Environmental, social and governance (ESG) standards have never had so much attention.
But even though they have always played a part in investing, ESG factors are some of the more misunderstood (or even worse, partly understood) parts of the whole stock market culture.
Let’s get to the bottom of what it all means, how ESG differs from other kinds of ethical and social investing, and how the world is changing because of it.
Here are the sections we’ll cover:
- What is ESG investing?
- The E in ESG
- The S in ESG
- The G in ESG
- How does ESG investing work?
- Does ESG investing mean sacrificing returns?
- Ethical, sustainable & socially responsible (SRI) strategies
- Is ESG investing all about morals?
What is ESG investing?
Matching your money to your morals has historically been a niche part of investing.
It’s the result of a seemingly unspoken acceptance that the ends justify the means when it comes to producing profits, with only a small number of people concerned with how the sausage was actually made.
But times aren’t just changing, they’ve pretty much changed.
A company’s impact on the environment (E), how it treats the society within which it operates (S), and how it upholds high standards of corporate governance (G) have never been so important.
And while the conversation initially began by analysing how companies affected the environment and contributed to climate change, arguably the past few years have focused more on the S and G in ESG.
But before we get into talking about the future of ESG or how we can integrate it into our investments, let’s go a bit deeper into how putting these expectations on companies helps.
The E in ESG
Tree-huggers, do-gooders, charities and just vegetarians generally.
These are the groups that used to be lazily associated with caring for the environment.
And while some people are finding it hard to snap out of those cringe-worthy stereotypes, the issue has most certainly evolved, especially in the corporate world.
All it took was an impending climate crisis and huge man-made environmental disasters to get the investment world interested in how companies affect the world around us.
And while it would be an optimist that said investors suddenly became climate activists, a cynic might be inclined to think they were more worried at how the big polluters would damage their portfolios.
The truth is probably somewhere in between but the result is a greater emphasis on limiting companies’ negative impact on the environment, and keeping an eye on them to make sure they’re complying.
From a purely capitalist point of view, massive oil spills attracting enormous fines from regulators and prospective taxes on firms not on top of their pollution levels had started to take cash out of shareholders’ pockets.
That’s when the more mainstream analysts and investors started to clock on to the fact there was an investment angle to all of thisl.
Holding companies to higher environmental standards would help combat climate change and decrease the likelihood of getting their knuckles rapped by increasingly environment-aware legislation.
The upside for investors wanting to know their money can be used for good is that it has never been easier to invest for a greener future.
The S in ESG
The S refers to society or the social aspects of running a business.
This might be analysing the employment practices of companies and making sure they’re not involved in modern day slavery or how they treat their employees overall.
And as well as fair labour practices, companies are now expected to meet social standards covering consumer protection and shareholder interests.
If it makes it easier to picture the extent of who falls into the ‘social’ label, think of all the stakeholders involved, including people not directly employed by a company but who feature somewhere along the supply chain.
Analysts covering some of the big tech hardware brands a few years ago made a point of asking company bosses where the tin in their products was sourced.
Some firms discovered they were inadvertently getting it from mines staffed by children and began investigating how the supplier got onto their production process.
Using this train of thought, 2020 has been a real eye-opener for investors who thought ESG was just about appeasing environmentalists.
Allegations of unfair employment practices in Boohoo factories, and the Black Lives Matter movement highlighting how firms approach diversity and inclusion among their staff have been big talking points.
Covid-19 and subsequent furlough arrangements have also shed more light on how companies handle cutting hours and decide on redundancies.
British Airways provoked heated responses from unions and politicians after announcing plans to axe 12,000 jobs earlier this year, with pub chain JD Wetherspoon coming under scrutiny for announcing it would not pay staff when pubs closed initially.
Arguably, 2020 has been the year of the S in ESG.
The G in ESG
G stands for governance.
The crosshairs here are on company management and how a firm adheres to the regulations of its industry.
It seems straightforward but there’s a difference between being a leader in the field, and the people at the top sailing close to the wind in the pursuit of short-term profits.
It’s also about how company management evidences a sustainable approach to running the firm.
Issues around C-suite pay creep in here.
Are bosses happy to pay themselves the big bucks while profits hang in the balance or employees further down the scale struggle to see wage increases?
