As the world becomes increasingly conscious of the impact of our actions on the environment and society, many investors are looking for ways to align their investments with their values.
One way to do this is through ESG investing. But what exactly is ESG investing?
Investing is a nuanced and sometimes complex space and values/impact-based investing is no exception. The space is filled with jargon and confusing terminology that can cause confusion. Additionally, ESG has become politicized which only adds to the issues.
Let’s cover the basics of ESG and discuss at a high level what it is and how it can apply to your investments.
Subscribe to Our Newsletter
Byline Bank sends regular insights on how to stay on top of your personal and business finances. Sign up today!
What is ESG?
ESG stands for Environmental, Social, and Governance, and it refers to a set of criteria that investors use to evaluate a company’s overall impact on the environment, society, and corporate governance.
ESG investing takes into account not only a company’s financial performance but also its impact on people and the planet. Companies that prioritize ESG principles are more likely to have a positive impact on society and the environment, which can lead to long-term sustainable growth.
ESG investing involves analyzing a company’s ESG performance and integrating that analysis into investment decisions. This means looking at a company’s environmental impact, such as its carbon emissions and waste management practices, as well as its social impact, such as its labor practices and community engagement. Governance factors, such as board diversity and executive compensation, are also considered.
In recent years, ESG investing has become increasingly popular as more investors seek to align their investments with their values. This has led to an increase in demand for ESG investments, which has in turn driven the growth of the ESG investing industry.
Why ESG investing is important
ESG investing is important for several reasons. For one, it allows investors to align their investments with their values and have a positive impact on society and the environment. By investing in companies that prioritize ESG principles, investors can support companies that are working towards a more sustainable future.
In addition, ESG investing can also provide financial benefits. Companies that prioritize ESG principles may be more likely to have a long-term sustainable growth trajectory, which can lead to better financial performance over time.
ESG investing can also help investors identify potential risks and opportunities that may not be reflected in traditional financial analysis.
As an example, let’s consider the Deepwater Horizon oil spill in 2010 as an example of an ESG risk factor.
- Environmental risk: The Deepwater Horizon event was one of the most significant environmental disasters in history, leading to massive pollution in the Gulf of Mexico. This resulted in extensive damage to marine and wildlife habitats as well as to the fishing and tourism industries.
- Social risk: The spill affected the health and livelihoods of people in the surrounding communities. Many fishermen and workers in related industries lost their jobs, causing a significant social impact. Additionally, health issues linked to the cleanup efforts emerged, creating further social harm.
- Governance risk: The incident also highlighted governance issues at BP. Prior to the event, BP had a history of safety issues, and the disaster raised questions about the effectiveness of its risk management policies and procedures. The subsequent investigations, financial penalties, and damage to their reputation are all tied to governance risks.
These risks and the failure to manage them appropriately had substantial financial and reputational impact on the company. This example illustrates the potential material impact of ESG factors on a company’s performance, and why it’s important for companies to identify, assess, and manage ESG risks.
Finally, ESG investing can also help drive positive change. By investing in companies that prioritize ESG principles, investors can send a message to companies that they value sustainability and social responsibility. This can incentivize companies to improve their ESG performance and work towards a more sustainable future.
The growth of ESG investing
ESG investing has grown significantly in recent years. In 2019, global sustainable investment assets reached $30.7 trillion, up from $22.9 trillion in 2016. This growth has been driven by a number of factors, including increased awareness of the impact of climate change, growing consumer demand for sustainable products and services, and the increasing availability of ESG data.
One of the key drivers of ESG investing growth has been the rise of passive ESG investing. Passive ESG funds track ESG indexes and invest in companies that meet certain ESG criteria. This approach has made it easier for investors to incorporate ESG principles into their portfolios without having to conduct their own ESG analysis.
Another factor driving ESG investing growth is the increasing availability of ESG data. As more companies report on their ESG performance, investors have access to more information to help them make informed investment decisions. This has led to the development of ESG ratings and rankings, which provide investors with a standardized way to evaluate a company’s ESG performance.
ESG investing strategies
There are several ESG investing strategies that investors can use to incorporate ESG principles into their portfolios. These strategies include:
- Negative screening: involves excluding companies that do not meet certain ESG criteria from an investment portfolio. For example, an investor may choose to exclude companies that have a poor environmental track record or engage in unethical business practices.
- Positive screening: involves selecting companies that meet certain ESG criteria for investment. For example, an investor may choose to invest in companies that prioritize renewable energy or have a diverse board of directors.
- ESG integration: involves incorporating ESG analysis into traditional financial analysis to make investment decisions. This approach considers both financial and non-financial factors when evaluating a company’s potential for long-term sustainable growth.
- Impact investing: involves investing in companies or funds that have a specific social or environmental impact. For example, an investor may choose to invest in a fund that supports renewable energy projects or provides funding for underserved communities.
