Understanding ESG and Sustainable Investing

Recent years have witnessed a shift in investor appetite, as they now look beyond just monetary gain. As the world becomes more sustainable, so do investors. Rational investors are increasingly aware of their investments and seek to invest in companies that can impact the world in a positive manner and maintain ethical, fair practices.

ESG Criteria

ESG investing has risen in popularity over the last decade as brands are increasingly aware of their impact on society. A study by Navex Global showed 88% of publicly traded companies had a specific focus towards ESG goals. Going forward, considering ESG factors are becoming increasingly popular as over 200 companies agreed to reach zero carbon emissions by 2040. There are three key aspects of ESG investing that measure the sustainability and ethical values of a company. It is important to note that funds and companies work with ESG in different ways, so before any investor chooses to invest in a fund, familiarisation with its procedures is encouraged.

Environment

Environmental criteria examine how a company’s manufacturing and distribution processes impact the environment. Typical examples are analysing pollution, waste, and energy use. Investors will investigate a company’s carbon footprint and whether they are using fossil fuel energy (oil, coal, and gas) or green energy (solar panels). They will also check if any toxic chemicals, such as pesticides, or harmful emissions are being produced. Other factors include deforestation, climate change, and resource depletion.

For instance, if a manufacturing company has high carbon emissions which create high pollution, the company would have a low ESG rating. An environmentally responsible investor would steer clear from such a company. On the other hand, an environmentally friendly firm that uses 100% renewable energy sources and has minimal waste would score high in an ESG analysis of the environmental part. As the world shifts towards renewable energy to reduce global warming, there is an increasing expectation for all firms to reduce their carbon footprint.

Social

Social criteria investigate business relationships, values, and how the company supports its community. Specifically, this concentrates on health and safety in the workplace and human rights such as child labour and slavery. They also consider how the company affects their local community – if they donate any funds to local charities and schools, for example. Recent developments also inspect gender equality, consumer privacy, and data security, such as whether the company is GDPR compliant. Additionally, diversity in the workplace is considered, which involves being accepted regardless of nationality and religion and other relevant topics within the social criteria.

A socially responsible trader would be deterred from a firm that sources their labour from Third World countries to abuse child labour. For example, the Clean Diamond Trade Act signed in 2003 stopped developed countries from importing diamonds mined in conflict countries. Prior to this agreement, diamond-rich countries would abuse child and slave labour to minimise mining costs and maximise profits. The social aspect of ESG extends further than solely internally, as it considers relations with suppliers and distributors to ensure all parties are treated fairly.

Governance

Finally, governance investigates the management and operations of a business to ensure a company is managed in an ethical manner. Common issues include corruption and bribery amongst shareholders, political lobbying, and board diversity. Investors will also look into a business’ tax strategy and ensure they are fully transparent with their financial accounts. Furthermore, investors will review relations between shareholders and leadership to verify all parties are being treated fairly.

For example, if a company is not transparent regarding its finances and is a culprit of tax evasion by bribing auditing firms, this is a violation of ESG criteria. Funds consisting of highly rated ESG companies would not incorporate the company into the fund; however, a firm with a highly diverse board with no involvement in any political lobbying or corruption would be ESG compliant.

Sustainable Investing

Sustainable investors seek to invest in companies and funds that create a better world. There are several methods to sustainable investing, such as socially responsible investing, ESG investing, and impact investing.

  • Socially responsible investing (SRI) is a form of ESG investing also referred to as negative screening. SRI investors focus on restrictions regarding ethical values such as conflict, politics, and religion. For example, an SRI investor may be deterred from companies that engage in animal testing. Another recent example is SRI investors taking into consideration the climate impact, as they avoid firms who produce large amounts of carbon emissions.
  • ESG investing involves selecting companies that cautiously monitor all three aspects of ESG requirements as previously discussed. Typically, this method is less restrictive than the former as it includes energy companies. Previous studies by Refinitivhave established a correlation between ESG investment funds and positive returns. Some investors argue the ESG factors can differentiate a sound investment from a weak one. These investors believe businesses with a low ESG score are not sustainable in the long run and are potentially weaker investments.
  • Finally, impact investing revolves around choosing businesses that have a positive social or environmental impact on society and the world. As stated by the Global Impact Investing Network (GIIN), impact investments tend to lay in healthcare, education, renewable energy, and agriculture sectors as these have the greatest impact on society. For example, investors may purchase stocks in a renewable energy production company in the hope of further aiding the reduction of fossil fuel usage.

Source: Global Banking & Finance Review
Author: Søren Otto Simonsen, Senior Investment Editor at Saxo Bank