We bet you’ve heard (and perhaps even used) the term ESG investing before… but if you haven’t, this concept is also known as sustainable investing, impact investing, or socially responsible investing.
In an increasingly mentally, physically, socially, and environmentally conscious world, many investors are now looking to put their money where their values are and the demand for ESG investments has surged. Mutual fund companies and brokerage firms have begun to offer exchange-traded funds (ETFs) and other financial products that adhere to ESG criteria.
In a study by Investopedia and TreeHugger, 60% of respondents expressed interest in ESG investments and 19% reported that they added ESG standards into their investment portfolios.
A report from the U.S. SIF Foundation showed that at the beginning of 2020, investors world-wide held $17.1 trillion in ESG-compliant assets. This is a huge jump from the $12 trillion held 2 years prior.
As more and more people are contributing to a sustainable world, investors are starting to identify potential risk factors in companies that don’t pertain to an ESG agenda.
Enough with the talk about ESG, it is about time we go over exactly what ESG standards entail and what this means for the investing world moving forward.
TABLE OF CONTENTS
|WHAT IS ESG?
|WHEN DID ESG INVESTING STRATEGIES START?
|HOW DOES ESG IMPACTS THE INVESTMENT LANDSCAPE?
|WHAT ARE THE COSTS OF IGNORING ESG IN 2021?
|IS ESG AN INEVITABLE PART OF THE FUTURE?
1. What is ESG?
Standing for Environmental, Social, and Corporate Governance, ESG serves as a set of standards for a company’s operations that a growing number of investors are using to evaluate their investments.
Let’s break down the criteria that ESG standards covers
The environmental standards of a company are based on environmental stewardship. This entails the responsible use and preservation of the natural environment through the use of sustainable practices that enhances the health and resilience of the ecosystem including the well-being of humans.
Factors regarding environmental criteria include, but are not limited to:
- energy use,
- natural resource conservation, and
- the treatment of animals.
The presence of environmental risks and the way in which a company is addressing and mitigating these risks plays a big part in their ESG adherence
Environmental risk can include factors such as:
- ownership of contaminated land,
- disposal of hazardous waste,
- management of toxic emissions, and
- compliance to governmental environmental regulations.
Environmentally conscious companies should:
- put out carbon or sustainability reports,
- limit harmful pollutants and chemicals,
- seek to lower greenhouse gas emissions, and
- use renewable energy sources.
A company’s business relationships are the first-place investors look when inspecting the social aspect of ESG investing. This includes their working relationships with suppliers and business associates as well as the treatment of employees, customers, and communities. The corporate structure and moral ground of a company are a huge part of ESG compliance.
We can imagine the Human Resources (HR) department would be a desired entity to speak with in regard to assessing the social aspect of an ESG investment.
A few questions to ask yourself when considering the social factors of a company are:
- Do they work with suppliers that hold the same values they claim to hold?
- Does the company donate a percentage of profits to local communities?
- Do the company’s working conditions show high regard for its employees’ safety?
- Are other stakeholders’ interests taken into account?
Socially conscious companies should:
- operate an ethical supply chain,
- support LGBTQ rights and encourage diversity,
- have policies to protect against sexual misconduct, and
- pay fair wages.
1.3 (Corporate) Governance
Governance touches more on how a company manages its finances, leadership, internal controls, and shareholder rights.
Accurate and transparent accounting methods and ensuring shareholders can vote on important issues is important to ESG investors. We’ve all heard stories of shady money management practices which poses a higher degree of risk for investors.
As far as the board members, the key for corporate governance is to avoid conflict of interest. Political contributions with the intention of unfair advantages among a company’s peers is a big no-no when it comes to ESG. Looking into the background of board members is a crucial part of due diligence when it comes to governance.
Companies adhering to corporate governance should:
- embrace diversity on their board,
- embrace corporate transparency, and
- employ a CEO independent of the board chair.
No company is perfect within the standards of ESG. Investors should decide what factors are the most important to them in respect to their investment criteria.
