What is ESG investing?

Investing philosophies evolve over time; influenced by a variety of economic, cultural, social and environmental factors. As society changes, so too does the way in which people invest. Perhaps the most prominent example in recent years is represented by a short initialism which you will undoubtedly encountered if you have an even passing interest in investment and financial news – ESG.

The rapid growth of ESG

Ethical and social investing has come a long way in a short space of time. Only a few decades ago ESG (Environmental, Social and Governance) and SRI (Socially Responsible Investing) didn’t even exist, today they’re on the radar of institutional and individual investors alike.

It’s scaling rapidly; according to the US SIF’s 2018 Report on Sustainable, Responsible and Impact Investing Trends, total SRI assets jumped 38% to $12 trillion since 2016 in the US alone. These assets represent 26% of the total US assets under management ($1 in $4).

Explaining ESG

The Environmental, Social and Governance (ESG) investment philosophy employs these three criteria (or ‘pillars’) to analyse stocks and make investment decisions. Put simply, ESG investing is about considering the environmental, social and governance factors alongside financial factors in the investment decision-making process.

Despite what some analysts may say, ESG investing is no longer a fringe activity. ESG investing is becoming a major force. And, that’s no wonder, when research shows that ESG investing can reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks they own (as well as sending a signal to others about their worldview).

So, with a broad definition in place, what exactly does each element of ESG investing involve? Let’s take a closer look.

Environmental

From the first days of the nascent environmental movement, through to today’s global movements to tackle climate change, companies (and their stocks) have come under scrutiny regarding their impact upon the environment.

The environmental component of an ESG investing strategy involves research into the various ways in which a company impacts the Earth (in both positive and negative ways). ESG investing aims to actively reward those companies that put environmental stewardship at the forefront of their operational practices.

What exactly do ESG investors look for in a company?

• Climate change policies and plans.
• Greenhouse gas emissions goals.
• Carbon footprint and carbon intensity measurements and policies.
• Use of renewable energy.
• Active avoidance of fossil-fuel derived electricity.
• The use of, or sale of, green technologies and infrastructure.
• Environmental benefits and incentives for employees (e.g. cycle to work schemes, policies to reduce business travel etc).

In order to demonstrate these credentials to ESG investors, many companies now report on their environmental impact using respected sustainability standards such as the Global Reporting Initiative (GRI) and Principles for Responsible Investment. Many companies also have dedicated sustainability pages on their websites, specifically for investors. However, be wary if these pages do not contain much data; some companies have been accused of ‘greenwashing’; giving the appearance of being green, but not following through with meaningful actions or commitments.

Investors can also identify truly ‘environmental’ companies by looking for their ESG rating. This is a rating system created by MSCI using a rules-based methodology to identify industry leaders and laggards. They rate companies on a ‘AAA to CCC’ basis scale according to their exposure to ESG risks and how well they manage those risks relative to peers.

Such ratings have proven enormously valuable for ethically conscious investors.

Example of an environmental leader

What companies would an ESG investor consider then? Perhaps the most prominent is Nike. Following years of effort, Nike now meets the environmental criteria of ESG. Nike employs a Chief Sustainability Officer whose job is to oversees the global company’s environmental efforts. Recent products, such as the Nike Space Hippie Flyknit, have been developed specifically with sustainability as a core consideration (in the choice of materials and manufacture etc). Nike is also actively using the environmental credentials of these products in their advertising and marketing campaigns. These days, being green sells.

Nike has also made a public commitment to reducing its carbon footprint; in 2015 the company joined a coalition of companies called RE100, all of which are committed to sourcing 100% of their electricity from renewable sources by 2025.

As with other ESG-minded companies, Nike also issues annual sustainability reports which use the GRI framework, the Sustainability Accounting Standards Board (SASB), and the United Nations’ Sustainable Development Goals (SDG) as performance benchmarks.

Social

Social element of ESG investing strategies considers the people-related elements of a company’s culture and operations. When it comes to social considerations, ESG investors ask questions such as; ‘how does a company treat its employees, customers, consumers, and suppliers?’, ‘how does a company’s actions impact its employees? ‘how does a company’s actions impact wider society?’.

To gain an idea as to how well a company is performing against these criteria, ESG investors will generally look at sustainability reports that include GRI or PRI standards, as these go beyond purely environmental factors and include information on employee, supplier and community elements too.

Other sources of information which ESG investors will often be minded to investigate include respected lists and annual rankings such as Fortune’s Best Companies to Work For and Forbes’ Just 100. Other sources of information include media reports on how companies treat employees, their lobbying efforts for or against social justice causes, whether they are pro or anti-labour union and more. An increasingly popular source of information used by ESG investors is Glassdoor which provides a good way to gauge employee sentiment towards their employer.

Typical factors an ESG investor will research and analyse include (but are not necessarily restricted to):

• Employee treatment, pay, benefits and other conditions.
• Employment engagement and turnover and churn.
• Employee training and development (e.g. is the company an Investor in People).
• Employee safety policies (including sexual harassment prevention).
• Diversity and inclusion policies (covering areas such as hiring, promotion etc).
• Mission / purpose of the organisation.
• Public stance on contentious cultural/social issues.
• Engagement in lobbying activity (both positive and negative).

