Environmental, Social, and Governance (ESG) investing is a rapidly growing investment discipline that includes many factors that make up traditional corporate best practices. Consequently, many firms that score well on ESG metrics are also solid investment opportunities. While ESG evaluation is popular with women and millennials—two groups that continue to gain prominence in the investment world— it continues to gain importance for all investors. This piece reviews ESG investing.
DEFINITION OF ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) INVESTING
Environmental, Social and Governance (ESG) investing (also referred to as sustainable, responsible and impact investing or socially responsible investing) utilizes a set of standards for a company’s operations that socially conscious investors use to screen potential investments.
Environmental criteria look at how a company performs as a steward of the natural environment.
- Examples include energy and water use, waste, pollution, natural resource conservation, and impact on climate change or carbon emissions.
- They also evaluate which environmental risks might affect a company’s income and how the company is managing those risks.
Social criteria examine how a company manages relationships with its employees, suppliers, customers, and the communities where it operates.
- Do the company’s working conditions show a high regard for its employees’ health and safety?
- Does the firm employ a diversified work force? Is the Board of Directors well diversified?
- Are stakeholders’ interests taken into consideration (stakeholders include employees, creditors, shareholders, government, and the community from which the business draws its resources)?
- Does it work with suppliers that hold the same values the company claims to hold?
Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.
- Does the firm use accurate and transparent accounting methods?
- Do common stockholders have the ability to vote on important issues?
- Does the firm avoid conflicts of interest in the choice of board members?
- Does the firm avoid engaging in illegal behavior or using political contributions to obtain favorable treatment? What constitutes an acceptable set of ESG criteria is typically subjective, so investors must do research to find investments that match their own values.
As ESG-minded business practices gain more traction, firms are increasingly tracking their ESG progress. Many firms publish detailed reviews of their ESG approaches in their annual reports and work is being done to standardize reporting—studies show significant divergences in ESG ratings across providers.
ESG INVESTING GROWING AT RAPID PACE
While Europe leads the world, ESG investing in the U.S. is growing at a rapid clip. The US SIF Foundation (a leading voice for ESG investing) found that sustainable, responsible and impact investing (SRI) assets accounted for $17.1 trillion— or one in three—of the $51.4 trillion in total assets under professional management in the U.S., as of year-end 2019. This represents a 42% increase over two years. From the first report in 1995, when assets totaled just $639 billion, to today, the sustainable and responsible investing industry has grown 27-fold and has matured and expanded across numerous asset classes.
A diverse investor base holds the $17 trillion in U.S. ESG assets under management including more than 530 institutional investors, 384 money managers, and 1,204 community investing financial institutions. Money managers cite client demand as a top motivation for pursuing ESG incorporation, while institutional investors cite fulfilling mission and pursuing social benefit as motivations. The importance of transitioning to a low-carbon economy, as well as human capital management, diversity, and health and wellness are seen as priority issues for the coming years. While climate change has become a leading issue, ESG criteria and shareholder engagement are being used to address many other issues including human rights, weapons, political spending, and other governance factors.
STUDIES SUGGEST A LINK BETWEEN CORPORATE SOCIAL RESPONSIBILITY PRACTICES AND FINANCIAL PERFORMANCE
Many research studies have demonstrated that companies with strong corporate social responsibility policies and practices are sound investments. Studies with such findings have come from Oxford University, Deutsche Asset & Wealth Management, Morgan Stanley Institute for Sustainable Investing, TIAA-CREF Asset Management, and Morningstar, among others.
With the recent availability of higher-quality company-level ESG data, researchers have been able to dive deeper into the relationship between corporate sustainability practices and financial performance. These studies show a number of positive relationships between companies that employ best practices addressing ESG factors that face their businesses and financial performance whether measured in terms of financial results or stock price. This is in contrast to utilizing purely exclusionary screens (for example, broadly screening out “sin stocks”) that can have a negative impact on a portfolio.
Part of the challenge of ESG investing today is the breadth of topics spanned in corporate ESG disclosures with hundreds of metrics available to investors. This has led to variations in different ESG ranking systems. The Sustainability Accounting Standards Board (SASB) and others are actively developing sustainability accounting standards to help companies disclose material information in SEC filings in a way that is decision-useful for investors. The most useful ESG data can give insight into a company’s culture and risk and typically coincides with corporate best practices. The following table reviews several key metrics available for ESG investors.
FACTORS THAT CORRELATE BEST WITH STOCK PERFORMANCE
A study by Goldman Sachs showed that many ESG factors that are associated with happy employees and efficient resource utilization are also positively correlated with stock performance.
ESG ANALYSIS TOOLS
Due to the significant growth in ESG investing, investment analysis tools are becoming commonplace. Bloomberg (a provider of business and market news, data, and analysis) has an extensive database of ESG metrics, rankings, and analysis. These can be used to assess a company’s environmental, social, and governance performance, both over time and versus peers.
Environmental metrics include factors like greenhouse gas emissions per revenue. Social metrics include factors like percent of women employees, employee turnover, and lost time to incident rate. Governance metrics include factors like percent of independent directors, percent of women board members, director meeting attendance, and board size.
S&P recently purchased RobecoSAM (an investment company focused on ESG investments) which annually evaluates more than 3,500 companies around the world for their ESG practices. Morningstar owns Sustainalytics, a provider of company-level ratings, and has developed a broad ESG platform, including fund and portfolio level analysis. Both S&P and Morningstar rankings are part of Bloomberg’s database and incorporate many of the metrics discussed above.
S&P’s rankings also determine membership in the S&P Dow Jones Sustainability Indexes. MSCI is also a major provider of ESG rankings and produces ESG indexes. These indexes are used for portfolio benchmarks, as the basis for exchange traded funds, and as part of the portfolio creation process.
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