ESG investing: What it is & why it matters
ESG investing: What it is & why it matters
Climate change risks, greater regulatory requirements, privacy and data security concerns, and workplace equality demands all pose new and growing risks for investors. The financial strains imposed by the COVID-19 epidemic have also had an impact on some companies' susceptibility to supply chain risks and their ability to control them. If companies do not appropriately manage their ESG (Environmental, Social, Governance) risk, they will face increasing complications and scrutiny.
As a result, investors are putting additional pressure on companies to manage and report on their ESG strategy and risk effectively. Demand for ESG products increased by 303.8% from 2017 to 2020. Asset management firms have shifted their traditional 60/40 mix of shares and bonds to ESG funds, which are expected to deliver higher returns than either equity or debt.
The rapid expansion of ESG investment is also being driven by millennial investors around the world, as well as sophisticated technology, such as artificial intelligence and alternative data extraction techniques, which are helping to reduce investor reliance on voluntary disclosure from corporations. To give dynamic content and financially relevant ESG insights, machine learning and natural language processing are helping to improve the speed and precision of data collection, analysis, and validation.
Lastly, while the topic is still debatable, there is a growing consensus that company strategy should not be solely focused on profit maximization. Long–term, sustainable growth is seen by companies that have a purpose beyond profit maximization at the center of their business strategy.
This investment shift is the culmination of a 70-year history that has resulted in an ever-increasing need for ESG-based strategy, action, and reporting.
The birth of ESG
The practice of ESG investing began as far back as the 1950s, though at that time ESG was known as socially responsible investing (SRI). SRI investors encouraged corporate practices that were morally grounded and promoted environmental stewardship, consumer protection, human rights, and racial or gender diversity. For example, some socially responsible investors avoid investing in businesses perceived to have negative social effects such as alcohol, tobacco, gambling, pornography, weapons, and fossil fuel production.
Yet, the term “ESG” wasn’t coined until 2004 in the United Nations Global Compact report “Who Cares Wins.” This groundbreaking report was the result of a collaboration between 18 financial institutions and nine countries to develop guidelines and recommendations on how to better integrate ESG issues into asset management, securities brokerage services, and related research functions.
“The institutions endorsing this report are convinced that in a more globalized, interconnected and competitive world the way that environmental, social, and corporate governance issues are managed is part of companies’ overall management quality needed to compete successfully,” the report stated. “Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate.”
The ESG conversation was fueled in 2015 by a convergence of three key events: the introduction of the Paris Agreement, the United Nations Sustainable Development Goals (SDGs), and the Task Force on Climate-related Financial Disclosures (TCFD).
- The Paris Agreement is an international treaty on climate change aims to keep global average temperature rise to 1.5°C over pre-industrial levels, a goal that scientists and vulnerable populations increasingly believe the world cannot afford to fail. To achieve this, 193 countries pledged to significantly and collectively reduce greenhouse gas (GHG) emissions, the principal source of global warming. Despite these pledges, scientists reported at COP26 that the Earth is on track to warm by nearly 2.5°C, exceeding the world's common climate goal by a full degree.
- The SDGs are a collection of 17 interlinked global goals designed to be a "blueprint to achieve a better and more sustainable future for all.” These goals are intended to be achieved by 2030.
- The Financial Stability Board created TCFD to improve and increase reporting of climate-related financial information. TCFD provides key guidance on what companies and investors should be focusing on to minimize climate risk, accelerate environmentally conscious governance, and transition to a low-carbon operation.
However, it was 2020 that launched the ESG conversation into the mainstream limelight. The COVID-19 pandemic brought economic disparities into focus and highlighted major inequality gaps in healthcare system. The United States was also forced to confront the continued impacts of systemic racism in waves of protests and dialogue that continue to shape the investment and corporate landscape today.
As we press on into 2022, ESG-related funds continue to break investment records and show no indication of slowing down. In 2021, an estimated $120 billion poured into sustainable investments, more than double the $51 billion of 2020.
What really sets ESG investments apart
Positive social change is a priority for socially responsible and sustainable investors, who consider both financial rewards and moral ideals when making investment decisions. This approach to investing is centered on identifying socially responsible companies and constructing portfolios that exclude corporations that have a harmful influence on society or the environment, as well as those that have a morally flawed value system.