Key ESG metrics and factors
When evaluating a company’s ESG performance, there are several key metrics and factors to consider. These include:
Environmental metrics
- Carbon emissions
- Energy efficiency
- Waste management
- Water management
- Biodiversity
Social metrics
- Labor practices
- Human rights
- Diversity and inclusion
- Community engagement
- Product safety
Governance metrics
- Board diversity
- Executive compensation
- Shareholder rights
- Anti-corruption policies
- Ethics and compliance
ESG investing vs. traditional investing
ESG investing differs from traditional investing in several ways. While traditional investing focuses primarily on financial performance, ESG investing takes into account a company’s impact on the environment, society, and corporate governance. This means that ESG investors may choose to invest in companies that prioritize sustainability and social responsibility, even if those companies may not have the highest financial returns in the short term.
ESG investing also involves a different approach to risk management. Traditional investing may focus primarily on financial risks, such as market volatility or credit risk. ESG investing, on the other hand, may also consider non-financial risks, such as reputational risk or regulatory risk.
Finally, ESG investing can also provide investors with a way to diversify their portfolios. By investing in companies that prioritize ESG principles, investors can gain exposure to industries and sectors that may not be represented in traditional investment portfolios.
ESG investing opportunities
There are several ways to incorporate ESG investing into your financial plan. These include:
ESG mutual funds and ETFs
ESG mutual funds and ETFs are the primary and most popular way to incorporate ESG. These are investment vehicles that invest in companies that meet certain ESG criteria. These funds may use negative screening, positive screening, ESG integration, or impact investing strategies to select investments.
The availability and popularity of these mutual funds and ETFs continue to grow and are making ESG investing more accessible than ever.
Green bonds
Green bonds are debt securities that are issued to fund environmentally friendly projects. These projects may include renewable energy infrastructure, sustainable agriculture, or water conservation projects.
Community investing involves investing in funds or projects that support underserved communities. These investments may focus on affordable housing, community development, or microfinance.
Impact investing funds
Impact investing funds focus on investing in companies or projects that have a specific social or environmental impact. These investments may include renewable energy projects, sustainable agriculture, or healthcare initiatives.
How to get started with ESG investing
If you’re interested in getting started with ESG investing, here are some tips to help you get started:
Define your values
Before you start investing, it’s important to define your values and determine what kind of impact you want to have with your investments. This will help you identify which ESG factors are most important to you and guide your investment decisions.
Research ESG investments
There are many ESG investment opportunities available, so it’s important to do your research to find the ones that align with your values and investment goals. You can start by researching ESG mutual funds and ETFs, green bonds, and impact investing funds.
Evaluate ESG performance
When evaluating ESG investments, it’s important to consider a company’s ESG performance. This may involve reviewing ESG ratings and rankings, as well as analyzing a company’s environmental, social, and governance metrics.
Consider your risk tolerance
Like any investment, ESG investments carry risks. It’s important to consider your risk tolerance and ensure that your ESG investments align with your overall investment strategy.
Monitor your investments
Finally, it’s important to monitor your ESG investments regularly to ensure they continue to align with your values and investment goals. This may involve reviewing ESG performance metrics, as well as staying up to date on any news or developments related to your investments.
ESG investing challenges and risks
While ESG investing offers many benefits, it’s not without its challenges and risks. Some of the key challenges and risks of ESG investing include:
Limited ESG data
While ESG data is becoming more widely available, there is still a lack of standardized ESG reporting. This can make it difficult for investors to compare ESG performance across companies and sectors.
Greenwashing
Greenwashing refers to the practice of companies making false or exaggerated claims about their environmental or social impact. This can make it difficult for investors to accurately evaluate a company’s ESG performance.
You are likely noticing that many “big name” financial institutions are putting the ESG label on their funds in an effort to follow the trend. However, there are many established but lesser-known funds that have been built on a foundation of ESG from the start.
Higher fees
ESG investments may sometimes carry higher fees than traditional investments, which can impact investment returns. This is a trade-off that many investors are comfortable with because of the alignment with ESG values.
Limited diversification
ESG investments may be concentrated in certain industries or sectors, which can limit diversification opportunities.
Performance trade-offs
While the data is inconclusive, investing in companies that prioritize ESG principles may result in lower financial returns in the short term, although there is evidence to suggest that ESG investments can provide better long-term financial performance.
Ultimately, there is no guarantee that ESG investments will perform better or worse than their traditional counterparts.
Whether you’re planning for your retirement or your family’s future, Byline Bank’s Wealth Management team is ready to provide customized solutions for your financial needs. Sign up today!
This article was from Wealthtender and was legally licensed through the Industry Dive Content Marketplace. Please direct all licensing questions to [email protected].
