As investors become more conscious of how companies are run, ESG investing has been getting more popular over time. In fact, new criteria has emerged to help investors analyze stocks according to ESG factors.
In this article, we explore how ESG investing can provide another useful lens for investors to analyze the stocks in their current portfolio.
What Exactly Is ESG Investing?
ESG Investing stands for Environmental, Social and Governance.
In recent times, investors are no longer looking for financial returns alone. Instead, they are starting to consider the impact which the companies in their portfolio have on the world.
As a result of this new shift, investors are now taking non-financial factors into account when deciding which stocks to include in their portfolios.
While publicly listed companies are usually not required to publish ESG metrics in their financial reporting, more companies are starting to make disclosures in their annual reports or sustainability reports.
Let us explore these environmental, social and governance factors in greater detail below.
The environmental factor addresses how a business's operations will affect the Earth through preserving, conserving and protecting the natural environment.
This can be further broken down into:
Greenhouse gas policies. How does the business control its greenhouse gas emissions? Does it try to reduce its carbon footprint? Does the business release harmful chemicals when manufacturing its products?
Resource conservation. How does the company reduce its water wastage? Are its water usage processes efficient? Does it engage in unsustainable practices like overfishing?
Renewable energy practices. Is the business relying on renewable energy sources? Does it contribute to an ecosystem of green products, technologies and infrastructure?
Waste management. Is the company managing its waste disposal properly? How does it encourage recycling practices?
The social factor considers how businesses interact with people and nurtures its relationships. This can include:
Employees. How are employees treated and compensated? Is there high employee engagement and low turnover? Is there training and development in place to help employees progress? Is there diversity in hiring, promotions and pay increases?
Customers. What is customer service performance like? Does the business enforce consumer protection? Has it been involved with lawsuits, recalls or regulatory penalties?
Community. Is the business supply chain sourcing ethical? Does the business have a mission or higher purpose? Does it take part in lobbying efforts and social justice issues?
The governance factors relate to how a company is structured and managed. This can include areas like:
Management. Are executives compensated for producing long-term business value? Is there a well-rounded board and management team? Are there potential conflicts of interest?
Shareholders. Do shareholders have the ability to nominate board candidates? Does the company communicate transparently with shareholders?
Policies. Does the business define and enforce ethical business practices?
By asking this extensive list of questions, investors can get a better understanding of how the business is run.
But how did ESG investing first emerge? Let us dive deeper in the next section.
How The ESG Investing Trend Started
In choosing which companies to invest in, some investors have always looked at factors beyond financial returns alone.
However, this decision-making process mainly depended on what the individual investor believed to be right or wrong. From their perspective, they would eliminate companies from their watchlist.
As time went by, socially responsible investing became viewed differently. It was no longer about aligned with the investor’s personal values alone, but about using ESG factors to identify business risks and growth opportunities.
Changing Societal Values
At the same time, society is becoming more vocal about ESG-related issues. People are running campaigns to promote environmental conservation, fair worker rights and analyze management personnel.
The ease of posting content through social media has made it easy for these views to be shared. With information being spread across the world within minutes, the bad practices of companies can be easily called out.
Therefore, businesses are now more careful in managing their ESG practices to avoid potential backlash from the public.
Growing Awareness Of ESG Factors
Policy makers have also improved regulation in ESG areas.
As ESG investing continues to grow, the financial markets are responding to its newfound popularity.
Companies are starting to reveal more information about their practices. Analysts are starting to build ESG investment metrics and tools. ESG ratings are also given to companies.
Due to increased demand, new investment products like ESG indices or ETFs are now available for investors to purchase.
In fact, the world’s largest asset manager Blackrock has also incorporated ESG factors into its analysis. They adopt a philosophy that "climate risk is investment risk" and plan to use ESG data to "build more resilient and better performing portfolios". This is known as "ESG integration".
Why ESG Investing Might Be A Better Alternative
ESG investing has obtained growing interest as sovereign wealth funds, retail investors and financial institutions consider the impact of ESG factors on their investments.
Here are two potential advantages of ESG investing:
Investing As A Social Function
First, ESG investing helps to advance the causes behind ESG factors. This includes protecting the environment, fair labour rights and transparent management.
This is especially true for endowment,pension and mutual funds which might manage huge pools of capital. In choosing pro-ESG businesses to invest in, these funds are indirectly making a positive contribution to society.
Improved Risk Management
From the standpoint of qualitative analysis, investors who adopt this approach might mitigate the risk in their portfolios.
A business that does not value the social ESG factor might not treat its employees well. As a result, there is a chance they might face worker strikes, litigation and negative publicity, resulting in lower future returns.
For example, Tyson Foods faced a lawsuit in 2020 for wrongful death after employees with COVID-19 symptoms were allegedly ordered to continue reporting for work.
Additionally, the energy provider PG&E declared bankruptcy in 2019 due to climate change-induced wildfires in California.
Had more attention been paid to environmental factors, it could have been possible for PG&E and its peers to avert the situation which befell them. By reducing their collective environmental risks, it is possible for businesses to become more resilient and preserve their growth.
In addition to the social good ESG investing brings, ESG criteria can help investors avoid companies that operate in unethical and unsustainable ways.
By integrating ESG factors into their business strategy, companies can avoid risks, achieve fewer business disruptions and potentially produce more reliable financial performance over time.
Companies with high ESG standards might have better long-term stock performance as well.
According to research from asset management start-up Arabesque, the S&P 500 companies in the top 20% for ESG outperformed those in the bottom quintile by more than 25% between 2014 and 2018.
The stock prices of ESG companies were also reported to be less volatile. Investors can also avoid potential PR crises as well.
An example can be found back in 2016 when Wells Fargo (NYSE:WFC) fired 5,000 employees. This happened after the Consumer Financial Protection Bureau uncovered a fake account scheme.
Their CEO John Stumpf was forced to resign and the bank lost its accreditation from the Better Business Bureau.
If investors had analyzed the corporate governance in Wells Fargo, they might have been able to avoid the fallout that happened.
What Are The Downsides Of ESG Investment Analysis?
Despite its potential, ESG investing has its disadvantages.
While ESG factors can often be quantified, it can be difficult to calculate how that factor influences the profits and losses of a company. For example, companies can calculate their employee turnover rate. However, it might not be easy to calculate the losses that one employee turnover can bring to the company.
Similarly, it can be hard to prove that environmental conservation practices will directly affect a company’s bottom line. It is possible for environmentally damaging factors to appear more profitable in the short term as well.
Excluding Potential Sectors
Additionally, some companies will not be considered to have high ESG investing standards simply because of the sector they’re in. This limits an ESG investor from owning stocks that can display great performance.
For example, tobacco and defense stocks have a track record of producing returns that are well above the average and even perform well during a recession. These sectors tend to be avoided by many ESG investors.
Lack of Standard Benchmarks
Currently, ESG investing does not have a universally applied standard. As a result, there can be inconsistencies across different ESG portfolios, funds and corporate management.
For example, some ESG funds might even hold tobacco stocks.