ESG investing is a growing trend in finance, and this article aims to provide context to the term and explain the reasons behind its exponential growth.
What is environmental, social, and governance (ESG) investing?
ESG investing is a type of investing that considers environmental, social, and governance factors when selecting companies to invest in. This means that ESG investors look beyond just financial performance, to factors such as a company’s environmental impact, its treatment of employees, and its corporate governance practices.
ESG investing is a way for investors to align their financial goals with their values, while also seeking to make a positive impact on the world.
How environmental, social, and governance (ESG) investing works
In the past few years, investors have been interested in investing their money in businesses that focus on sustainability for two main reasons:
- 🌍 ESG investing aligns value-driven investors‘ with their investment decisions, by supporting companies that have strong ESG practices and avoiding those that do not.
- 💸 Companies exhibiting strong ESG credentials may be seen as more profitable and risk averse in the long term, presenting a good economic opportunity to invest in.
ESG investing has seen a surge in popularity, prompting brokerage firms and mutual fund companies to offer financial products that align with these values.
To assess a company based on ESG criteria, investors look at a broad range of behaviours and policies; environmental, social, and governance.
Environmental
The first category covers environmental impact: how well the business conserves the natural world, and how they’re working to protect the future of the planet.
Key areas include a company’s:
- Carbon footprint
- Energy efficiency
- Waste disposal strategy
- Natural resource preservation
- Pollution levels
Social
The second category covers social impact: how well the business operates with (and within) the community.
Key areas include a company’s:
- Data security
- Diversity and inclusion
- Working conditions
- Labour standards
- Community donations
Governance
The third category covers governance: the standards used by the company’s leaders to operate it from the top.
Key areas include a company’s:
- Board member composition
- Accounting transparency
- Executive compensation
- Stockholder voting rights
- Clandestine dealings or conflicts of interest
How do investment firms companies for an ESG fund?
ESG investing firms assess companies’ ESG performance in a variety of ways; they may:
- Review company reports business practices
- Conduct their own investigations into the company
- Rely on ESG ratings purchased from third-party rating agencies
ESG ratings have become a common way to measure a company’s sustainability performance. Scores are determined by third-party rating agencies, which use their own methodologies to measure the business’s performance across the environmental, social, and governance pillars.
Companies will pay to have their ESG performance rated, often at significant expense, because ESG ratings are becoming increasingly important to investors and other stakeholders. As a result, ratings providers are experiencing a surge in popularity, with some of the most well-known firms including JUST Capital, Morningstar Sustainalytics, and MSCI ESG Research.
The problem with ESG rated funds
The growing interest in ESG rating providers has been met with concerns about their inconsistency and lack of trust. Investors need clear and comparable information about how different companies are performing in the ESG sphere, but with the rating’s industry unregulated, companies are free to use their own methodologies. This can lead to a situation where a business receives different, often more positive, ratings from different providers, depending on the methodology used.
In recent months, the UK’s Financial Conduct Authority (FCA) has announced a voluntary code of conduct for rating firms that seeks to ensure that ratings are high-quality, free from conflicts of interest, and transparent.
What does ESG investing mean for a business?
With ESG investing on the rise, businesses are incentivised to incorporate those same environmental, social, and governance principles into their corporate, or ‘ESG’, strategy. This means taking steps to lower pollution, CO2 output, and reduce waste. It also means having a diverse and inclusive workforce, at the entry-level and all the way up to the board of directors.
It was once thought that ESG is only costly and time-consuming to undertake, but many organisations now see the benefits that come with incorporating ESG factors into their planning.
The future of ESG investing
In June, the International Sustainability Standards Board (ISSB) published its first two finalised standards. The standards are intended to provide a comprehensive global baseline of sustainability disclosures, specifically focused on the needs of investors and the financial markets.
Elsewhere, the EU has implemented its Corporate Sustainability Reporting Directive (CSRD) which looks to fix key structural weaknesses in current ESG regulation around reporting, improving the quality of disclosure information.
Finally, regulators are increasingly scrutinising the role of ratings providers in ESG investing, with the FCA is considering mandatory requirements for those offering ratings to ensure their consistency and trustworthiness. These changes are intended to safeguard the accuracy and effectiveness of ESG investing in the future, as well as to facilitate a just transition to a sustainable future.
