ESG investing

ESG is a hot topic right now for investors. Understand what ESG investing is all about and how you can use it to diversify your portfolio.

ESG stands for environmental, social and corporate governance. The term is used as a shorthand way of referencing an investment strategy that takes those three factors into account.

The term has its roots in 1950s America. Investment companies managing pension funds began to evaluate the effect their investments would have on the wider society and then take that into account when choosing businesses to put money into.

What is ESG investing?

ESG investing is about putting money into companies that, for the most part, do the right thing and make the world a better place. It means investing in companies that operate sustainably, treat their employees well and do good for the societies in which they operate.

As ESG investing has become more popular, some data analytics companies have created scores to help investors get a better idea of what they’re investing in.

A better ESG score might, for example, mean a company only uses a small amount of fossil fuels, so it could be a more appealing investment for investors looking to put their money into greener companies.

The problem with ESG scores is that they can take a wide range of factors into account and end up being misleading. A company that burns loads of fossil fuels might score badly on its environmental rating but then score incredibly well on its social and governmental standards.

The result of this is that some ESG funds have actually ended up putting money into big oil and gas companies — hardly the sort of thing you’d associate with sustainable investing!

Environmental investing

The environment is often the first thing that comes to mind when people talk about ESG investing. In some cases, the term ‘ESG’ is used as a shorthand to only discuss environmental investing.

There are some obvious ways in which environmental factors might play a role in an ESG investment strategy. For example, someone might choose to invest in solar power companies and not put any money into oil producers.

But not all environmental investing is as simple as this. Analysts looking at ESG factors might look at your supply chain or examine how you deal with waste.

For example, a furniture manufacturer that uses wood sourced from unsustainable timber suppliers might be seen in a negative light by ESG investors. Similarly, a company that deals in sewage treatment might be more appealing to ESG investors if it disposes of wastewater in a sustainable way.

Ultimately, almost every company will impact the environment in some way. The environmental part of ESG investing takes this into account and tries to work out how much a business’ activities will hurt the planet.

Social investing

The social part of ESG investing looks at how a company’s activities affect the wider societies in which it operates. In simple terms, it looks at how a company’s activities will affect its relations with the people and institutions in the places it operates.

Because relations with people and institutions are so wide-ranging, that means the ‘S’ in ESG can end up taking into account a huge range of factors.

It might mean looking at how diverse a company’s staff is or whether it provides enough consumer protections to its customers.

Social investing can also end up taking into account cultural and political factors. For example, if a company was selling goods to a dictator, ESG investors might want to avoid it based on social factors.

As you can probably see, social factors in ESG investing can end up being much more wide-ranging than environmental factors. That makes it harder to quantify exactly what they are and more likely that they’ll vary from business to business.

Corporate governance investing

The final ‘G’ in ‘ESG’ stands for ‘corporate governance’. This fancy term deals with the way in which a business is structured and how it treats its employees.

Investors looking at a company’s corporate governance might examine how much a CEO was paid relative to other employees or see if there is anything unethical in the ownership structure of the company.

The most common part of corporate governance that we are likely to read about or see is how large business treats its lowest-level employees. For example, the way Amazon treats its warehouse workers or the conditions in factories Nike uses to make its shoes could all fall under corporate governance standards.

Deep dive: What ESG investing is and what it means for your investment portfolio

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