ESG Investing – a Comprehensive Guide
Any human resources specialist worth his salt will tell you that the young people coming into the workforce today are different from their fathers and grandfathers. In addition to a preference for horizontal hierarchy structures, today’s youngsters are environmentally, socially, and ethically more aware and sensitive.
These young workers want to contribute to organizations whose social, environmental, and ethical impact they deem sustainable and positive. This trend has been increasingly rearing its head in investing.
For today’s young investors, making money is no longer the only priority. Modern investors are only willing to throw their financial backing behind businesses that champion relevant social, environmental, and governance-related causes. That is how ESG investing has grown into a $30 trillion global trend, generating record-high inflows every year.
What is ESG Investing?
ESG investing is a form of sustainable and responsible investing that evaluates businesses and the investment opportunities they present by considering a selection of environmental, social, and governance factors. An ideal ESG investment supports one’s personal values while making a positive impact on the world.
ESG factors alone do not determine the overall rating of an investment opportunity. Performance-related factors are also important. But ESG considerations have a significant say in whether or not an investor is willing to commit to a business.
ESG investors want their investment dollars to achieve more than generate a profit. They want their money to exert a positive effect on the world.
Defining ESG Investing
Defining ESG investing is not an exact science. What may seem sustainable and attractive from one investor’s perspective may not be attractive or ESG-aligned from the point of view of another.
ESG factors tend to be subjective, but they do adhere to some common guidelines.
To find out whether a business is ESG-aligned from your perspective, consider the following factors.
Standing for the E in ESG, environmental considerations define the impact of a company’s activity on the planet in positive and negative terms. Some of the environmental factors ESG investors consider are:
- The emissions and pollution the activity of the business generates
- The overall carbon footprint of the business
- The emission of greenhouse gases and company policies related to the management of these pollutants
- The impact of the organisation on forests and nature
- The fossil fuel use of the business and its plans to transition to renewable energy
- Water usage, pollution, and the impact of the business on the water supplies of neighboring communities
- Environmentally friendly waste disposal and recycling policies
Other environmental factors exist, but these are some of the most obvious.
The social component of ESG concerns the impact the business has on humans, including clients, employees, and the local communities. The impact of a business reverberates throughout society, producing various positive and negative outcomes. Some social factors to consider from the perspective of ESG are:
- How the company relates to human rights issues and violations
- How the business sources its raw materials and supplies
- The company culture it maintains regarding employees and their treatment
- The working conditions it provides for its employees
- The attitude of the business toward inclusion and diversity
- The profound, long-term social impact of the activity of the company
- How the business treats its customers and the steps it takes to address their needs
- The regulatory standing of the business, its past infractions, etc.
How the executives of the company lead the business, how they uphold internal policies and police the internal functioning of the business have an impact on the performance of the company and the social and environmental factors that determine its ESG profile.
Some of the governance issues to consider are:
- The company culture regarding executives and management personnel
- The nature and alignment of executive compensation with business performance
- Diversity and inclusivity in the executive ranks
- Investor rights and the corporate structure of the business
- The makeup of the Board of Directors
- The relationship the business maintains with various regulatory agencies
Together, these three guideline categories paint a decent picture of a business from the perspective of most ESG investors. Bear in mind, however, that investors may and likely will have specific preferences ESG-wise.
Why Do Investors Care About ESG?
As mentalities shift, and the education system places more and more stress on individual empowerment, people grow to recognize that their choices have far-reaching effects on society, the environment, and their communities.
What we do matters, and how we invest our money is a significant part of who we are and how we relate to society. Knowing that your investments support ethical and environmentally conscious businesses doesn’t just give you peace of mind. It grants you the satisfaction to know that you have done your part in making our world a better, fairer, and more livable place.
We should not neglect the practical implications of ESG either.
Better Investment Performance
Making money is still the top driver of investing activities. And statistics show that ESG investments represent the future in many ways.
On the one hand, ESG investing may one day become the only viable way to let your money work for you.
The UN backs responsible investment as a way to make the world a better place. And its principles for responsible investment foreshadow an age where global financial sustainability is the defining quality metric of investment opportunities.
