Esg: Environmental, Social, and Governance: Why Is Esg Investing Gaining Ground Across the Financial World?

What is ESG?

Climate change has made it as vivid as a bright day that companies have a significant impact on their environmental and social ecosystems. The rising need to integrate sustainability into doing business led to the coining of the concept of Environmental, Social, and Governance (ESG). The business section with whom ESG has a close association is the institutional investors. For these investors, not only the financial performance of a company but also its ESG performance has begun to matter a lot. Not only institutional investors but retail investors also can make a small difference on the climate front by following ESG while investing.

ESG is a set of criteria that measures how well a company is taking care of its natural environment and the local and global communities in which it works and impacts. The impact of a company on its environment could include its carbon footprint, energy and water consumption, raw material utilisation, exploitation of natural resources, use of toxic substances that are harmful to the environment, waste management, and so on. Similarly, the social impact involves hiring practices for racial equity or equality, local community interactions, human rights records, labour practices, equal pay, inclusivity of the work environment, etc. The third part of ESG, that is, Governance, refers to how positively the management and leadership of a company implement and internalise positive changes about the first two parts- namely, environmental impact and social impact.

How ESG is Measured

The ESG of a company is usually rated on a 100-point scale based on reports and data such as annual reports, management practices, board structure, media coverage, stakeholder feedback, work compensations, sustainability impact, etc. There are rating agencies that follow different methods and tools to make their assessments. What reflects in an ESG score is the company’s sustainability index as compared to its peer companies.

As evident from the above discussion, it is hard to measure ESG, and it has no single universal methodology. Data availability could sometimes become a huge hurdle in this process. The quality of data and the subjective biases of the evaluators could also render the ESG measurement problematic.

Another important aspect of ESG measurement is the evolving nature of the very foundations of the concept. For example, LGBTQIA+ equity entered the ESG discourse only at a later stage. The issues and priorities keep on changing and evolving, and the rating agencies have to keep this in mind.

There are frameworks available for assessing ESG, and some accepted frameworks are,

Global Reporting Initiative (GRI)

Sustainability Accounting Standards Board (SASB)

Task Force on Climate-related Financial Disclosures (TCFD)

United Nations Sustainable Development Goals (SDGs)

What Is The Quantum of ESG Achievements So Far Globally?

The Global Sustainable Investment Review 2020, published by the Global Sustainable Investment Alliance, noted the following major achievements on this front-

Assets under sustainable investing reached USD 35.3 trillion in 2020. This is a 15% increase on the previous two years.
Sustainable investment assets constitute 35.9% of total assets under management.
Canada, The United States, Japan, and Australia are the leaders in sustainable investment.
Europe saw a decline in sustainable asset investments in the 2 years before 2020. Still, the US and Europe own more than 89% of the world’s sustainable investment assets

The same biennial report in 2022 found the following-

Assets under sustainable investing came down to USD 30.3 trillion in 2020. This is a decline from 2020.
In non-US markets, sustainable development assets under management grew by 20% from 2020.
Many markets have changed their methodologies to integrate sustainable investing. This shows the idea is taking root and stabilising.
Australia, New Zealand, and Japan increased their proportion of sustainable investing assets as compared to total managed assets.
Sustainable investing spread to more regions of the planet
The most favoured sustainable investing strategies adopted by investors worldwide are four- 1) corporate engagement, 2) shareholder action, 3) ESG integration, and 4) Negative or exclusionary screening.

What is Corporate Engagement and Shareholder Action-Based Investing Strategy?

This is all about stakeholder action beyond where they ask their portfolio managers to avoid investing in ‘dirty’ companies and sectors such as fossil fuels, mining, and chemicals. This is a realisation on the part of the investor that divestiture alone is not the path ahead for environmentally responsible investors. They can invest in ‘dirty’ sectors and continue to engage with the companies whose shares they own to bring in positive change. They can write letters to the company leadership, constantly engage with the top executives of the companies to carve a sustainable path forward, and thus push for carbon-neutral strategies. This is a way of bringing about change from the inside.

