Learn more about aligning your values with your investments.
The term “ESG” has been popping up frequently in conversations, the media and corporate statements. And there’s a very good reason we’re hearing so much about ESG, since it has a lot to do with investing in a sustainable future for people and our planet. But this increased awareness of the term doesn’t necessarily mean investors have an increased understanding of what ESG is all about. This article will help narrow that divide.
ESG investing encompasses three core concerns – environmental, social and governance – and how those considerations are applied to investment opportunities. More about the specifics in a moment, but basically, ESG investing is generally defined as any strategy that incorporates one or more environmental, social and governance factors in investment decisions and active ownership. It can take many forms and may go by different names, including sustainable investing and responsible investing, but these approaches all assume that the health of our environment, the strength of social infrastructure in our communities, and the way companies are managed play vital roles in creating value. Importantly, incorporating ESG risk analysis into research can help determine the true value of an investment, mitigate risk and identify new opportunities.
Let’s take a closer look at the three ESG factors, how they might be relevant to investors and what impact they can have on investment decisions:
Environmental factors include how a company’s operations impact the natural environment (such as air quality or water contamination) and how the environment impacts the company’s operations (for example, water scarcity or rising sea levels).
As concern grows over environmental risks, such as climate change, loss of biodiversity and other threats, society is increasingly penalizing polluters through taxes or regulatory change.
Companies with improving or better ESG performance will be seen as having more sustainable business models. New products and services that can accelerate the transition to a cleaner, low-carbon economy could unlock significant business opportunities and attract increasing support among investors.
Social factors focus largely on the relationship between a company and its employees, consumers, suppliers and communities.
Companies that mismanage these relationships can face a risk of increased regulation and the alienation of valuable business partners, talent and other stakeholders. On the other hand, companies that manage these relationships well can build robust value chains while maintaining a presence at the forefront of social change.
Governance relates to the structures or systems put in place to ensure the company’s management is effective. Issues most relevant to investors include the structure and oversight of the board of directors, executive compensation, capital management, dividend payouts, and mergers and acquisitions.
While firms can incur operational and disclosure-related costs as they engage in good corporate behaviour, they can also become more efficient, gain greater trust from stakeholders and reduce the probability of abnormal or unforeseen losses, among other long-term benefits.
Why investors may consider ESG
Depending on the specific strategy, ESG investing can aim to align a portfolio with a set of ethical or personal values and generate measurable social and environmental outcomes. Sustainable investing can also offer investors access to vital information about a company’s ESG incident record, which can help them assess the long-term viability of the business model if faced with future ESG challenges, which could include internal labour stoppages or polluting incidents as well as external pressures such as water scarcity, regulatory changes or a divergence in investor preferences. There can also be issues related to vulnerabilities in corporate strategy, inadequate governance or poor decision making, all of which can be important factors to investors since they can have a significant impact on a company’s share price.
Benefits and drawbacks
The most obvious benefit to ESG investing is how it can align your financial portfolio with your personal values and beliefs. Knowing your investment choices have been made with a vision of helping to build a better world can offer a sense of contentment. Financially, it’s clear that companies with strong ESG records can perform better than those with less impressive commitments to ESG. Moreover, portfolios that integrate ESG analysis into the investment decision-making process have been shown to outperform those that don’t.
While there are many benefits, there are some potential shortcomings to be aware of. For example, sustainable investing may necessitate divesting from specific industries, such as oil. If sectors incompatible with the strategy experience strong growth, an ESG portfolio could underperform on a relative basis. It’s also important to carefully choose your ESG strategy and fund, as the popularity of ESG investing has unfortunately led to greenwashing on the part of some corporations and fund managers. A deep analysis of the portfolio’s investments is therefore even more critical. The fact that there is little standardization of ESG data (that is, ESG data providers operate with different methodologies), means comparing companies and funds can be very difficult.
Looking closer at positive impacts
Not long ago, ESG investing primarily consisted of excluding investments in companies that produce goods and services known to be harmful to the environment and society. While this approach is still used (see “Negative screening” in the sidebar below), today's portfolio managers are becoming more proactive by engaging directly with firms and investing in the ones that can make the most positive impact. This engagement goes beyond simply integrating ESG factors into investment decision making, to actively encouraging companies to improve their sustainability credentials through ongoing stewardship.
ESG can say a lot about you
ESG investing continues to evolve and respond to the desires of investors who want to support solutions to some of the serious issues currently facing our world. While it can be challenging to keep up with all the latest details, speaking with your advisor about aligning your personal values and financial goals is a perfect way to start making a difference through ESG investing.
ESG investing can be carried out in different ways
Almost all ESG approaches aim to deliver competitive financial returns by managing ESG risks and identifying ESG-related opportunities, but there can be differences in how this is achieved. Some of the most common options available include:
- ESG integration (including active ownership) considers and analyzes ESG factors as part of the investment decision-making process. It aims to deliver competitive financial returns through identifying ESG risks and opportunities.
- Stewardship is a process of continually developing best practices throughout the various stages of the investment life cycle, through company engagement, ongoing review by the fund manager, proxy voting and direct asset operation.
- Negative screening involves excluding and/or divesting from companies in certain industries, which most commonly include the alcohol, tobacco, firearms and weapons, and gambling sectors.
- Positive or best-in-class screening targets companies or industries with better-than-average ESG metrics and records.
- Thematic/sustainability-themed investing specifically targets certain ESG themes, such as clean energy, green property, aligned solutions, etc.
- Impact investing focuses on investments that can make a social or environmental difference. Impact investing can aim to deliver competitive financial returns or, in some circumstances, below-market-rate returns for investors who are not particularly focused on financial reward.