Example of a social leader

Multinational professional services company Accenture is an example of a company which takes the lead on social/workplace issues. In fact, Accenture’s approach is such that it has been recognised as one of Fortune’s Best Companies to Work For for over 10 years. Accenture closely monitors diversity and inclusion within its workforce and has plans in place to improve its workplace gender ratios. Accenture aims to have 50% female and 50% male employees by the close of 2025. They’re not stopping there either. By the end of this year Accenture aims to have 25% female managing directors.

Governance

How does a company’s board of directors’ conduct company oversight? How shareholder-friendly versus management-centric is a company? These are just a few of the questions ESG investors seek to find answers to when looking at investing in a company.

The majority of corporate governance issues crop up as companies prepare for their annual general meetings and issue shareholder statements. Shareholders will often have the opportunity to vote on a variety of issues such as executive compensation, director appointments and shareholder proposals.

Governance topics which ESG investors will typically research and analyse include (but are not limited to):

• Executive compensation, bonuses and other benefits.
• Compensation tied to measures which deliver long-term business value, rather than short term business value.
• Diversity of the board of directors and senior management team(s).
• Transparency in communications with shareholders and whether the company has been targeted by activist shareholders in the past.
• The company’s relationship with regulatory bodies and other relevant institutions.

Example of a governance leader

International beverage producer Diageo is a shining example of good governance in practice.

Several committees oversee policies such as remuneration, nominations, audit and more, ensuring that Diageo adheres to good governance guidelines wherever possible. Additionally, the company has implemented a Code of Business Conduct which sets out standards of integrity and ethical behaviour to which all directors and employees are expected to adhere. A Board Diversity Policy rounds things out, committing Diageo to diversifying its board membership and achieving gender parity.

The benefits of ESG investing

As the examples above make clear, major companies are actively embracing the ESG agenda; and it appears to be benefiting their businesses. Not only are they perceived as being environmentally and socially conscious, but their embrace of the ESG agenda is also good for their bottom line; many of the most outspoken ESG companies are also the most successful financially.

But, what benefits can an ESG investment philosophy make to investors themselves? The next section of this article explores just that…

ESG investing can reduce risk

Whilst some companies may appear to offer substantial returns (e.g. fossil fuel and other extractive companies), when viewed through an ESG focused lens (which takes into account forthcoming environmental legislation and climate change for example), investment in these companies appears less attractive.

When companies actively embrace ESG considerations they put themselves in a better position to deal with future shocks. PG&E, the state of California’s utility company is a prime example of what can happen when a company fails to take environmental factors into account. Climate change has meant that the state of California has become increasingly arid, making wildfires more likely. Having failed to factor climate change into its forward planning, PG&E didn’t make the necessary investments in its transmission and distribution network. The result? Enormous wildfires and the collapse of its power network. PG&E ended up declaring bankruptcy, leaving investors out of pocket.

Investors that view PG&E from an ESG perspective would have avoided what ended up being a costly investment.

ESG investing can (sometimes) lead to higher returns

If a company takes ESG considerations seriously, is it also true that the company will deliver higher better share price performance for investors? An increasing body of research and observational data indicates that this seems to be true. The logic goes that a company with a strong commitment to ESG considerations will also be a company with exemplary management teams. This is because ESG considerations go hand-in-hand with long-term thinking and the ability to demonstrate, and stick to, a vision and mission.

In a world in which CEOs and board of directors choose to maximise quarterly profits at the expense of longer-term performance and profitability, companies that are committed to ESG considerations will offer better value to investors that are practicing ‘buy and hold’, longer term investing strategies.

The point that ESG focused companies’ share price performance is at least comparable, if not superior to their low-ESG peers is borne out by hard data. A look at the S&P 500 shows that companies in the top quintile in terms of ESG attributes outperformed those in the bottom quintile by more than 25 percentage points between the beginning of 2014 and the end of 2018. Additionally, the high-ESG companies’ stock prices were less volatile over this same period.

So, investments in high-ESG companies can really pay off…

The risks of ESG investing

Like any investment strategy, ESG investing has its risks in addition to its benefits.

One of the most significant risks lies in the fact that ESG is still very much a fledgling industry. There remains an ongoing debate as to what things should be measured (and how) in order to arrive at an ESG score. As mentioned earlier, many companies have spotted the marketing potential associated with the perception of being a high-ESG company; but they’re not necessarily committed to following through with the necessary actions – an approach known as ‘greenwashing’. Until ESG standards have been truly codified and universalised, ESG investors run the risk of being ‘duped’ by ESG ‘in name only’ companies (however the growing number of huge financial institutions moving into ESG should provide investors with growing confidence).

Interested in ESG investing?

If you’d like to find out more about ESG investing and how you can invest your capital in an ethically, socially and environmentally friendly way, speak to Blankstone Sington today.

This article does not constitute personal advice. If you are in doubt as to the suitability of an investment, please contact one of our advisors. Past performance is not a reliable indicator of the future. The value of your investment can go down as well as up, and you can get back less than you originally invested.