“What is the purpose of investing?” On the face of it, this might seem a simple question to answer. Afterall, investing is all about making money… right? Perhaps not entirely. While wealth planners and other financial professionals certainly do aim to help their clients achieve financial goals, money-making is no longer the sole motivation for many of today’s investors.
Of course, profitability remains a considerable influence on investor decision-making, but an increasing number are also motivated by the impact of their actions beyond the bottom line – they want to know the companies they support are working to make the world a better place or, in the least, not to make matters worse.
This shifting mindset can be seen clearly in the ever-growing presence of ESG, impact, ethical, sustainable, responsible, and ‘green’ funds within the market. In fact, according to Morningstar’s Global Sustainable Fund Flows report for Q4 2021, global ESG fund assets increased to $2.74 trillion in December 2021, from $1.65 trillion at the end of 2020.
Given the likelihood that you will soon find clients expressing their interest in this area (if they haven’t already), we’ve put together a jargon-busting, three-point guide to ESG investing. We hope it will help you to communicate the core themes and intentions of this investment approach.
1) What is ESG Investing?
ESG investing is a strategy used by investors – and their intermediaries – to put their money to work with companies who score highly for certain environmental, social, and corporate governance factors. These scores are generally obtained via independent third-party research houses like MSCI, S&P Global, and Morningstar.
There are many reasons to consider this investment approach, and benefits often go beyond the initial impacts of good practices. For example, a company that treats workers fairly and pays them well will likely see improved employee wellbeing and welfare while also being less likely to face costly industrial action in future. In this example, the benefits are measurable both in financial and human/ethical terms.
This style of investment assesses both the risk of poor ESG scoring (to the environment, business reputation, and society) and the potential opportunities arising from good ESG factors such as the competitive advantage for a business that isn’t reliant on costly fossil fuels, or the reduced risk of corruption where board and c-suite actions are highly visible.
2) What does ESG mean?
ESG stands for environmental, social, and governance (or corporate governance). It is fair to say that these topics are emotive. This can lead to differences of opinion over their meaning; however, each one has a widely accepted definition within the business/investment space:
E – Environmental
When considering a company’s environmental credentials, a researcher might focus on the direct impact of its operations on the environment. So, for example, carbon emissions, waste and water management, or pollution.
An environmental score may also factor in the risks of climate change on the company and its industry. For example, if a particular business is reliant upon the use of depleting natural resources, its perceived future value will be limited. Conversely, a business which relies on renewable materials (or fuel) would score well in this area.
S – Social
The social factor is mainly focused on a company’s relationships with its people and wider society. Social concerns also reach into the animal kingdom, with issues such as animal testing being a consideration for many ESG scorers.
A broad subject, measuring the social impact of a company includes looking at diversity and inclusion (both in policy and practice), human rights, consumer protections, the impact of business operations on local communities, health and wellbeing of employees, and a deeper look into supply chains to consider things like child labour practices, and fair pay for foreign workers.
G – Governance
Corporate governance looks at the people, structures and processes that govern the overall function of a business. This includes things like business ethics, accountability and reporting, tax and accounting practices, board and c-suite pay, bonuses, and diversity as well as employee welfare, equitable pay, workplace culture and company values.
3) What is an ESG Score?
ESG scoring is widely considered to be the most accurate measure of a firm’s attitudes to the triple bottom line (also known as the 3Ps) of sustainability in business – people, planet, and profit. In other words, it is a way for investors to measure a business’ success not only by money made, but by their impact on the environment and society.
By analysing metrics under the three headline areas (E, S, and G), a scorer will rate companies on a range of metrics which combine to produce an overall score. Metrics tend to include a company’s exposure to controversial areas like oil and gas, weapons, tobacco, alcohol, and gambling, but they will also be rated on things like:
- Waste management
- Use of renewable energy
- Health and safety practices
- Product and consumer safety
- Community relations
- Fairness and accountability in corporate governance
- Business ethics
- Equitable pay
The data used to measure ESG scores usually comes from corporate filings, press releases, and financial statements, as well as academic studies, press and criminal investigations, and government/regulatory reporting.
This approach to scoring is by no means infallible. After all, most ESG factors are subjective (and so difficult to measure). Metrics depend on the standards, viewpoints, and criteria-weighting decisions of the researchers and data providers. Nevertheless, it remains the approach that is widely accepted by market commentators, investors, fund managers, and MPS providers as the best possible way to measure a company’s ESG credentials.