Understanding ESG

In a world that increasingly values the Corporate Social Responsibility (CSR) landscape, ESG investing, short for environmental, social, and governance investing, has seen an upward trajectory. Fueled by the belief that corporations should use their wealth and influence beyond simply making a profit, investors across the board are drawn to firms that place emphasis on responsible business practices.

Photo credit: What is environmental, social and governance (ESG)? (techtarget.com)

Understanding ESG

ESG investing is an approach that takes three key factors into account when making investment decisions. The first is the environment, which includes aspects like how a company handles pollution, waste management, and climate change. The second is social, which considers a firm’s impact on society, including issues like employee well-being, community involvement, and diversity initiatives. The third aspect is governance, which examines how a company is managed, examining issues like transparency and board structure.

Benefits of ESG Investing

  1. Ethical Alignment: ESG investing allows clients to incorporate their investment choices with their personal ethics and values. It offers the chance for clients to support companies that prioritize ethical principles, giving investors satisfaction that their contributions are in line with their beliefs.
  2. Risk Reduction: ESG investing can help mitigate risks associated with climate change and other environmental concerns. By investing in companies that are being proactive about addressing these issues, investors can potentially minimize negative impacts of events.
  3. Long-term Viability: Companies with strong ESG standards have shown enduring financial success. Companies that prioritize ESG value sustainability and innovation, potentially leading to higher returns to investors.

Drawbacks of ESG Investing

While ESG investing offers numerous benefits, it is important to consider some of the potential drawbacks associated with this investment strategy.

  1. Subjectivity and Greenwashing: The metrics for environmental, social and governance elements can be subjective, leading to different interpretations. Some companies may even engage in a practice known as “greenwashing”, which involves showcasing an inflated account of their ESG practices than what is implemented. This can make it challenging for investors to determine true sustainability efforts from a firm.
  2. Limited Investment Opportunities: ESG investing opportunities may be limited for certain industries. A prominent example is the fossil fuels field, which has limited options for ESG metrics. This can restrict the diversification of an investment portfolio and pose challenges for investors aiming to completely align their ethics with their investments.
  3. Potential Higher Costs: Considering ESG metrics in addition to regular investment due diligence can require additional time and resources. This can lead to higher overall costs, which may impact the returns of an investment portfolio.

Explaining ESG Investing’s Rise in Prominence

ESG investing’s upward trend can be traced back to several components. The mounting awareness of climate change and other environmental concerns has prompted investors to seek avenues for reducing their exposure to various environmental risks. One  reason for this is the increasing frequency of extreme weather events, such as floods, droughts, and wildfires, which are impacting millions of people and businesses by damaging physical assets and disrupting global supply chains. According to a report by Bloomberg Law, at least 29 extreme weather events caused more than $1 billion in damages in 2022, with the expectation for extreme weather events to become more frequent in the future. The report suggested that investors make climate-related risk assessments a regular part of their research to minimize environmental risks. ESG investing offers a way to address the challenges posed by the climate crisis, offering a proactive approach to help protect the viability of investments as well as the environment.

The social impact of businesses is becoming a key point of focus in 2023, driving investors to align their portfolios with their ethical values and principles. This is fueled by the growing demand for CSR within the business world. Investors are keen to support firms that are committed to having a positive social impact in addition to generating positive returns. A 2022 survey conducted by Morgan Stanley revealed that 80% of investors consider ESG important in their investment decisions. This can encompass everything from green energy initiatives to employee and board member diversity within a firm.

As mentioned in our ESG and SRI investing analysis from 2021, despite regulatory changes in recent years, ESG investments continues to be a viable strategy. 2020 brought many social justice and sustainability issues to the forefront through the Black Lives Matter Movement and the COVID-19 pandemic. As we enter a post-pandemic era in 2023, many of these issues continue to hold importance and are being brought into the spotlight.

Regulatory bodies around the world are recognizing the importance of ESG investments and taking steps to support them. The United States Securities and Exchange Commission and the European Union have recently announced steps to enforce ESG disclosure requirements, a telling sign of the field’s upward trajectory. Such regulatory and governmental support enhances transparency, reduces greenwashing, and boosts overall investor confidence, thereby facilitating the growth of these assets.

The global market for ESG investments reached $35 trillion in 2021, demonstrating the significant expansion within the field. A Bloomberg report projects that ESG investments will reach $53 trillion by the year 2025. This suggests that ESG investing not only aligns with investors’ values but also offers potential financial gains.

Graph credit: https://privatebank.jpmorgan.com/gl/en/insights/investing/how-smart-esg-investing-could-boost-portfolio-returns

As ESG investing continues to grow in popularity, it is poised to reshape business operations and influence how investors make vital investment decisions. What used to be viewed exclusively as a niche philanthropic investment strategy is now transitioning into a useful tool that may help deliver enhanced risk-adjusted returns over the long term. By incorporating ESG frameworks into their investment strategies, clients can support enterprises that place importance on long-term sustainability, social responsibility, and excellent governance, thereby contributing to a more viable and equitable future.

ESG investing involves the exclusion of certain securities for non-financial reasons. This may result in the investor forgoing some market opportunities that may have been available to those not subject to such criteria. There is no guarantee that any investment goal will be met.

Presented by Vidhi Pathak                                                                                                                            Authored by Carl Holubowich, CFP®