2. When Did ESG Investing Strategies Start?
ESG investing actually began way back in the 1960’s. Deriving from the activity of socially responsible investing (SRI), the early ethics of ESG involved excluding stocks and/or sectors from investments that conducted business operations in relation to tobacco, guns, or goods from regions of conflict. ESG as a term was officially coined back in 2004 by Kofi Annan, a former UN Secretary General. The first recorded study on ESG was conducted in 2005, dubbed “Who Cares Wins,” and was backed by some (20) of the world’s largest financial institutions with combined assets under management of over US$6 trillion.
3. How Does ESG Impact the Investment Landscape?
As many investors are looking to incorporate ESG factors into their investment decisions, the ESG market, based on its growth history, is set to double in 2021 alone.
European regulators are looking to heavily implement ESG factors within their financial sector in support of the green deal and the implantation of a more sustainable economy.
The green deal calls for the federal government to gradually remove fossil fuels from America’s business operations and put plant-warming greenhouse gas emissions across the economy to rest. The green deal additional pledges to support high-paying jobs in clean energy industries, further pushing the ESG narrative.
Did you know? The Portfolio Decarbonization Coalition (PDC), a United-Nations-sponsored group of 27 European institutional investors and asset managers, have committed to $600 billion to fund green projects and investments. The PDC currently controls $3.2 trillion in assets, which means nearly 20% of their assets under management (AUM) are pledged towards ESG-related investments.
4. What Are the Costs of Ignoring ESG in 2021?
There is a never-ending mountain of pressure to implement ESG from legislators, investors, and the business ecosystem itself. Companies need to perform well in terms of ESG to remain attractive to an employer or as a brand.
49% of millennial millionaires make investment decisions based on social factors. Venture capital companies, startups and tech companies are anticipating the law to lean towards ESG concepts, making ESG implementation essential for these emerging industries.
With the direction the financial sector is trending towards lately, ESG may just become mandatory for all organizations. If asset managers were to be required to comply with ESG reporting, that scrutiny would be passed on to the entirety of their portfolios.
Notable ESG regulations include:
- The Canadian government’s new Impact Assessment Act was designed to better integrate social factors into the regulatory assessment of major projects. Taking the social component one step further, indigenous engagement has also become an increasingly important part of government and corporate engagement in Canada.
- The 2018 Carbon Tax implementation, caused the government to develop regulations intended to significantly curb methane emissions from the oil and gas sector by 2025.
- At the Biden Administration Climate Summit, President Biden unveiled an enhanced nationally determined contribution (NDC) for the United States, pledging to reduce greenhouse gas emissions by 50% to 52% from 2005 levels by 2030. The U.S. NDC was developed by the National Climate Task Force by using a whole-of-government approach that took into account technology availability, current and future cost reductions, and the role of enabling infrastructure.
- The European Union SFDR (Sustainable Finance Disclosure Regulation) entered into force on March 11, 2021. It imposes mandatory ESG disclosure obligations for asset managers and other financial markets participants with substantive provisions.
- The EU Sustainable Finance Action Plan: A significant policy objective by the European Union to promote sustainable investment across the continent. Parts of it are effective from March 2021. The aim is to reorient capital flows towards sustainable investment and away from sectors contributing to climate change, such as fossil fuels.
- The EU Taxonomy: The European Union Taxonomy is arguably the most ambitious text aiming to give a non-financial overall score covering all facets of sustainability, from ESG to biodiversity, and pollution treatment. The EU taxonomy is a classification system establishing a list of environmentally sustainable economic activities. For investors, companies, and financial institutions—the regulation defines which economic activities qualify as sustainable and evaluate their environmental performance. From January 2022, financial market participants are required to report how and to what extent their financial products align with the EU Taxonomy, a framework to classify environmentally sustainable economic activities.
Looking beyond ethical concerns, past events such as the BP oil spill in 2010 and Volkswagen’s emissions scandal have proved there is a significant cost to ignoring ESG policies. Both events cost the companies involved billions of dollars in associated losses and major decreases in stock price.
BP plc. ($BP) saw their stock price go from US$59.46 on April 9th, 2010 to US$29.35 on July 2nd, 2010 following the disastrous spill.
