What exactly is ESG investing? No uniform definition exists, but at its heart, ESG investing is an investment methodology that allows an investor to apply a set of criteria that aligns portfolio investments with the investor’s ethical considerations or values. Many investors use environmental, social, or governance factors to evaluate potential investments. And since ESG criteria are based upon corporate attributes, they apply to both stocks and bonds issued by a company.
ESG investing originated in the 1960s and was then known as socially responsible investing. At the time, many institutional investors were looking to exclude specific companies or entire industries—such as companies involved in cigarette production or doing business with the South African apartheid regime—from their portfolios. Some investors use other terms, such as sustainable investing, impact investing, and mission-related investing, which are used either as synonyms or represent specific flavors of ESG investing. Regardless of the nomenclature, a common theme is their focus on generating both financial and nonfinancial returns.
Let’s take a closer look at environmental, social, and governance criteria:
Environmental:
Environmental criteria examine how a company performs as a steward of natural resources and the environment. This may include, among others, the following factors:
- Carbon intensity
- Fossil fuel reserve ownership
- Water usage intensity
- Pollution
- Alternative energy utilization
- Green buildings
- Energy efficiency
Social:
Social criteria screen based upon how a company manages its relationships with employees, suppliers, customers, and the communities where it operates. Examples include:
- Labor practices
- Human rights
- Animal welfare
- Data protection and privacy
- Diversity
- Business involvement in practices such as major disease treatment, education, firearms, and predatory lending
Governance:
Governance deals with a company’s leadership, executive pay, audits and internal controls, and shareholder rights. Examples of governance factors include:
- Board of directors’ independence
- Frequency of director elections
- Common equity voter protections
- Compensation policies
- Accounting controls
- Risk oversight
- Shareholder engagement
- Management structure
What constitutes an acceptable set of ESG criteria for an investor varies and depends on that investor’s beliefs and ethics—whether the investor is an organization, such as a non-profit, or an individual. Some focus on a short list of specific issues like carbon emissions and energy efficiency, while others take a broader view that incorporates factors from all three sets of criteria.
Several organizations have created guidelines for what constitutes ESG best practices. One such organization is the Sustainability Accounting Standards Board (SASB). This non-profit has developed accounting standards and disclosures for public corporations to release materially important ESG information for investors. In addition, index and data providers like MSCI and Morningstar now provide investors with ESG portfolio scoring and benchmarks. And several service providers have created proprietary scoring systems that rate companies on their exposure or commitment to ESG-related factors.
If you’re comparing potential investments, it’s important to note that the specific factors vary from group to group, so understanding the underlying methodology is critical.
Implementing ESG Strategies
To the extent an investor wishes to incorporate ESG factors into his or her portfolio, it can be accomplished in several ways. Three of the most common methods can be used to address different goals.
Exclusionary screening is the predominant form of ESG investing and, as the name suggests, is an approach that excludes companies with undesirable ESG characteristics from an investment manager’s opportunity set. This approach is typically best suited for investors primarily concerned about not supporting companies with operations or values that are antithetical to their missions or priorities. Exclusionary screening can be used by investors that employ a zero-tolerance approach to specific factors such as coal extraction and weapons manufacturing.
Thematic investing strategies pool the assets of multiple, like-minded investors to create leverage that can be used to influence the corporate policy related to ESG issues. Thematic investing can be accomplished by mutual fund and exchange-traded fund asset managers. Common themes for ESG fund managers include specific factors like religious values, gender diversity, and low carbon emissions, as well as the three ESG themes more broadly. These funds can be cost-effective solutions for investors whose ethical considerations or missions align with these funds.
Despite the inherent complexities and a number of practical challenges, ESG investing is growing dramatically as more institutional and individual investors look for ways to align their portfolios with their values.