Institutional investors at the forefront of the global financial system already know that ESG issues will become more and more relevant for investment practices in the future. In anticipation of the coming ESG era, they have developed six principles to standardise their approach and attitudes toward ESG.
The signatories of the principles pledge that they will integrate ESG considerations in decision-making and investment analysis.
On the other hand, ESG-focused investments have consistently outperformed legacy investments over the last couple of decades. Simply put, investing in an ESG-focused business makes you more money.
Observing the principles of ESG makes businesses more sustainable and resilient to foreseeable or unforeseen shocks. Being fair, ethical, and sustainable is the recipe for long-term success. It is, therefore, hardly surprising that ESG-facing businesses make more money and earn their investors more through dividends.
The Morgan Stanley Institute for Sustainable Investing produced a whitepaper in 2019, in which it concludes that sustainable funds minimise downside risk when compared to traditional funds.
Sustainable businesses built on healthy organizational cultures and ethical decision-making are more resilient when faced with market shocks. The ongoing global pandemic has confirmed the value of solid, intelligent leadership coupled with sustainable business models.
ESG addresses the root causes of problems that lead to market shocks, so it is hardly surprising that ESG affinity reduces risks.
ESG is no Longer a Small Investment Niche
According to CNBC, European ESG investments exceeded $14 trillion in 2018.
In the US, sustainable investment opportunities swallowed $12 trillion in the same year. And the trend isn’t likely to slow, although the global pandemic and the war in Ukraine may distort the numbers temporarily.
ESG isn’t just here to stay. It is bound to take over. Millennials and members of Generation Z will increasingly shape workforces in the future. At the same time, these generations will make up a larger and larger segment of consumers.
Businesses can ignore ESG at their peril. The consequences of a lack of awareness in this regard will be real and unforgiving.
According to a Bank of America prediction, a wall of money the size of the S&P500 is set to flood into ESG over the next couple of decades.
ESG Investment Strategies
So you’re looking to future-proof your investment approach while increasing your returns without taking on more risk. ESG is the obvious answer. How do you go about incorporating ESG investments into your portfolio?
The most popular ESG investment strategies are:
- ESG integration
- Negative, norms-based, and positive screening
- Community/impact investing
- Shareholder action and corporate engagement
- Focusing on sustainability-themed investments
According to data from the Global Sustainable Investment Alliance, every one of these strategies, except for norm-based screening, saw massive growth between 2016 and 2018.
Negative, Norms-based, and Positive Screening
Coincidentally, negative and norms-based screening are the two most popular ESG investment strategies.
Investors who engage in these strategies eliminate a stock category from their portfolio. Tobacco companies are the merchants of death according to science. They can give back to the communities and devise ways to streamline their governance, but they can never justify the product they sell from an ESG perspective. That makes their stock a prime target for exclusion from any ESG-focused investment portfolio.
Investors engaging in positive screening only consider the most ESG-focused stocks for their portfolios.
ESG integration is a slightly more refined investment strategy. Investors who use this approach look at the ESG profile of the business whose stock they consider for investment purposes. Depending on the degree to which the company has integrated the ESG principles, the investor may or may not decide to buy the stock.
Investors are free to perform ESG analysis through their means. They can also enlist the services of an ESG research and rating agency.
Morningstar is one of the top ESG rating agencies whose services cover sustainability ratings and sustainable investment-related education. Not many companies can boast a high Morningstar sustainability rating. The agency hasn’t even granted Tesla a high sustainability rank.
The ESG screener of the agency allows users to set personalized criteria to find sustainable investment funds that suit their individual needs and tastes.
Shareholders can shape the ESG profiles of the business in which they invest by lobbying investment management firms to adopt the principles of ESG and push for change. These management firms are often the largest shareholders, and their demands carry considerable weight.
Investors engaging in impact investing look for worthy social causes they can support through their investments. Impact investments can be community-oriented, or focused on businesses and sectors with a direct social and/or environmental impact.
Thematic investing shifts the focus of the investor from specific sectors and businesses to emerging or predicted long-term trends. Investors with high risk appetite find thematic investing interesting because it allows them to identify future drivers of returns.
