What is ESG Investing?

Definition

What is ESG Investing?

ESG Investing (also known as “socially responsible investing,” “impact investing,” and “sustainable investing”) refers to investing which prioritizes optimal environmental, social, and governance (ESG) factors or outcomes. ESG investing is widely seen as a way of investing “sustainably”—where investments are made with consideration of the environment and human wellbeing, as well as the economy.1 It is based upon the growing assumption that the financial performance of organizations is increasingly affected by environmental and social factors.2

The principles of ESG investing are nothing new. Hundreds of years ago, religious and ethical beliefs influenced investment decisions. Muslims established investments that complied with Sharia law, which included prohibitions on weapons. The first ethical unit trusts in the US and UK were developed by Quakers and Methodists.3 Today, the growing prominence of corporate social responsibility (CSR) and social sustainability has led to increased investor awareness about ethical participation in the market. ESG investing may have officially entered mainstream investing discourse following the release of the Principles for Responsible Investments (PRI)4 in 2006 – a set of United Nations guidelines for the incorporation of ESG factors into business policy and strategy.5 The PRI have over 2,000 signatories and are widely considered the official point of reference for all things ESG investing.

The ESG Investing Boom

Recent years have seen a significant expansion of ESG investing around the globe as organizations and individuals increasingly recognize the interdependencies between social, environmental, and economic issues.6 The COVID-19 pandemic encouraged this trend notably.7 Market disruption and uncertainty caused by the pandemic in 2020 led many investors to turn to ESG funds for increased resiliency. In fact, the first three months of 2020 saw $45.6 billion USD flow into these funds globally.8 $30.7 trillion currently sits in sustainable investment funds worldwide, and it is predicted this could rise to around $50 trillion in the next two decades.9 More investors are looking to fund organizations and products that support and promote sustainability, and comply with emerging regulations such as climate change regulations. This demand has been met with increased action on ESG issues in the business world, as well as progressively higher returns on investment for ESG funds due to their resilience against conventional market disruptions.10 Portfolios incorporating ESG and sustainability also frequently perform better in the long-term than those that don’t.11 For example, US financial services firm Morningstar found that over a period of 10 years, 80% of blend equity funds investing sustainably outperform traditional funds.12 They also found that 77% of ESG funds which existed 10 years ago have survived, compared with 46% of traditional funds.

This boom in ESG investing can be attributed to a range of factors. As supply chains become more complex, there is a wider awareness of social, labor, and human rights issues and risks for the business world.13 Growing concern for environmental issues such as climate change also influence investor decisions.  The heightened engagement of groups previously less involved in traditional investing—particularly young people and women—is also thought to have contributed to the ESG investing boom.14 To reflect these evolving societal values and norms, it is important that organizations adopt forward-looking ESG practices if they want to remain competitors in their industry and contribute to the common good.

Industries which are slow to uptake these changes receive increasing criticism and pressure from stakeholders, investors, and concerned citizens alike. Legal obligations are also expected to progressively tighten for these industries. In May 2021, a Dutch court ruled that Royal Dutch Shell cut greenhouse gas emissions by 45% by 2030.15 In the same week, ExxonMobil and Chevron faced pressure from their shareholders to reduce the companies’ contributions to climate change. It is likely these events will spark further transformations within these industries.

What topics fall under ESG and how are they rated?

ESG issues cover a variety of topics which are applicable to all industries and organizations in one way or another. While the avoidance of “sin stocks” was traditionally considered central to investing ethically, ESG investing entails a broader scope of issues, including:

Environmental

Social

Governance

  • Climate change
  • Greenhouse gas (GHG) emissions
  • Resource depletion
  • Waste and pollution
  • Water and energy efficiency
  • Deforestation
  • Biodiversity
  • Working conditions
  • Equal opportunities
  • Human rights
  • Employee diversity
  • Health and safety
  • Child labor and slavery
  • Community engagement
  • Philanthropy
  • Business ethics
  • Executive pay
  • Board diversity and structure
  • Bribery and corruption
  • Political lobbying and donations
  • Tax strategy
  • Compliance

 

There are few (if any) areas of business operations where ESG is not relevant. However, not all ESG issues are given equal weight when it comes to investing. Just as every investor in the market has different values and motivations, it is unlikely that an organization will (or should) prioritize all ESG issues in their business strategy. Those that are prioritized by investors and organizations are determined by the environmental, social, and economic circumstances of the time, and what is deemed more important and material to a company, given their industry, geography, and specific circumstances. Some prominent ESG issues influencing investors include:

  • Organizations’ efforts to mitigate climate change and other environmental disasters such as biodiversity loss. For example, have they achieved or are they on the way to achieving net-zero emissions?
  • Human rights issues within an organization’s supply chain. For example, have they published a Modern Slavery Statement or disclosed supply chain details within annual reports?
  • Workplace diversity and equal opportunities. For example, what proportion of the organization’s employees identify as underrepresented groups? How diverse is management?  Is there equal representation at the executive and C-suite levels?

An organization’s performance against ESG issues helps stakeholders make key decisions, and there are many tools available to measure or report on ESG performance. Some of the most popular include CDP, the Global Reporting Initiative (GRI), the Task Force on Climate-related Financial Disclosures (TCFD), and EcoVadis. These groups help companies measure and report on performance in a range of areas including governance, climate-related risks and opportunities, emissions, resource management, procurement, engagement strategy, and many others.

Some other platforms commonly used by investors to determine company ESG ratings include the Dow Jones Sustainability Index (DJSI), Morgan Stanley Capital International (MSCI), FTSE4Good, and ISS ESG solutions. These indices tend to be more investor-oriented, providing succinct metrics about a company’s financial performance. However, there are an abundance of ESG indices, frameworks, and standards organizations can choose to report or align to, and each should perform its own assessment of which best suit their goals and investor preferences to optimize their ESG reporting.

How can my organization attract investors through ESG?

“Our conviction is that companies perform better when they are deliberate about their role in society and act in the interests of their employees, customers, communities and their shareholders.” —BlackRock, 2021

It is vital for organizations to recognize and embrace the shift occurring in the investing world. No longer does the term “investor” solely refer to a select group of people. Rather, investing is increasingly understood as a tool to vote with one’s dollars, attracting a diverse range of people around the globe. The range of factors investors consider when making decisions has become much broader, reflecting this gradual diffusion of more progressive and holistic ESG values into the investing arena.

As issues such as climate change and COVID-19 have demonstrated the fragility of business-as-usual approaches, they have also highlighted the importance of organizational resiliency. Shareholders and stakeholders expect a transition towards more environmentally, socially, and economically sustainable business activity to support future generations. Organizations must build their adaptive capacities by considering an increasingly wider range of metrics in their business operations and long-term strategies. By identifying ESG benchmarks which are material to them and setting robust targets against these, organizations can set themselves up for success.

For more information on creating business resiliency, download our ESG Roadmap to Resilience white paper.

 



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11 Lieberman D, 2020, ‘Impact Investing 2.0—Not Just for Do-Gooders Anymore’
The Journal of Investing, 29 (2) 58-69; https://doi.org/10.3905/joi.2019.1.112
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