A point tied to this is how leaders treat incentive plans.
Does the prospect of a big bonus incentivise them to sacrifice the overall health of their firm in order to meet short-term targets?
What analysts often see is that the mood at the top filters down through a company and becomes a characteristic of the entire business - getting it right in the boardrooms matters.
What’s more, fund management groups with the heft to invest millions want to see a solid business model overseen by a team that values integrity and provides sustainable returns.
In this sense, sustainability has very little to do with ethics and everything to do with making sure a firm is headed up by trustworthy, dependable management with a track record of maintaining progress and delivering consistent growth.
Risking high quality growth to pursue vanity projects, low-value acquisitions or short-term profits doesn’t cut it anymore.
How does ESG investing work?
So now we’ve got to grips with what the initialism encompasses, the question is - how do these standards get onto the priority list of the companies we invest in?
How can we check up on them and, if we want to, how can we identify the ones leading the way?
Well, the pressure to make ESG a priority comes mainly from two places - the regulator and the investment industry.
Industry bodies laying down the law in sectors like oil, banking, consumer goods etc. will have their own goals often passed down from governments on the likes of reducing carbon emissions or increasing female representation on company boards.
They will then make it known to the companies they speak to that there is an expectation of their alignment on these issues. They can often set sector goals and ‘encourage’ firms to meet them. The carrot and the stick are both perfectly good incentives.
The other big source of pressure tends to come from large fund management groups. Again, these firms will have expectations placed on them by their shareholders, private owners or regulators.
But the clout they wield comes in the form of money.
Asset managers quiz company bosses on their ESG credentials and look at how well they are putting them into action.
They speak to competitors, customers and suppliers to create a view of a company’s approach to doing the right thing by their stakeholders, the environment and their immediate community.
These investors go further by diving into the balance sheet to see if sustainability is at the core of what the firm does.
They do this on behalf of their often massive pension schemes, and ultimately millions of people like you and me.
That means they have the power to demand change from companies who aren’t cutting the ESG mustard, consider investing in those who are showing how it’s done, or walk away completely from the basket cases.
There’s a responsibility here to use their position of influence to support good practice where they see it and, at the very least, call out the laggards where it’s evident.
That’s because these groups are ultimately accountable to us, the end investors, and should guide our savings towards sustainable practices in line with what we can reasonably expect from a company, as a member of the public.
Realistically, these stewards of capital just want to know that the companies they invest in are not falling foul of ESG standards.
Not only does this satisfy their own sustainability goals but it also reduces the odds that their invested capital is exposed to unnecessary risks like fines or fraud.
This has created an opportunity for the investment industry. By rating companies on ESG and sustainability standards they allow others to decide if they want to invest in them or steer clear.
On the Freetrade app you can find sections containing companies carrying high ESG ratings, full lists of firms involved in green energy, and businesses run by female CEOs.
These are not novelties however. We need to remember there is a clear investment goal here and the industry has finally come round to realising that sustainability and positive change breeds long-term success and consistent returns.
That leads us nicely onto by far the most common question investors ask around ESG.
Does ESG investing mean sacrificing returns?
No. In fact the opposite could be true.
The usual suspects always appear in these conversations - the likes of the tobacco or arms companies that have provided handsome returns but wouldn’t pass most ESG screening processes.
The argument is that by ruling them out, you rule out returns.
And it’s true that excluding a group of companies from your portfolio means you’ll have a smaller set of firms to choose from.
What most people don’t realise is that serious investors do this every day already.
The difference is that they apply their own screens based on different factors like company size, sector or profitability.
Adding a sustainability or ESG screen doesn’t reduce the pool of long-term winners any more than any other process.
If anything it sieves out those companies whose sustainability has never been questioned but for whom it is a real danger in the years ahead.
It’s hard to see how regulations could lighten up on the tobacco industry, for example.
Whereas green energy companies are actively receiving government grants and tax breaks around the world.
What you gain through this process is a higher average level of sustainability among the companies who pass the test. This, in turn, provides the opportunity for more sustainable investment returns.
And the most recent evidence supports this view.
Research conducted on firms throughout 2020 shows that those at the top of the ESG scale have performed better since the March lows, with a direct correlation between the worst ESG-rated firms and the worst investment returns this year.