Many ESG investors are still motivated by ethical concerns and values alignment, but ESG differs from SRI in that it takes a more in-depth look at financial materiality. To acquire a broader view of investing risk and opportunity, many investors are including ESG considerations into the investment process alongside traditional financial analysis.
ESG investors make selections based on a larger set of criteria that aren't swayed by moral judgment or limited to environmentally and socially conscientious corporate practices. ESG investors analyze and rank organizations based on data and analysis of how ESG risks and opportunities can affect the company's performance, rather than fully excluding companies and industrial sectors based on blanket criteria such as alcohol, animal testing, or weapons.
The purpose of ESG
The purpose of ESG investing is to increase profits by investing in well-managed, socially responsible companies. ESG funds screen for shares based on value and growth, as well as ESG-focused governance procedures, sustainability scores, disclosure policies, fossil fuel exposure, religious observance, and workplace diversity. To be deemed a good ESG stock, a company must have a history of aligning its operations to support programs that benefit the environment, employees, local communities, and shareholders. Independent groups can utilize ESG ratings like MSCI and Sustainalytics to check this behavior.
By default, this technique frequently promotes sustainable investments while simultaneously ensuring the same degree of financial returns as a traditional investment strategy. Institutional investors frequently utilize ESG ratings to demand high standards of corporate behavior. Investing in ESG enterprises and supporting ESG alignment can also help fund broad projects to conserve energy, reduce waste, improve working conditions, and enforce ethical corporate practices, among other things.
ESG criteria & ratings
ESG investing, unlike non-ESG funds, focuses on three core pillars that are critical to today's company management and investors. Pollution, climate risk, exposure to harsh weather, carbon management, and the exploitation of finite resources are all examples of environmental challenges. Product safety, human rights, workplace safety, customer data protection, and diversity and inclusion are all examples of social issues. Accounting standards compliance, succession planning, anti-competitive activity, and a strong ESG management strategy are all examples of governance challenges.
Data analytics are also utilized to measure and quantify ESG concerns and used for both mandatory and optional reporting. Based on data obtained from a range of sources, including securities filings, voluntary business disclosures, governmental databases, academic research, and media reports, ESG rating agencies develop individual standards for analyzing and rating ESG performance. ESG indicators such as a company's carbon emissions, board diversity, or safety protocols are converted into segregated environmental, social, and governance scores, which are then integrated into a single primary grade using analysts and algorithms.
Most rating providers rely on data published by non-governmental organizations that collect ESG data from participating companies, such as the Global Reporting Initiative (GRI), the Value Reporting Foundation’s SASB Standards, CDP, and the SDGs.
The growing demand for ESG
In 1995, the US SIF Foundation (The Forum for Sustainable and Responsible Investment) estimated the size of the sustainable and responsible investment universe in the United States to be $639 billion. Assets have grown more than 18-fold since then, with a compound annual growth rate of 13.6 percent. According to Bloomberg Intelligence, global ESG assets could reach $41 trillion by 2022 and $50 trillion by 2025, accounting for one-third of global assets under management.
With continued climate-related disasters and variable weather patterns, tighter regulations around GHG emissions, rising demand for renewable and sustainable energy, biodiversity and supply chain ethics issues, and growing concern over social and governance issues, 2022 is expected to see an even greater expansion of ESG related trends and investments.
As firms and investors gain more power and influence, their actions and decisions have a greater impact on the future. ESG investing's rise can be seen as a proxy for how markets and society are evolving, as well as how valuation principles are responding to these changes. Most businesses face a significant challenge in adapting to a new environment that favors smarter, cleaner, and healthier products and services, as well as letting go of the dogmas of the industrial era, when pollution was free, labor was merely a cost factor, and scale and scope were the dominant strategies.
For policymakers, it should be a welcome market-led development that ensures that the common good is not sacrificed at any cost in the pursuit of short-term profit. For ESG investors, ESG data will continue to become increasingly relevant as a means of identifying companies that are well positioned for the future and avoiding those that are likely to underperform or fail.
ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.