Supporting companies that implement sustainable and ethical business practices is a form of ESG investing. ESG stands for “environmental, social, and governance,” and is an investing strategy that prioritizes financial returns while also taking a company’s effects on its stakeholders and the environment into account. Companies in this category must fit within a particular ESG framework.
While investing in ESG funds has gained popularity in recent years, this is not a new practice. The first noted example of ESG investing began in the 1960s, but awareness around these issues can be traced back much further.
The Origins of ESG Investing
The concept of values-aligned investing has existed for centuries. However, it wasn’t until the 1960s—when investors started curating their portfolios around business activities such as tobacco production or involvement in the South African apartheid—that it became a well-known and often-utilized strategy. There have been many iterations and terms used to describe what we know today as ESG investing.
ESG investing has been shaped over the decades by a few proactive industry pioneers, including American investment advisor Amy Domini. In the 1990s she created the Domini 400 Social Index, which highlighted companies that were focused on being socially and environmentally responsible. Amy then went on to create the Domini Social Impact Equity Fund a year later, which saw great success and proved that investments rooted in this kind of awareness could deliver high returns. Still an active resource today, the Domini 400 Social Index has been renamed the MSCI KLD 400 Social Index.
The first high profile mention of ESG investing was in a 2004 report from the United Nations. The report—titled “Who Cares Wins”—encouraged investors to champion ESG practices for the future. It gained traction worldwide, and inspired more serious conversations about sustainability, respect, and diversity in pursuit of a holistic approach to investing.
Additionally, the European Union recently released a Corporate Sustainability Reporting Directive. This reporting mandate requires companies to make corporate sustainability disclosures related to ESG requirements, and deliberately audit sustainability data. The reports must include environmental matters, diversity, and human rights information—a win for investment transparency and potential risk assessment.
Understanding ESG Criteria
ESG criteria outlines a specific framework that companies must use to evaluate their sustainability and business practices. Reporting is broken up into three categories: environmental, social, and governance.
The environmental component addresses how a company’s practices affect the planet and natural world. This covers aspects like:
- Carbon emissions
- Air pollution
- Water usage and conservation
- Renewable energy usage and green energy initiatives
- Waste management
The social component focuses on how a company treats its internal and external stakeholders, including employees, customers, and the larger community. These factors can be assessed using a variety of considerations:
- Employee treatment
- Fair employee wages
- Ethical practices
- Diversity and inclusion
- Data security
- Mission, values, and social justice views
- Sexual harassment policies
- Customer service and satisfaction
The last component—governance—examines the structure of a company, as well as its leadership compensation and business ethics. Examples of governance include:
- Diversity of leadership and board members
- Executive pay, including yearly salary and bonuses
- Reporting to stakeholders
- History of large-scale lawsuits
- The board voting process
An investment’s ESG score measures the sustainability of an investment in each of the above categories.
Measuring and Reporting ESG Performance
One of the biggest challenges ESG still faces today is its ongoing need for performance and reporting standards. In its current iteration, companies and investors measure key performance indicators and report their findings across various mediums. However, this system has proven to be less than reliable.
In 2020, the U.S. Securities and Exchange Commission (SEC) Investment Committee dedicated themselves to creating an ESG disclosure framework that would help bridge the data and reporting gaps. That effort culminated this year, as the SEC instituted a new 2023 rule requiring funds that claim to be ESG-focused to be no less than 80% aligned with the fund’s stated goals with respect to their investment policies. This new rule ensures that companies are fully transparent with investors, and creates a new standard of ESG reporting.
While the SEC framework is still solidifying, the European Union (EU) recently adopted the European Sustainability Reporting Standards, which will standardize how companies within the EU report ESG-related actions. These updated reporting standards are slated to take effect on January 1, 2024. The new requirements will ensure the ESG reports meet consistent guidelines moving forward.
If you research ESG today, you can utilize third-party sources to validate potential ESG performance. The most common source you’ll come across is the MSCI ESG Ratings. MSCI ESG Ratings uses a rules-based methodology to identify industry leaders according to their exposure to ESG risks and how well they manage them. Other rating agencies include Bloomberg ESG Ratings, CDP Scores, ISS ESF Ratings & Rankings, and Refinitiv ESG Scores.
The Impact and Advantages of ESG Investing
ESG issues are important to investors. According to a study by Capital Group, 89% of investors consider ESG issues in some form as part of their investment approach—and for good reason. ESG can potentially offer benefits to investors who prioritize values-based investing and want to ensure their dollars go to companies who are aligned with the causes they care about.
Some notable advantages of investing in ESG include:
- Potential for high returns: Contrary to popular belief, research has shown that sustainable investing can improve your returns. But not all investment opportunities are created equal, ESG or not. It’s imperative to do your own research and get professional advice.
- Align investments with values: Values-aligned investing can be a meaningful addition to your investment strategy. Investing in companies that reflect your values and ethics can be a main advantage to ESG.
- Reduce portfolio risk: A study by Morgan Stanley found that sustainable funds consistently produced lower risk than traditional funds, regardless of asset class. The same study found that traditional funds had a higher potential for loss.
- Positive impact on the environment and society: Investing in ESG companies aims to create a better, healthier world. Investing in companies prioritizing the environment, employees, and leadership structures can help improve global sustainability efforts and promote positive change.
Challenges and Critiques of ESG Investing
ESGs can be an excellent way to integrate more sustainable and impactful investing into your portfolio, but there are also some concerns you should be aware of:
- No regulations or standards: The lack of standards and guidelines for evaluating ESG performances is just beginning to be addressed, so there are still many inconsistencies across ESG portfolios and funds.
- Minimal long-term performance data: Because of the decades-long lack of standardization, there aren’t reliable sources on the long-term financial success of ESG companies. Without these critical performance numbers, it’s difficult for investors who prioritize financial returns to make a decision based on hard data.
- Subjectivity: There is still no strict definition of what an ESG investment is. What you may consider an ESG investment may not be what another person thinks it is, and vice versa. This can make it difficult for investors trying to find a fund that truly aligns with their values.
- Potential for greenwashing: Because no reporting standards existed for so long, companies could potentially make false or misleading claims about their credentials. The process of a company creating a falsely positive impression about how it impacts the environment is referred to as “greenwashing.”
Is ESG investing driving lasting change that will help the environment and the people it impacts? It can be difficult to say. There needs to be continuous improvement in ESG methodologies and reporting to ensure ESG authenticity. Fortunately, there are some hopeful indications that the industry is headed in that direction.
Future Horizons of ESG Investing
With the possibility of a stricter framework and reporting standards, the future of ESG investing is bright. As investors become more and more interested in how their investments impact the environment and society, it’s possible that ESG investing could become the new standard in finance. Perhaps in 10 years “ESG investing” and “investing” will be interchangeable terms, because they’ll mean the same thing.
Getting Started with ESG Investing
Deciding which ESG companies to invest in is a similar process to traditional investing: you need to decide your ESG criteria, research potential investments, and work with a professional who can help guide you through the process.
ESG standards and options have come a long way over the decades. While there’s still plenty of room for improvement, investors passionate about the environment, society, and sustainability should consider exploring ESG investment opportunities. If you’re interested in trustworthy resources, or want to discuss incorporating this kind of values-based investing into your own portfolio, get in touch with our team.
Sources:
Lumberg, James. “A History of Impact Investing” Investopedia. 11 Sep. 2022.
“Corporate sustainability reporting.” European Commission.
ESG Ratings & Climate Search Tool, MSCI
“Sustainable Reality: Analyzing Risk and Returns of Sustainable Funds.” Morgan Stanley. 2019
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