Sustainability fits nicely into this category, given the megatrends that will likely shape our future in the near and long term.
BlackRock have identified several such emerging megatrends:
- Technological breakthroughs that enable other trends to form
- Climate change and resource scarcity
- Demographic and social changes
- Shifting economic power
The Challenges of ESG Investment Strategies
In theory, it is easy to define best-in-class ESG-focused businesses with strong E, S, and G profiles. In practice, it can be quite a challenge to find investment opportunities that combine the three into a strong holistic ESG profile.
The sheer amount of data one has to process to arrive at relevant results means that the edge belongs to research firms that specialize in ESG analytics.
How to Screen for Satisfactory ESG Profiles
All companies face ESG issues that lead to ESG risks, affecting their economic outlooks. Some organizations manage these risks better than others, however. A simpler approach to painting an accurate ESG profile is to look at the exposure of the business to ESG risks, the way it manages these risks, and assess the gap between the two.
ESG profiling can be inconsistent, however, from one rating agency to the other. And negative ESG labeling may blind investors to great investment opportunities, often without justification.
Why ESG is the Future
The largest investors in the world are inevitably emerging as the most powerful global players capable of initiating change on issues like climate change, poverty, etc.
As people increasingly demand action from these players, ESG considerations become impossible to circumvent. Investment funds, asset managers, foundations, and endowments are aware of the blowing winds of change, and ESG is high on their agendas.
ESG matters to everyone. And it has no alternatives.
Green Investment Funds
Green investment funds represent attractive targets for ESG investing. By investing in these funds, you can add a green tinge to your portfolio, or paint it entirely green. The options are surprisingly numerous. The following sectors harbor some of the most attractive green investment opportunities:
- Pollution control
- Renewable energy
- Environmentally friendly transportation
- Waste disposal and reduction
- Water investments
- Alternative agriculture
The pollution control industry is everywhere. From reducing vehicle emissions to controlling the greenhouse emissions of industrial plants, the opportunities are many. The pollution control industry reacts to news of new legislation mandating stricter emission standards.
The renewable energy industry is huge. It incorporates solar energy, hydroelectric power plants, wind power, and geothermal energy. Renewable energy is constantly on the cutting edge of technology. This green investment sector offers some high-risk, high-reward opportunities for investors with high risk tolerance.
Electric vehicles are all the rage these days. Companies like Tesla make headlines regularly and offer outstanding investment opportunities. Tesla is but the surface of the green transportation sector, however. Other companies are working on newer, more ambitious technologies that may bring about breakthroughs in green transportation.
Alternative agriculture avoids the use of pesticides to grow crops organically. Sustainable fishing technologies look to replace our overfished oceans as a top food source.
Water is one of the most precious resources we have. Water management looks to provide answers to a looming scarcity of freshwater. Collecting, purifying, and distributing water, these technologies carry massive growth and investment potential.
Recycling opportunities continue to pop up everywhere as technologies develop. In addition to metal, paper, and glass, we can now recycle car parts, electronics, vegetable oil, and batteries. The business enterprises developing and powering these technologies offer outstanding green investment opportunities.
Someday, we may even be able to recycle plastic effectively and efficiently.
When We Ignore ESG
The consequences of ignoring ESG can be dire for organizations and people all over the world. Yet the longer-term importance of conducting sustainable business often takes a back seat to the lure of short-term monetary gains and pseudo-solutions to existential problems. Nowhere is this kicking the can down the road mentality more easily observable than in various environmental issues.
The plastic industry has changed our lives in ways no one could have imagined. Plastic products are ubiquitous, and they solve everyday problems. An ESG-averse approach to the industry has created situations in which the world’s largest plastic-producing economies cannot handle the waste they create.
The easiest short-term solution for industrialized nations was to dump their plastic waste on communities in Southeast Asia under the guise of “recycling.”
Plastic Waste is Drowning Southeast Asian Countries in Pollution
Recycling plastic is a noble undertaking that saves the world from plastic waste and creates jobs as well as recycled pellets we can use to create new plastic products. Or so the theory goes.
