ESG investing is based on environmental, social, and governance considerations. It is becoming an increasingly important part of the investment process for many. These investors are looking not only for financial returns but also to positively impact the world through their investment choices.
This investment style is also known as socially responsible, sustainable, green, and impact investing.
ESG investors prioritise optimal environmental, social, and governance outcomes when making investment decisions. They invest with the environment and human well-being in mind and the usual economic factors.
This means investors increasingly take non-financial factors into account when making decisions. However, these non-financial factors can significantly impact investment risks and growth opportunities.
Underlying the move towards ESG investing is the idea that companies are more likely to thrive and provide strong returns if they create value for all their stakeholders. These include shareholders, employees, suppliers, customers, and our wider society.
Essentially, ESG investing promotes the premise that good corporate behaviour means better business results. ESG issues can pose serious risks to the operations and profits of companies. Companies can mitigate their impact and provide more favourable returns for all stakeholders by proactively engaging with and managing ESG issues.
Why base your investment on ESG?
ESG investing is seen as a way to invest sustainably and has risen alongside a growing focus on corporate social responsibility. ESG investors recognise the interdependencies between social, environmental, and economic issues. Astute investors realise that incorporating sustainability factors into their investment decisions can enhance long-term returns.
There are few (if any) areas of business operations where ESG considerations are irrelevant. However, different companies may give ESG factors different weight. Just as individual investors come to the market with particular values and motivations, companies will prioritise various ESG factors in their operations.
The prioritised factors will depend on what the company considers more critical, given its circumstances. For example, companies in the energy industry will have quite different ESG considerations from companies in the technology sector.
What are the key factors?
The key ESG factors are:
- Environmental factors — conservation of the natural world
- Social factors — consideration of people and satisfaction
- Governance factors — standards for running a company
We can break down each of the pillars of ESG investing into constituent considerations, which vary across industries. Let's take a closer look at some of the individual components.
Environmental factors can encompass:
- Direct and indirect greenhouse gas emissions
- Waste production, including hazardous and non-hazardous waste
- Direct and indirect energy consumption
- Water usage, whether drawn directly from a water source or via intermediaries such as water utilities
Social factors can encompass:
- Relationships with employees, suppliers, customers, and the communities in which the companies operate
- Human capital management, health and safety issues, and minimum wage concerns
- Workforce culture, gender diversity, and data security
- External social factors such as animal welfare, social opportunities, and product liability.
Governance factors can encompass:
- Accurate and transparent accounting methods
- Voting rights of shareholders on important issues
- The avoidance of conflicts of interest for board members
- Ensuring companies comply with laws and don't use political contributions to obtain unduly favourable treatment.
ESG investment strategies
There are different strategies available to those looking to invest following ESG principles. These include:
- Negative screening: Where sectors or companies that do not align with the ESG considerations of the investor are excluded from investment consideration.
- Positive screening: Where investors seek companies that are outperforming or improving faster than their peers on ESG measures or seek to invest in companies solving specific ESG issues (such as climate change).
- ESG integration: Where investors integrate ESG criteria alongside traditional financial data into their investment selection process.
- Impact investing: Where investors target a specific social or environmental impact, with investments generally project-specific
- Active ownership: Where shareholders engage with companies on ESG issues to initiate changes in corporate behaviour
Each approach will result in differing outcomes for investors and the companies they invest in. There is no overall consensus on which strategy is 'best' — this will depend on each investor's goals.
How popular is ESG investing?
ESG investing is gaining popularity at a rapid rate. According to an investment managers survey in 2021, ESG investing had reached critical mass, with more than 70% of institutions and more than 75% of fund selectors implementing ESG considerations in their investment decisions.1
The ESG movement has been accelerated by the COVID-19 pandemic as investors sought increased resiliency in the face of market disruption and uncertainty. ESG funds have shown increased resilience against conventional market disruptions.2 The pandemic also impacts social values, meaning it could prove to be a pivotal point for ESG investing.
Increasing numbers of investors seek to support organisations that promote sustainability and comply with emerging climate change regulations. In the United States, ESG funds are seeing record inflows and an unprecedented number of product launches.
Likewise, the Australian sustainable investment market is reaching new highs, increasing to $1.281 trillion in 2020 compared to $983 billion in 2019.3 The proportion of responsible investment assets under management to total managed funds grew from 31% to 40% in 2020, despite only a 2% increase in professionally managed funds in Australia over the same period.
The United Nations released its Principles for Responsible Investment way back in 2006.4 Since then, interest in socially responsible investing has grown exponentially. As of 2023, ESG investing has truly gone mainstream. This has many implications for listed companies, which will need to improve their approach to environmental and sustainability issues to attract investment.
For investors, the rise of ESG investing means it is easier than ever to invest sustainably. There are now a record number of funds that offer investors green investment options in Australia and abroad.
How is index investing linked to ESG?
Whether investing in index funds is ESG investing depends on the index. In many cases, the answer is no. This is because index investing is, by nature, impartial. An index such as the S&P/ASX 200 (ASX: XJO) does not consider ESG factors.
This means to invest under ESG principles, an additional layer of selection is needed. These days, however, some indexes consider ESG considerations and exchange-traded funds (ETFs) that follow these indexes.
This means investors can access diversified portfolios of companies that meet the environmental, social, and governance criteria required to be included in ESG investment indexes. Examples such as the S&P Global Clean Energy Index and Nasdaq Future Australian Sustainability Leaders Index make it easier for index investors to invest sustainably.
What are the challenges of ESG investing?
What constitutes a socially and environmentally responsible approach is subjective. Individuals will have different opinions about whether certain investments meet ESG criteria. Greenwashing is a genuine concern and can undermine efforts to invest sustainably.
Greenwashing occurs when a company spends more time and money marketing itself as environmentally friendly than minimising its environmental impact. This can mislead investors and consumers seeking to transact with environmentally conscious brands.
Companies use greenwashing to appeal to environmentally conscious consumers without making meaningful changes to their business practices. It can involve selective disclosures, symbolic actions, and hidden trade-offs. To avoid being taken in by greenwashing tactics, investors need to dig deeper than advertising claims and assess whether the companies they are considering have made meaningful changes to address ESG concerns.
Continuous monitoring is required for companies that have taken positive ESG actions to ensure ESG standards are met. Many companies that account for ESG considerations set key performance indicators and report on these to keep investors informed.
Active investors can play a role by engaging with the companies they own shares in to encourage positive ESG behaviours. This engagement may include voting on company matters in accordance with their ESG concerns.
Consideration also needs to be given to services and products that purport to be more environmentally friendly than alternatives but ultimately have a potentially negative impact on the environment. Environmentally friendly paint is one such example. It is touted as having a lower environmental impact than regular paint. However, it still contains chemicals that can harm human health and the environment.
Foolish takeaway
Ultimately, the rise of ESG investing is likely to positively impact the environment, social issues, and company governance. Increasing awareness of these factors means companies must take concrete action to improve internal practices and avoid negative externalities.
For investors, the increasing popularity of ESG investing means it is easier than ever to invest in a way that supports positive environmental, social, and governance outcomes.
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