ESG Investing For Dummies
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The term “ESG investing” is often used interchangeably with sustainability or impact investing, but it isn’t a stand-alone investment strategy that provides positive impact. ESG (which stands for environmental, social, and governance) is a framework that uses a rules-based approach to evaluate companies based on their commitment to positive ESG factors and has become a fundamental part of investment analysis.

ESG definition illustration © Elnur / Shutterstock.com

Investors are increasingly applying these non-financial but material factors to identify and mitigate ESG-related risks. Therefore, ESG integration is consistent with a manager’s fiduciary duty and investment due diligence processes to consider all relevant information, beyond traditional financial metrics, in order to better understand their ESG-related risks. The ESG framework is critical in supporting the shift into mainstream ESG investing, while also being a foundation for more specific socially responsible investments (SRIs) and direct impact investments.

Impact investing is more about the type of investments that a manager is targeting, while ESG factors are part of an investment assessment process. Also, impact investing is seeking to make a measurable, positive, environmental/social effect with the investments a fund manager purchases, whereas ESG is a “means to an end,” serving to identify non-financial risks that may have a material impact on an asset’s value. Therefore, while there is no direct sustainability impact from ESG, the adoption of the principles has continued to evolve, and some specific trends have emerged that are key elements in evaluating a company’s position on the virtual sustainability road map:

  • Currently, climate change and the move toward net-zero greenhouse gas (GHG) emissions by 2050 have dominated the agenda for the Environmental aspects.
  • Meanwhile, the coronavirus pandemic has increased consultation around the interconnection between sustainability and the financial system, with particular emphasis on the Social aspects, highlighting which companies are fully engaged with their employees and community, while championing diversity and inclusion.
  • Last but not least, a similar light has shone more brightly on the Governance aspects, particularly board composition, executive compensation, and a willingness to engage in the sustainability reporting process.

Be wary of the potential for “greenwashing,” in which ESG investment products are sold as some form of solution to the world’s ills or a quasi-charity donation that produces a sustainable impact while providing the investor with a return. While achieving a good ESG score is a positive indication that a company has a sustainable approach to management, that doesn’t in itself suggest that they will achieve a sustainable impact.

Which sustainability goals should be followed?

The United Nations Sustainable Development Goals (SDGs), which are aimed at ending poverty, protecting the planet, and ensuring that all people enjoy peace and prosperity, can be seen as a stimulus behind the renewed focus on sustainable investing. The COVID-19 pandemic of 2020 was a stark reminder that the world isn’t on track to achieve those goals as we head into the final decade before the deadline, and so world leaders must increase their efforts.

However, everyone needs to pull their weight, and who better than business to lead the charge with their know-how, technology, and financial resources? The target is several life-changing “zeros,” with the primary focus of responsible investors currently converging on having zero emissions and ending discrimination with respect to color and gender. It’s important to remember that these goals are integrated and that action in one area will affect outcomes in others, which should balance social, economic, and environmental sustainability.

The SDGs are targeted to be met by 2030, while more specific targets under the Paris Agreement, such as net-zero emissions, are due to be met by 2050, with some countries pushing more aggressively for earlier target achievement. Major developments in 2020 with respect to emissions targets included the Democratic election in the United States, with President Joe Biden being receptive to the U.S. remaining among the Paris Agreement signatories. In addition, China’s President Xi Jinping pledged to peak greenhouse gas emissions by 2030 and reach net-zero emissions by 2060. As China is currently a major polluting nation, this is a further positive step toward mitigating climate change.

What’s the future of ESG investing?

A survey by PwC (that’s PricewaterhouseCoopers) predicted that the share of European assets in ESG-related investments is likely to almost quadruple from 15 percent to 57 percent by 2025. Also, more than three-quarters of investors surveyed, including pension funds and insurance companies, suggested they wouldn’t buy traditional funds but rather would focus on ESG products by 2022. Investing in ESG seems to be focused on future-proofing returns but also companies protecting their reputation. Moreover, COVID-19 has added further momentum to the trend, with companies and investors recognizing the need to embrace ESG as the norm rather than the exception.

However, there is still a lack of agreement on the material ESG issues that are impacting firms, a lack of uniformity in the regional approaches to ESG, and a lack of standardization of key ESG ratings and data points. Meanwhile, associated with this is the plethora of disclosure and reporting requirements to consider (see the previous section), along with further mandated regulation on the horizon. Furthermore, there are emerging trends around stewardship, with varying degrees of engagement and voting participation undertaken by different asset owners and managers.

Of course, in the background are fundamental concerns around environmental, social, and governance issues that face governments of the day. Europe seems to be leading the way, with the European Commission pursuing a major green recovery package that seems to be focused on the rebuilding of coronavirus-affected economies to tackle the even greater threat of global warming. Meanwhile, the new administration in the United States is making positive noises, and China has pledged to target net-zero emissions by 2060.

In short, there is plenty of stimulus to further fuel the ESG fires that have contributed toward greater enthusiasm from investors toward socially responsible investment under an ESG framework. Perhaps the further development of Machine Learning (ML) and artificial intelligence will enable enhanced analysis of ESG data; however, the old phrase “garbage in, garbage out” should be remembered if the data isn’t verified through appropriate disclosure and reporting standards. The year 2020 also saw consolidation in the ESG ratings space and greater collaboration among the reporting standard-setters, with new actors adding further input to the discussion. You won’t be short of material to satiate your appetite for sustainability! Whichever direction the market takes, ESG will be the focal point for sustainable investing for at least the next ten years, to the point where universal acceptance will negate the need to say “ESG investing” anymore, as it will be the norm.

About This Article

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About the book author:

Brendan Bradley is co-author of FinTech For Dummies. He fosters and develops support for new ­investment areas, including AI-assisted research for automated modeling and transforming ­unstructured financial content in the ESG ecosystem.

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