How Plastic Recycling Works
Plastic recycling is tedious and expensive. To recycle discarded plastic, workers sort the waste using optical sorting equipment. The sorted plastic goes to a reprocessing plant, where it is washed, and shredded. Following some more sorting, the plant melts and expands the plastics into recycled plastic pellets. The process is time and energy-intensive. And the resulting products are “downcycled,” meaning that they result in inferior products that end up in the landfill when people inevitably discard them again.
Recycling plastic costs more than getting rid of it in “alternative ways.” Incinerating and littering are solutions, but the cheapest option is the landfill, and that is where the overwhelming majority of plastic waste goes.
Until 2018, China accepted plastic waste for recycling. Most of the plastics the world sent to China ended up in landfills there, however. The country’s 2018 foreign waste import ban put an end to the practice unleashing the flood of plastic waste on smaller Southeast Asian countries.
Plastic waste has begun accumulating in the US and other industrialized countries as well. Once it hits the landfill, plastic takes a while to break down into microplastic pollutants that end up in the air, water, and ground, poisoning crops, people, and animals.
The Problem with Plastic Recycling
We tend to believe that most of the plastic we shove into recycling bins ends up reused one way or another. That is far from the truth.
The EPA says that in 2018, only 8.7 percent of the plastics discarded in the US were recycled. The rest went into landfills or ended up in Southeast Asia. We can safely assume that this percentage is even lower for less developed countries.
We staunchly believe in the efficiency of plastic recycling because the oil industry has spent billions of dollars over decades to convince us that most plastic is recyclable. It is not. The only solution is to use less plastic.
The Consequences of Ignoring ESG
The way the world has treated the problem of plastic waste is a classic example of what happens without ESG. Profit-focused thinking focusing on short-term solutions seldom leads to sustainable outcomes. And it hurts low-income communities the most while the profits land in the pockets of fossil fuel giants.
One doesn’t have to look far to gain a sense of the harm plastic pollution does on a day-to-day basis. In San Diego, plastics litter the streets and “adorn” the beaches. In Southeast Asia, the world’s new dumping grounds for plastic waste, the problems are more acute, however.
Plastic waste covers landfills two meters deep. In many places, locals open-burn the junk next to low-income communities.
Given that people of color inhabit these low-income South Asian communities, what’s currently taking place there is nothing short of environmental racism, according to Greenpeace.
The plastic industry exploits the most vulnerable humans, and it has taken full advantage of the lack of ESG oversight and awareness over the last couple of decades. It has repeatedly shunned responsibility and threw sand in our eyes through its advertising campaigns focusing on recyclability and sustainability.
From the perspective of the ESG investor, this plastic waste fiasco establishes many targets for negative screening investment strategies.
The main “culprits” of the plastic waste disaster and beneficiaries of the profits that result from it are the fossil fuel companies such as Chevron Phillips, Dow, ExxonMobil, and BP. The list does not end there, however.
Consumer goods companies are on board the plastic profits train as enablers. No ESG-focused investment portfolio should feature companies like Pepsico, Coca-Cola, and Nestle either.
Instead of coming up with real solutions to the very real problems it creates, the plastic industry continues to exploit every opportunity to foist its products on people and hamstring alternatives. And such opportunities seem to pop up everywhere.
The Covid-19 pandemic placed medical services under unprecedented strain world-over, sending the global economy into crisis mode. Instead of putting its weight behind building and delivering more ventilators, the plastic industry exploited people’s anxieties about infection vectors to smear reusable bags.
Plastic surfaces favor the survival of the Covid-19 virus, yet that fact didn’t prevent the plastic industry from touting single-use plastics as a solution to slowing the spread of the disease.
Plastic waste “exports” love the lack of regulation. Once China blocked the flow of foreign waste into the country, Thailand, Vietnam, and Malaysia became the targets until they introduced similar laws.
India, Turkey, and Indonesia were next on the list.
The only solution is to nip the problem at its source. The European Member States are focusing on ending double standards concerning plastic recycling and ending the export of low-grade plastic trash.
Passing the burden of dealing with the consequences of plastic pollution to low-income communities halfway around the world is untenable. Plastic-producing countries will have to figure out ways to deal with the trash they create themselves.