Ultimately, companies with the most sustainable characteristics could be less likely to be blindsided by corporate governance scandals, environmental disasters or so-called vice taxes (which all end up hitting profits) in years to come.
In this sense, including a layer of ESG analysis when looking at companies to invest in simply adds more thorough due diligence to the whole process. Never a bad thing.
Ethical, sustainable & socially responsible (SRI) funds
So, hopefully we’re past the idea that you have to be a cold-hearted capitalist to make money, or you should waive any care about money if you want to provide a social benefit.
The sweet spot in the middle is where we find socially responsible investing (SRI). This is a way to allocate capital to maximise both financial return and social good.
An example might be funding social housing initiatives or water cleaning products for use in underprivileged communities.
Cloud computing provider Blackbaud aims to sit in this bracket and serves nonprofits, foundations, education institutions, healthcare organizations and religious organizations with finance and analytics software.
With an SRI mindset, investors can identify net contributors to positive causes and champion them, rather than simply ignoring firms who aren’t involved.
Again, on the Freetrade app there is a wide range of ESG and SRI ETFs (like iShares Japan SRI or MSCI UK Socially Responsible) to give investors the chance to invest broadly in firms enacting change for good.
The term raises an important point though - there tends to be a spectrum of what ESG-minded investors want from the companies they choose to invest in.
At one end of the sliding scale we have investment with no concern for ESG and on the other we have charity with no thought given to profit.
And at the halfway point we bissect the middling crowd into those actively wanting to do good with their money, and those just not wanting to do bad.
Something that sits beside this spectrum is the issue of ethics.
While there are ethical funds and investment strategies out there, the problem is that what’s ethical to me might not be ethical to you.
The subjectivity can be confusing and the screening process tends to be about identifying and blacklisting the negatives rather than supporting the positives.
Some ethical investors might avoid whole industries like alcohol, practices like animal testing, or the likes of media groups publishing pornography, purely on moral grounds.
The advantage here is that like-minded investors know their money will not conflict with their morals even if companies in these sectors become more attractive on more generic ESG measures.
Incorporating these strategies can also often be adopted by individuals, for whom violating religious or cultural rules is simply not acceptable.
More broadly, the reason many of us are drawn to ESG investing is because we feel there’s something the mainstream industry is missing out.
Even with their increased adoption of ESG mindsets, companies still might not give us exactly what we need sometimes due to our personal aversion to certain industries or their lack of distinctly positive causes we’d like to be involved in.
Objective ESG features can help here by defining what investors can consistently expect from specific strategies.
And putting to one side non-negotiable ethical aspects like what’s not allowed in certain religions or faiths, for which there are specific investment companies out there, this is where it helps to talk objectively about sustainability instead.
From an investment standpoint, it’s simply not sustainable to keep channelling money towards projects that don’t provide a return whether they have a short-term positive influence or not.
Close attention to sustainability lets investors see how repeatable and reliable a firm’s long-term corporate plan is, how resilient its revenue streams are and how likely it is to survive, given its environmental impact and changing consumer habits.
This has been the thinking behind the leaps and bounds made in ESG over the past few years and is the one slowly getting rid of nauseating images of trees, windfarms and solar panels in fund brochures and slideshow presentations.
Is ESG investing all about morals?
When I started investing, one of the industry’s star investors told me quite clearly that investors didn’t pay him to be a moral compass for them, rather they only paid him to make them money.
I’ve thought about that a lot over the years, and I’ve steadily seen it make less and less sense to the point that I think it’s utter rubbish now.
But it’s not the unfettered capitalism I have a problem with, it’s the fact that it misses the point completely.
Sustainable companies have been the most successful this year.
By attempting to drive the highest sustainable returns, you’ll eventually end up investing in those with the most sustainable practices and the companies least likely to get fined or slammed by regulators. And you can absolutely end up going good along the way.
What this type of statement does show is how far apart the ideas of social good and profit used to be and how inextricably linked they are today.
While ESG will attract those more socially-minded, you don’t have to think that way to adopt its principles.
For me the big takeaway is that you don’t have to be Greta Thunberg to want to know the companies you invest in are being run like they should, for the good of all involved.