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Environmental, Social, and Governance investing, or more commonly known as ESG investing, refers to investments that are made considering economic aspects as well as human wellbeing.
The investment type is based on the assumption that social and environmental factors affect an organization’s financial performance.
It is the consideration of an investment’s impact on environmental and social factors. Environmental factors include things like energy use, water usage, pollution, etc. while social factors include things like community relations, workplace diversity, and more. Governance covers the ethics and corruption of corporations or companies that are being invested in.
Below, we discuss ESG investing in detail.
What is ESG Investing?
ESG investing has gained a lot of momentum in the past decade or so. While there is no single universally accepted definition, ESG investing is generally regarded as investments that consider economic, social, and environmental factors associated with companies.
There are three core components of ESG investing:
- Environmental: This includes the effects of a company’s products and services on the environment, such as emissions, waste, and water usage.
- Social: This includes the effects of a company’s operations on employees, customers, and communities.
- Governance: This includes ethical considerations such as corruption, bribery, and human rights abuses.
The rationale for ESG investing is that social and environmental issues can have a significant impact on a company’s financial performance. For example, if a company negatively impacts the environment or its employees, it may face regulatory fines or higher operating costs.
While it may have gained popularity recently, ESG investing isn’t exactly a novel concept. Ethical and religious beliefs have heavily influenced investments throughout time.
For instance, Muslims established investments in compliance with Sharia law, which prohibits weapons. Today, the rise of concepts, such as social sustainability and corporate social responsibility, has increased the investor focus on the ethical side of things.
Does ESG Investing Outperform?
ESG investing is often referred to as an ethical or green-type investment. However, this is somewhat misleading. Studies indicate that companies with good ESG scores don’t perform better for these reasons alone. Rather, it seems that they do so because they tend to have a lower risk.
This makes sense considering social and environmental factors can lead to greater risks in a company’s business model. For example, using carbon-intensive energy sources may pose a high risk to oil companies. Thus, one way of understanding whether ESG investing outperformance is valid or just based on lower risk is to compare it against indices that are assumed to be sustainable.
If the idea behind ESG investing has any valid merit, then it would be logical to expect it to out-perform traditional investments over the long term.
Does that mean ESG doesn’t outperform? There are a few different ways to answer this question. The first is to look at studies that compare the performance of companies with good ESG scores against the ones with lower scores.
Most studies that have analyzed ESG investing reported positive results.
A paper from New York University found that over 200 studies published since 2015 showed results in favor of ESG investing, claiming that it boosts returns. These studies have led to the increased popularity of ESG investing.
Self-proclaimed ESG funds have attracted $340 billion in just two years.
Another way to answer this question is to look at long term performance data between sustainable and traditional investments.
While there isn’t a lot of robust data on this subject yet, what evidence is available suggests that sustainable investments do outperform traditional ones.
But it seems like too much of the hype surrounding ESG investing is based on flawed analyses.
Flawed Underlying Analysis
A study by Scientific Beta claimed that ESG investing does not offer downside risk protection that its proponents claim it does.
The researchers say, ”Our findings do not question that ESG strategies can offer substantial value to investors. Instead, they suggest that investors who look for value-added through outperformance are looking in the wrong place.”
Scientific Beta studied 24 ESG strategies that were claimed to be outperforming by other academic papers. The researchers did find evidence of these investments outperforming.
However, in all markets, they found that nearly three-quarters of the instances of outperformance were due to quality metrics. These include conservative investment and high profitability.
The response to this study has been mixed. While some managers and investors disagree with it, others are relieved that someone has said out in the open what was previously being whispered about ESG investing in the financial market.
But Scientific Beta is not the first to warn about the potentially flawed underlying analyses surrounding ESG investing.
The SEC also issued a ”risk alert” recently, informing that some investment companies, private funds, and investment advisors misguide investors about ESG investing.
How to Evaluate ESG Performance?
Before you take the ESG investing route, it’s best to know how you can evaluate the funds’ performance.
Companies with ESG initiatives must publish measurable goals. Plus, they should report their progress against these goals in their sustainability reports.
But, not all companies publish these reports. So, it’s important to do your due diligence on a company before investing in its ESG fund. Try looking for reports that follow Global Reporting Initiative’s ESG standards.
Or, you can look for reports that comply with the standards set by the United Nations Principles for Responsible Investment.
If you’re looking for an even more rigorous way to evaluate a company’s ESG performance, consider impact investing. Impact investments are made in companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.
The reports required for impact investing are even more detailed than corporate sustainability reports. You can use your existing due diligence process to evaluate ESG funds that have a track record of making impact investments.
Remember, while ESG isn’t perfect, it does offer many benefits. The key is knowing how to get the most from an ESG investment fund.
You can also validate sustainability reports through third-party sources, such as:
- MSCI ESG Ratings
- Sustainalytics ESG Ratings
Shortcomings of ESG Investing
Although ESG investing can be beneficial if done right, it has some risks.
Lack of Universal Standards
Globally, there are no agreed-upon standards that all markets or countries follow to evaluate ESG performance. So, it can be difficult to compare a company’s performance from one report to another.
This lack of standards also makes it difficult to track the impact of ESG investing over time. As shocking as it sounds, some ESG funds also hold tobacco stocks. These inconsistencies make it difficult to create universally accepted standards.
Greenwashing is when a company tries to improve its image by exaggerating its environmental or social initiatives.
It can be difficult to determine whether a company is genuinely trying to improve its ESG performance or if it’s just doing things for show.
Lack of Transparency
Some ESG funds do not disclose their holdings publicly. So, you may not know what companies your money is invested in. This lack of transparency could lead to you inadvertently investing in controversial industries like fossil fuels.
If you find out that the ESG fund you invested in is making these types of investments, it may be too late to pull your money out.
ESG investing isn’t perfect, but it does offer many benefits when done right. You should do your due diligence before investing in an ESG fund.
And if you are looking to invest responsibly, it’s important that you are able to evaluate the sustainability reports of the companies where your money will be invested.