You want to invest in companies that are going to make you money, but you also want to make a difference in the world. Well, that, in a nutshell, is what ESG investing is about.
You may have heard ESG investing can reduce profile risk, generate hefty returns, and make you feel good about where you’re putting your money. But, like any investment, you don’t want to invest in ESG companies unless you understand how ESG investing works, as well as the risks involved. So, to help you get started, here’s what you should know about ESG investing.
What is ESG Investing?
ESG investing—environmental, social, and governance—is a sustainable approach to investing in which you put your money in companies you believe will positively shape the world.
ESG investors believe that in the long run the most profitable companies will be those that proactively solve environmental and social problems. To find these companies, ESG investors rely on certain independent ratings and reports, such as the Corporate Responsibility Report, which measures how well a company treats the environment, social justice issues, and their employees.
How is ESG Different Than Socially Responsible Investing (SRI)?
First off, keep in mind that ESG is a part of a family of value-based investing, to which Socially Responsible Investing (SRI) also belongs. Like ESG, SRI involves investing in companies for their environmental and social impact, which is why these two investing approaches can be easily confused.
But they are different. And they differ in one significant way: rather than rely on ESG criteria that screens in companies, SRI investors screen out companies based on their personal values. SRI investors don’t want to become complicit for actions they deem morally wrong, which is why they’ll exclude certain companies from their portfolios.
For example, an SRI investor may avoid investing in tobacco companies, as they find tobacco morally corruptible, even if certain tobacco companies strive for sustainable and ethical practices, ones that make them ESG worthy.
Like SRI investors, ESG investors have moral motivations, but they also have economic incentives, too. ESG investors believe a company’s environmental, social, and governance performance will have a long-term impact on its profitability. They may hold similar convictions with SRI investors, sure, but ESG investors may not strive to balance their investments with their personal convictions.
What Does ESG Stand For?
ESG stands for environmental, social, and governance, and any company that wants to qualify as ESG must rank high in these three areas. Here’s a closer look at each of these pillars.
Companies have been pumping carbon into the atmosphere at dangerously high levels for a long time, and ESG investors are sick of it. The environmental pillar of ESG involves evaluating what a company is doing (and not doing) for the health of the planet, as well as what ecological footprint the company leaves.
Environmental issues aren’t just ethical. They’re long-term growth issues, too. Unmitigated climate change could cause superstorms, climate “wars,” political unrest, increased global poverty, and resource scarcity. Companies that start preparing for these risks now will do much better than companies that don’t.
Looking at a company’s environmental performance can involve looking at these factors:
- Animal rights
- Air and water pollution
- Biodiversity on land use
- Carbon output
- Climate change stance, policies, and actions
- Development of green products and technology
- Energy efficiency
- Transparency about a company’s climate goals and how it’s meeting them
- Use of fair trade suppliers or organic ingredients
- Water stewardship
- Waste management
When you’re looking at a company’s environmental impact, you’ll want to pay close attention to these factors. Of course, don’t just look at a company’ self-declared policies and call it a day. Look at sustainability reports prepared by reputable agencies, such as the Global Reporting Initiative (GRI) or the United Nations Principles for Responsible Investing (PRI) in order to get an objective understanding.
The social aspect of ESG involves measuring a company’s treatment of people both inside and outside its doors. That means how a company treats its employees, partners, suppliers, community, and stakeholders.
Social issues play a vital role in a company’s long-term profitability. Not only can lawsuits, scandals, and bad press devastate a company’s revenues, but companies with disgruntled, unhappy, and burned out employees are far less productive than companies with higher levels of employee engagement. Additionally, companies that don’t treat employees well have higher turnover rates, which requires companies to spend more money recruiting, hiring, and training new employees.
