Investing Basics: ESG Investing

What is ESG investing?

 
ESG investing includes an explicit assessment of environmental, social and corporate governance (ESG) issues in the context of investment decisions.

Integrating such issues is now common practice for asset managers in assessing risks and opportunities, as ESG issues include many non-financial risks.

ESG issues are divided into three different components. Environmental issues include anything to do with the natural world, such as climate change, pollution or waste management; social concerns our everyday lives, such as modern slavery, human rights or child labour; governance relates to the way a business operates and is managed, including issues such as bribery, corruption, diversity and political lobbying.

The three ESG components typically overlap and one issue will not normally solely define a company’s rating or performance.

Furthermore, these issues may vary across industries, locations and the company’s target investors; ESG issues are not static but dynamic, constantly changing with the social or environmental landscape.

Key to ESG investing is active engagement; active ownership by investors drives change in companies towards more innovative and sustainable products or services. It also drives shareholder returns, as it helps reduce the risk of ESG issues and enhances opportunities driving value growth.
 

Change towards ESG investing

 
The idea of investing in assets that align with the values of the investor is not new; examples of socially responsible investing (SRI) are the exclusion of tobacco or alcohol investments and companies operating within the South African apartheid regime.

However, since the UN Principles for Responsible Investment (PRI) were established in 2006, there has been a far greater focus on investing in companies that mitigate ESG risks or create opportunities.

This is a voluntary set of investment principles to encourage signatories to integrate ESG into their portfolios; first principle states that investor signatories, of which there are more than 3,000 with more than $100tn under management, ‘will incorporate ESG issues into investment analysis and decision-making processes’.

ESG integration incorporates ESG factors in the risk and returns profile of an asset to enhance portfolio performance; it may also exclude companies that do not meet performance requirements, such as fossil fuel exploration in the Arctic.

By contrast, impact investing targets companies searching for measurable solutions to environmental or social issues, as well as a return; for impact investors, financial returns are not the biggest driver of investment and expectations are diverse.

ESG has grown exponentially in recent years; global assets under management that apply to ESG data doubled in four years to 2020 to top $40tn (source: PIOnline).

ESG monthly flows hit record levels toward the end of 2020, since when sustainable investing entered a more challenging phase after shining during the pandemic.

The performance of many ESG funds suffered over the following 12 months, with less money is flowing into them; Russia’s invasion of Ukraine as well as inflationary dangers have thrown up some questions around the global energy transition and other ESG principles.

An increase in global climate catastrophes and greater media focus has fuelled debate about environmental and social issues over the last 10 years, with a shift away from Friedman’s traditional shareholder capitalism model towards increasingly stakeholder-focused capitalism.
 

Measuring ESG

 
A lack of standardised metrics by which to measure a company’s ESG performance and the opacity of annual reporting has created a challenge; no advisory board or agency has provided a consistent set of standards or a framework that allows investors to assess a company’s ESG performance.

UN’s Sustainable Development Goals provided the first formal common framework for multiple stakeholders in 2015, which provides targets for companies aiming to ‘end poverty, protect the planet and ensure that all people enjoy peace and prosperity by 2030’, although reporting remains patchy.

The World Economic Forum’s metrics, developed by the Big Four accounting firms: Deloitte, Ernst & Young, KPMG and PwC in September 2020, allow investors to measure ESG performance against economic activity; standardised ESG performance reporting provides greater transparency for investors.

Sustainalytics and MSCI provide ratings for companies based on their ESG and corporate governance to allow investors to assess the non-financial risks associated with companies more easily.
 

Why do investors want to integrate ESG?

 
ESG investing grew in popularity as evidence showed that it provides safer and stronger returns to shareholders. a Morningstar study demonstrated the outperformance of ESG funds over non-ESG funds over one-, three-, five- and 10-year time frames.

Other studies suggest that companies with robust ESG targets often have lower costs of capital, lower volatility, and less incidence of corruption, bribery or fraud; highly rated ESG companies are good long-term, high-conviction, low-turnover investments, enabling investors to meet their fiduciary requirements.

Previous reticence due to concerns over short-term performance seems outmoded, with new studies demonstrating that ESG funds outperform over both the short and long term; asset managers or individual investors should be concerned about the risks and opportunities that any business presents, including the long-term implications of environmental or social challenges.

The opportunity to create financial returns, while also creating positive social or environmental impacts, meant that ESG integration became something that every asset manager took notice of, based on three key drivers.

First is evidence suggesting that ESG improves long-term investment performance in the face of long-term structural headwinds and tailwinds.

Second is a push for investments to better align with personal values, which is driven through demographic change; millennials are twice as likely to be interested in investments dedicated to solving social and environmental problems.

Finally, with greater emphasis on making sustainable choices in our everyday lives, investors want their money to make a positive social and environmental impact.

Now, greater transparency of ESG issues from companies in their annual reporting or the standardisation and adoption of ESG rating systems, investors are far better placed to judge the ESG performance of their investments.