gradual transformation has occurred in response to the heightened expectations society is now placing on businesses. This altered landscape has brought together companies' and investment firms' values, reputation, and profitability. (Moynihan, 2023) When done correctly, investors can contribute to positive change while potentially achieving strong financial returns by incorporating environmental, social, and governance factors into their investment decisions. As the world faces pressing challenges, ESG investing has the potential for individuals and institutions to align their portfolios with their values, promoting a more sustainable and equitable future.
Bibliography
Alexander, F. (2023). The portfolio defense of ESG (SSIR). Retrieved from https://ssir.org/articles/entry/the_portfolio_defense_of_esg?utm_source=Enews&utm_medium=Email&utm_campaign=SSIR_Now
Bildner, J. (2023) Impact Investing Can’t Deliver by Chasing Market Returns. Retrieved from https://ssir.org/articles/entry/impact_investing_cant_deliver_by_chasing_market_returns?utm_source=Enews&utm_medium=Email&utm_campaign=SSIR_Now
2022 Edelman Trust Barometer Special Report The Geopolitical Business. Retrieved from https://www.edelman.com/trust/2022-trust-barometer/special-report-geopolitical-business.
Moynihan, H. (2023). (rep.). Investors and the ESG Blind Spot: Upholding Civic Freedoms as Part of Geopolitical Corporate Responsibility. Retrieved from https://www.chathamhouse.org/2023/07/investors-and-esg-blind-spot.
Sherman, J., & Olazabal, V. (2022). Using Foundation Capital for Good: Opportunities in the Balance Sheet. The Foundation Review, 14(4), 4.