ESG stands for environmental, social, and governance; these are factors outside the traditional financial metrics used to identify risks and rewards in investing.
Environment:
- Conservation concerns (climate change, biodiversity, greenhouse gas emissions, waste and pollution, resource depletion and sustainability, deforestation)
- Climate concerns (measuring, reporting, and adapting to climate risk)
Social: The treatment of people (working conditions, employee relations and diversity, community, health and safety, conflict)
Governance: Company management (donations and political lobbying, corruption and disclosure, employee diversity and board structure, executive pay, tax strategy)
Despite misperceptions that ESG investments are not as profitable, choosing investment options that consider ESG issues leads to more thorough and better-informed investment decisions. Financial analysis and portfolio managers use a wide range of tools to determine the financial value of an investment; incorporating environmental and climate change considerations can help them avoid significant losses from extreme weather events and long-term climate trends.
Socially Responsible Investing
ESG factors started to gain importance early on for their use in excluding equities from investment portfolios based on moral and ethical values, often called “sustainability investing”, “socially responsible investing” or “SRI”. Individuals can select investments based on both the typical financial metrics and ESG metrics that align with their own individual set of values. SRI funds can range from expensive higher-fee funds to inexpensive options. You can:
- Create your own SRI portfolio: Choose individual stocks and mutual funds that align with your interests.
- Use a robo-advisor: Use algorithms to create a sustainable investment portfolio that aligns with your risk-tolerance and goals.
There are many ESG implementation approaches that you can choose from; each have different methods and objectives:
Exclusionary Screening: Remove companies from your portfolio that conflict with your values.
- Best-in-class Selection: Invest in funds that score companies according to a best-in-class selection method which prioritizes stocks that score better on ESG metrics.
- Thematic Investing: Invest in a thematic fund which focuses on a single ESG issue like clean energy or female leadership.
- Active Ownership: Use your ownership rights to directly engage with companies on their performance on ESG issues.
- Impact Investing: Invest in specific projects designed to fulfill ESG goals such as electric cars, microfinance loans, or affordable housing projects.
- ESG integration: Approach ESG investing with the aim to improve your investment’s financial and risk performance with the understanding that non-financial ESL issues affect a company’s long term performance.
Sustainable investing in the U.S. using ESG factors has been growing rapidly. According to the US SIF Foundation’s 2020 report, assets under management that are using ESG strategies grew from $12 trillion in 2018 to $17.1 trillion in 2020, a 42 percent increase. This type of investing is now used in one third of the total US dollars under professional financial management. The use of ESG factors has also expanded beyond its initial popularity in socially responsible investing; new advancements have pushed for corporate responsibility and transparency for ESG factors.
ESG Reporting
ESG factors like climate change can have a significant impact on the financial metrics of a company. ESG metrics are usually not included in standard financial reporting, but an increasing number of companies have been recognizing the demand for transparency on corporate sustainability and social responsibility practices. Companies are accountable to their investors, employees, customers, and non-governmental organizations that seek to understand a company’s relationship with ESG issues. As of July 2020, 90 percent of companies in the S&P 500 have published sustainability reports.
Soon many companies will be required to report on some ESG issues. ESG reporting will soon be mandatory for large companies within the European Union. In the U.S., the Biden Administration and various federal agencies have taken steps towards requiring the consideration of climate and disclosure of climate risks in investing and asset management. Unlike some of the other ESG factors, climate risk could quickly become a part of the core set of financial metrics used in all U.S. investing.
ESG Reporting Frameworks
International interest in sustainable investing has motivated the creation of ESG frameworks. Frameworks can set goals for ESG reporting and measure progress towards implementing them. Organizations can reference frameworks or use them as a guide for establishing an ESG reporting process.
Some of the most prominent ESG frameworks include:
The Task Force on Climate-Related Disclosures was established in 2015 by the Financial Stability Board (FSB) to develop a principles-based framework of voluntary disclosures for climate change risk. The organization has explored the possible effects of physical and transition risks within different climate change projections.
UNPRI is an international network of investors supported by the United Nations. They seek to implement six aspirational Principles of Responsible Investment to incorporate ESG factors and commit to responsible and sustainable investing. Over 1,750 signatories representing $70 trillion dollars have committed to following the Principles.
ESG Standards
Many different actors are working to create a standard for the more formal incorporation of ESG factors into the investing and disclosure processes. The goal of these organizations is to establish voluntary climate-related financial disclosures for companies and individuals. Standards facilitate the disclosure of consistent, comparable, and reliable ESG information.
Some ESG disclosure companies seek to help create broad standards for impact reporting to encourage transparency on corporate impacts to the economy, environment and people. Others focus on more specific ESG concerns that are expected to have a material financial impact on a company in order to provide information for investors and financial providers.
In September 2020, five of the leading ESG standard-setting organizations announced a comprehensive reporting system that includes both sustainability disclosures and financial accounting disclosures. These organizations are:
- The International Integrated Reporting Council (IIRC)
- The CDP, formerly the Carbon Disclosure Project
- The Sustainability Accounting Standards Board (SASB)
- The Global Reporting Initiative (GRI)
- The Climate Disclosures Standard Board (CDSB)
Conclusion
The incorporation of ESG factors in investing can encourage more stable, more profitable, and more ethical investment practices. Companies that have prepared for a future of weather volatility and extreme temperatures stand a better chance of withstanding the financial hazards of climate change. While many consumers have been interested in the option of incorporating ethical investing into their portfolios for many years, recent growth in the use of ESG factors has been driven by corporate actors. Governmental and consumer pressure for transparency and disclosure will likely continue to raise the importance of ESG reporting.
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