Following the Volkswagen scandal regarding a computer software that cheated on federal emissions tests, the vehicle makers stock ($VOW3) dropped from EU$162.20 per share on September 4th, 2015 to EU$106.60 per share on October 9th of the same year.
5. ESG is an Inevitable Part of the Future
As ESG sentiment continues to increase, companies are constantly looking for ways to integrate ESG standards into their businesses in anticipation of mandatory requirements. For companies that have already been around for some time, this typically involves a deep dive into the core framework of the company’s structure.
There is growing concern for regulatory, legal, or reputational issues down the road if companies today do not start sprinkling these standards into their businesses. New businesses will be looking to incorporate ESG practices from inception, as the pressure to include these investing standards starts from the very beginning. Startups looking for funding will inevitably need to implement ESG policies from the get-go if they want a stellar chance at convincing investors about their idea.
The value that ESG creates is evident; European investors have poured EU$120 billion into sustainable investments since 2019, which hints that this modern style of investing is more than well-funded.
ESG investing has shown that it is more than just a strategy to feel good about where you are putting your money. It pays off.
It has been demonstrated that companies including ESG practices have shown:
- higher financial growth,
- lower volatility,
- higher employee volatility,
- lower legal and regulatory fines and sanctions,
- higher top-line growth, and
- more cost reductions.
However, the following inconveniences seem to plague companies with poor ESG performance:
- higher cost of capital,
- higher volatility,
- labor strikes, and
- fraudulent accounting.
Although ESG investment choices were not always the most profitable, often referred to as tradeoffs on the investor’s part, the landscape seems to be gradually morphing to satisfy the hungriest investors. There was a time were plenty of non-ESG companies were performing spectacularly on a financial level, while ESG companies were falling behind.
With the decrease of limitation for ESG choices and growing global concerns regarding ESG standards, this sentiment has already begun to change.
Large investment firms such as JPMorgan Chase, Wells Fargo, and Goldman Sachs have all published yearly reports that review their ESG approaches. In true financial service company fashion, the bottom-line results are the primary object of review, which shows that ESG investing can appeal to even the most data-driven, profit-seeking, and capitalistic investors; retail and institutional alike.
Five major global markets (Europe, U.S., Japan, Canada, and Australasia [New Zealand and Australia]) have seen their compounded annual growth rates (CAGR) reach 7.3% to US$35 trillion at the start of 2020 from 2018. This beats the 3.5% CAGR of all professionally managed assets over the last two years.
Governing bodies around the globe are becoming more involved in the integration of ESG standards into the mandates of companies. In 2019, 90% of the new regulations that came out were rolled out by government agencies and the number of these regulations that are applying to investors has risen substantially.
The agenda for a growing number of companies and investors seems to be trending towards having a clearer understanding of the challenges created stemming from the climate crisis. Companies are being required to promote and incorporate alternative energy sources, and greatly enhance the transparency around corporate governance to earn the long-lasting trust of investors.
Plenty of exchange-traded funds (ETFs) have been incepted to allow investors to achieve broad exposure into the ESG world. Here are several notable ones with their 2-year returns highlighted to showcase their performance, including the pandemic-induced market correction:
- Shelton Green Alpha Fund (NEXTX) +154.23%
- iShares Global Clean Energy ETF (ICLN) +101.07%
- iShares MSCI USA ESG Select ETF (SUSA) +59.81%
- Vanguard FTSE Social Index Fund (VFTAX) +57.11%
- 1919 Socially Responsive Balanced Fund (SSIAX) +42.05%
- Parnassus Core Equity Investor (PRBLX) +34.86%
There are plenty of emerging, evolving, and disruptive markets dominating the equities markets such as crypto funds, battery metals, plant-based foods, and psychedelics; the list goes on. However, it is rare we see such a broad trend dominate all aspects of the market, from the retail market, to the institutional market, to governing bodies; ESG can be implemented to practically every sector there is, making it one of the most significant trends this market has seen in quite some time.
Are you bullish on ESG?