ESG Investing & ESG Criteria Explained
In this post we’ll explain what ESG Investing is as well as provide insight into ESG criteria.
ESG Investing Definition
The acronym ESG stands for environmental, social, and governance. ESG investing can be thought of as a close cousin to socially responsible investing or impact investing. In short, ESG investing involves a set of screening criteria that investors use to evaluate companies’ broader societal impact. ESG investing continues to grow in popularity as shareholders increasingly demand more from companies than just a financial return. Likewise, consumers increasingly demand more from companies than just products. Stakeholders are looking at companies to be good societal stewards in addition to for-profit entities.
ESG Investing vs Socially Responsible Investing
While related, ESG investing does differ from socially responsible investing. For instance, socially responsible investing typically means the exclusion of a certain criteria. A socially responsible investor may exclude investing in gun manufacturers or oil companies.
ESG investing is more holistic. For example, an investor using ESG criteria may invest in a particular company because she believes sufficient financial returns can be achieved but also because of the company’s diverse board of directors, fair labor practices, and transparent supply chain. The ESG framework has similarities with the triple bottom line framework which focuses on profits, people, and the planet.
So how does one evaluate companies under an ESG framework? Let’s talk a bit more about ESG criteria.
ESG is still emerging and to my knowledge there isn’t an agreed upon ESG reporting standard. This makes it difficult to pin down exactly what ESG criteria are given there is no universally agreed upon framework.
That said, lots of work is ongoing to develop ESG criteria. Putnam has done some excellent work when it comes to defining ESG criteria. Below are some examples for environment, social, and governance criteria.
Environmental ESG Criteria 🌍
- Climate change risk
- GHG emissions
- Water intensity and stress
- Renewable energy use and exposure
- Materials sourcing and intensity
- Recycling and reuse
- Biodiversity and ecosystems impact
Social ESG Criteria 🙋♀️
- Employee diversity and development
- Safety, labor rights, equity
- Supply chain and distribution management
- Product safety
- Pricing philosophy
- Privacy and data security
- Links to systemic risk
Governance ESG Criteria 🏛️
- Board structure and composition
- Management incentives, ownership, pay alignment
- Accounting and business ethics
Here is a great visual map that Putnam developed addressing the ESG criteria
As of 2020 there is no standard ESG reporting requirements. While CEOs and boards continue to hear that delivering profits to shareholders is not enough, we have not yet reached a point where standardized reporting is mandated.
It is easy to envision a future where companies report on ESG metrics in a similar fashion as they report out their financial statements.
But at this time companies cannot be compelled to perform ESG reporting or disclose a variety of non-public information.
Evolving the ‘check-the-box’ mentality ✔️
ESG is evolving from the perception of it being a check-the-box exercise. If executives take a sincere look at the aim of ESG they’ll likely see it’s a good use of their time from both a societal standpoint AND financial standpoint. Bad ESG events or outcomes can cause the loss of shareholder value.
- Environmental: Consider something Deep Water horizon for BP ($19 USD fine and stock price hit).
- Social: Consider the Me Too movement. For example Steve Wynn’s company saw it’s stock decline upon sexual misconduct allegations.
- Governance: Consider Enron (it’s now extinct) or other companies involved governance related issues.
It’s clear there ESG criteria can have a material impact on financial matters of a firm.
Why should you care about ESG Investing?
Hopefully the idea of companies improving environmental, social, and governance factors alone is enough to compel one to care about ESG investing.
Want another reason? It popular! Take a look at the Google Trends graphic below to see the huge spike in searches for ESG Investing. It’s been up and to the right with no sign of slowing down anytime soon. Anyone interested in investing or involved with a public company should take note and become educated about ESG investing.
Millennials & CEOs
Younger investors in particular are more socially conscious and want to invest in companies that do more than provide shareholder return. It’s likely that the next generation of investors will continue to push more and better when it comes to ESC data and reporting. As consumers vote with their dollars they often wish to vote in line with their values.
CEOs are getting in on the act too. The NY Times published an article here on which highlighted how more and more CEOs believe it is their responsibility to do more than deliver share holder value. It’s clear both consumers and leadership of large corporations continue to weigh ESG type considerations.
Can ESG Investing Provide Superior Financial Returns?
The jury remains out on this question. There are a number of factors that make this a tough question to answer:
- Lack of standardization: Without standardized ESG criteria and ESG reporting it is hard to make apples-to-apples comparisons.
- Industry differences: It can be hard to compare across industries. How do you compare an oil company to a soda company to a green cleaning company? Each faces different circumstances and choices when it comes to ESG inputs which can make it hard to definitively say one ranks higher on ESG metrics than another.
- Role of government: Government can compel certain industries to do certain things by engaging legislation. Legislation differs across jurisdictions and is often changing. This adds yet another wrinkle to evaluate ESG metrics.
- Difficulty obtaining data: Because companies are not required to disclose ESG data in a standardized way it can be difficult to obtain and verify it. Certain data can be obtained from websites like Glassdoor but as a whole it can be highly challenging to get a good data set for the huge population of companies that exist.
- Difficulty turning data into actionable info: Even if we have a great data set how do investors use it to get an edge when it comes to investing.
In a perfect world companies that have good marks across ESG criteria also could product top tier financial returns. As of now the jury remains out but you can be certain this s an area that will continue to receive attention from investors, academics, and institutions.
Interested in learning more about ESG? Check out these two great podcasts to learn more.
- Katherine Collins on Invest Like the Best (episode #129)
- ESG Now podcast
Thanks for reading. Let us know in the comments if you consider ESG factors when you invest!
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