When you’re evaluating the social pillar, look for these factors:
- Community service and relations
- Customer service ratings and satisfaction
- Data protection and privacy
- Diversity and inclusion, especially in hiring and promotions
- Employee engagement initiatives (or lack of them)
- Employee pay, benefits, perks, safety policies, and treatment
- Human rights and social justice stances
To find information on a company’s social conduct, you can look at the same reports as you did for environmental concerns, both the GRI and PRI. Additionally, you may also want to check out Canada’s top employers in Forbes magazine, or even read reviews on employee rating websites such as Glassdoor.
Finally, a company is only as good as its leaders, and ESG investors are keen on investing with companies with an excellent board of directors. Companies that score high in the governance pillar have a diverse board of directors who don’t let self-interest get in the way of making the right decision. Other governance factors to look at include:
- Board election and length of board member terms
- Communication, responsiveness, and transparency with shareholders, including the details and outcome around stakeholder lawsuits (if any)
- Conflicts of interest among board executives
- Corrupt practices, including using political positions to gain favorable treatment or other forms of bribery
- Diversity of management, leadership, and executives
- Executive compensation, bonuses, perks, and any large exit bonuses
Again, to find information on governance performance, you can find details in a company’s GRI or PRI. If you can’t find governance details in these reports, you can always use the SEDAR database to locate any Canadian company’s public records.
What Are the Benefits of ESG Investing?
Beyond making investors feel good about the companies in which they invest, ESG investing offers some unique benefits. Here are some reasons to consider taking an ESG approach to investing.
1. Long-term opportunities
Among value-based investing, ESG is unique in that it looks for companies that will remain profitable in the far future. For instance, a company that produces renewable energy products will outlast a company that produces fossil fuels, as climate change is rendering the latter obsolete and unprofitable.
2. Reduced portfolio risk
The long-term opportunity that ESG presents can help investors hedge investment risks. Not only are these companies offering profitable solutions to big issues, their focus on ESG helps them avoid unacceptable practices and behavior that could result in financial losses.
Take the American company Tyson foods, for instance. During the pandemic, Tyson allegedly ordered employees with COVID-like symptoms to continue working. They also didn’t provide face coverings for employees. Not surprisingly, Tyson faced immense public criticism, which resulted in a sharp decline in share prices along with a lower morale around their brand.
3. Higher returns
Long-term opportunities and reduced volatility mean ESG investments can promise significant returns. Because ESG companies are thinking about their profits decades in the future (and not just short-term quarterly gains), you can feel confident knowing you’re investing in a company with longevity.
What Are the Risks of ESG Investing?
ESG investing can help investors identify companies with long-term growth potential and ethical practices. But it’s not without its risks. Here are three any prospective ESG investor should be aware of.
1. No agreed upon standards
ESG investors often lack standardized metrics for assessing companies. Most companies still self-report their ESG metrics, and though independent rating agencies exist, they often weigh ESG factors differently.
2. Appearances can be deceiving
Though Corporate Responsibility Reports and Glassdoor reviews help keep companies responsible to ESG factors, some companies will still get away with greenwashing. They’ll appear to be doing good environmentally, socially, and corporately, when in reality they’re simply giving a false appearance of goodwill.
The risk of this, of course, is that a company’s ill practices will eventually come back to haunt them financially. The public will find out where the company’s values truly lie, causing a drop in share prices.
3. ESG limits choices
ESG investors can invest in a limited pool of companies who pass ESG metrics. Right now, that pool is pretty lucrative. But if companies fall out of ESG standards, the selection of profitable companies shrinks.
Is ESG Investing Right For You?
ESG investing can be pretty exciting. You’re investing in companies that can significantly impact culture, society, and the planet, not to mention companies with above-market returns.
Of course, as always, you’ll want to do your homework. Read a company’s Corporate Responsibility Report and check Glassdoor or other independent rating agencies to evaluate a company’s environmental, social, and corporate impacts.
If ESG gets you exciting, you’re probably the right investor for it. Check the TSX’s most promising ESG stocks, or invest into an ESG fund, which can spread your money across multiple companies.