What is ESG Integration?

The UN-supported alliance of asset managers, namely, Principles for Responsible Investment (PRI), has defined ESG integration as “the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions.” This is an investor continuously doing ESG-based investment analyses and making decisions based on them.

Here, the investors have to find a balance between lowering their risk, generating profits, and, all the same, investing in companies complying with the ESG factors. They can also choose to be active investors exclusively in ESG-compliant companies.

The economy of the world is changing in such a way that investors who integrate ESG factors are going to make better gains in the long term.

Another consideration for ESG-integrated investing is to study and foresee a negative fallout that a company might incur because of its non-compliance with ESG factors. By making this analysis a continued process, the investor can stay away from stocks that might just crash in the near or far future when the companies become liable to negative legal and social consequences owing to their ESG non-compliance.

What is Negative or Exclusionary Screening?

Investment managers also use a tool called screening as part of their ESG investing strategies for asset allocation and portfolio construction. Screening uses a set of filters to decide which stock to include or exclude in the portfolio. These filters will be devised based on investor preferences, investor ethics, and values that the investor wants to hold on to. For example, the investor might want to create a filter based on the quantity of greenhouse gases that a company emits. The filter will work as a standing instruction for the asset manager and will be like, ‘avoid highest emitters’ or ‘include lowest emitters’.

A Few Successful ESG Investing Funds

Based on the Morningstar Analyst Ratings, a few top funds that lead the ESG investment path are,

PIMCO Total Return ESG

Parnassus Core Equity

Parnassus Mid Cap

Brown Advisory Sustainable Growth

PIMCO Low Duration ESG

iShares ESG MSCI USA Leaders ETF

iShares MSCI USA ESG Select ETF

Retail Investors and ESG

For a long time, it has been debated whether retail investors can afford to make sustainable and responsible investing, given the risks involved and unpredictable profit outcomes. However, the truth is that not only institutional investors but retail investors are also growing more and more alert about ESG-integrated investing.

A 2023 research paper found that ESG news is an important factor affecting the portfolio allocation decisions made by retail investors. However, it was also revealed that retail investors made decisions based on the ESG performance of companies only when they found it profitable or when the ESG performance added value to the company.

The Future of ESG Investing

There is a rising concern that we need to change the way ESG is measured. The drawbacks of the present system are three, according to a Harvard Business Review article-

Those who rate the companies usually focus on easily measurable ESG elements and neglect complex and difficult-to-measure aspects which could have great value.
The rating process and methods oversimplify the ESG elements to be measured so that they fit into an already set framework.
The ESG data is too diverse and complex to be reduced into a single rating-digit

To surmount these limitations, the Harvard article suggests two solutions. One is specialisation on the part of the rating agencies, as well as asset managers, that is, each one of them operates focusing only on one part of ESG- environmental, social, or governance. This will help the rating methods and figures to become more realistic and manageable.

The second solution suggested by the Harvard Business Review article is to prepare a regulatory framework and allow companies to jointly declare their ESG goals. This will help investors navigate the muddy waters of bogus claims and unrealistic goals declared individually by companies in their annual reports and vision statements, which, for the investor, do not provide a clear picture for comparison.

Irrespective of confusing data and apprehensions about pecuniary benefits, ESG investing is taking root and growing almost exponentially. Eventually, these investment decisions could be the driving factor towards the corporate world's acceptance and compliance with climate-friendly practices.

References

Global Sustainable Investment Review 2020 published by Global Sustainable Investment Alliance.

What is ESG Integration? April 25, 2018, Principles for Responsible Investment, unpri.org

Screening, May 29, 2020, Principles for Responsible Investment, unpri.org

15 Top Funds Leading the Way on ESG, Alyssa Stankiewicz, May 13, 2021, morningstar.com

‘Retail Investors and ESG News’, 2023, authored by Qianqian Li, Edward M Watts, and Christina Zhu.

It’s Time to Change How ESG is Measured, July 10, 2024, Lauren Cohen, Umit G Gurun, and Quoc Nguyen, Harvard Business Review.