Definition: ESG investing is a form of investment that emphasizes non-financial but environmental, social, and governance factors or metrics (rather than just financial returns) when making investment decisions. It is an ethical perspective towards the company’s performance and potential.
ESG investing goes like this:
- E – Environmental Factors
- S – Social Factors
- G – Governance Factors
These are the three critical factors employed for determining investments that seek to improve society and the planet rather than an emphasis on profit alone.
Content: ESG Investing
- Environmental Factors
- Social Factors
- Governance Factors
- ESG Mutual Funds
- Trends in 2021
ESG Investing Explained
Note, however, that there is no formally recognized global approach to measuring and presenting ESG metrics yet. Investors commonly use different data sources and analytical methods to arrive at ESG conclusions.
Since it emerged in the 1950s and 60s, the concept has continued to be embraced among institutional and retail investors.
Today, areas like ethical considerations and conformity with values inspire several ESG investors. The field continues to expand in scope—over 11,000 firms worldwide report on adopting ESG principles into their business models. Also, 125 organizations are involved in research efforts focusing on ESG investments.
It is often used interchangeably with terms like “sustainable investing” and “socially responsible investing (SRI).” The ESG score of any investment measures the sustainability of such an investment concerning the three factors mentioned above. In a nutshell, an investment’s ESG score measures the sustainability of investment in terms of the three ESG components or elements.
Understanding the ESG concept requires a comprehensive understanding of the make-up of the factors that constitute the concept. These are briefly discussed below:
Environmental factors include how companies conform to climate change mitigation rules, e.g., dangerous gas emissions, land and other natural resources, efficient use and conservation of energy, sustainability of products, water quality, and waste management, among others.
Social factors include issues internal and external to the company. For instance, does the company engage in projects that promote corporate social responsibility (CSR) in healthcare, education, water supply, housing, etc.? What are the working conditions and overall employee relations? Does the company encourage diversity and gender equality when recruiting workers? What product quality and safety standards are in place in the company? Does the company respect human rights?
This factor is concerned with the diversity and remuneration of the leadership, managerial, and board levels of companies; the degree of independence of the board as well as their attitude towards shareholders; ethical practices; voting rights; accounting and tax compliance policies; executives’ salaries and allowances with those of lower workers, among others.
ESG Mutual Funds
These are equity and bond portfolios that are evaluated according to environmental, social, and governance principles. This means that such public and private sector portfolios have been strenuously examined in terms of sustainability and other ESG metrics. Therefore, an ESG mutual fund should only accommodate securities with a high sustainability score while excluding organizations and governments with weak scores.
Studies indicate that considering ESG before choosing mutual funds leads to more optimal investment decisions. It also showed that ESG mutual funds could outperform non-ESG mutual funds partly due to better risk management options, especially when contending with challenging issues. For example, a firm that observes anti-climate change rules by limiting its carbon emissions would be subject to much reduced regulatory or societal risks than one whose activities contribute to climate change. Therefore, with reduced risks, the shares of the former are expected to experience lower volatility over time.
The popularity of ESG mutual funds has been on the rise over the years. The expected social capital investors are bound to reap by being seen as contributors to corporate social responsibility and the efforts against global warming and climate change, among others. Moreover, despite these non-financial investor commitments, returns from ESG funds are not compromised, thus adding to their popularity among investors.
ESG Investing Trends in 2021
To understand the changing scenario and investing ideology of the people, let us discuss its recent trends:
Climate change expected to attract more investor attention
Governments and other stakeholders have been slow in observing the Paris Agreement on climate change that called for reducing global gas emissions to 2˚C. Investors that support the Agreement are expected to talk companies into radical anti-climate change policies and possibly face declining investment choices if such talks are fruitless.
Uniform standards for reporting ESG
As passive investments continue to gain more popularity, the finance sector continues to lack standardized ESG reporting principles required to channel investment inflows into more diversified asset classes. If ESG reporting becomes standardized for stocks, quoted firms will have to abide by such regulations or standards.
Though efforts at standardization are not relenting and sound signals from stock exchanges like China, Hong Kong, and Thailand, 2021 should usher in more progress in this direction.
Use of ESG to bridge the inequality gap
The COVID-19 pandemic has clearly shown the extent of inequalities worldwide and the loopholes of the crisis management system of the organizations. This has made investors more aware of the social component of ESG. Thus, the pandemic has created an opportunity to introduce financial and business innovations that bridge, if not eliminate these inequalities, to create more inclusive and equitable societies.
A Harvard University study found that the social concept of ESG is “seriously under-conceptualized and fails to draw substantive and procedural human rights standards.” It is expected that the above scenarios will witness improvements in 2021.
Increased focus on corporate social responsibility (CSR)
As observed above, there are notions that the social factor or component of ESG lags behind the other two factors in terms of both studies and practical applications. This should experience some changes in 2021, thanks to the COVID-19 pandemic, whose impact on society, politics, and labour relations has been immense.
The ways businesses manage their employees and the social and political environments in which these employees operate will be pivotal in terms of long-term organizational survival, profitability, and capacity to attract investor funds.
Hydrogen slowly but steadily emerging as an alternative fuel.
Lately, hydrogen fuel has witnessed a resurgence as an anti-climate change fuel option and has been recognized by some government’s sustainable recovery and economic growth policies. Governments that have made it a priority include the UK, Germany, the Netherlands, the EU, and the US, which has October 8 as National Hydrogen and Fuel Cell Day. Funding is also not in short supply – Germany provided 7 billion Euros some time ago for increased efforts in hydrogen technologies.
Hydrogen fuel is attracting increased attention because of its zero-carbon nature when burnt with oxygen. It transforms into water vapour, making it very ideal for situations where there are no substitute technologies for internal combustion. It also holds some promise for renewable energy storage.
But several impediments have stalled the wide use of hydrogen as fuel, notably ineffective production methods. However, with the introduction of new, climate-change-friendly ways of production, 2021 is likely to be a year of significant consolidation in the exploration and ultimate adoption of hydrogen.
ESG investing tries to address mainly environmental and socio-governance challenges that arise from investments. Since it emerged several decades ago, it has been expanding in scope and adoption. More investors are inclined towards it because of the social capital it provides.