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Simple Explanation of ESG Investing

What is ESG?

Finance
2022-08-15
What is ESG Investing?

ESG is the abbreviation for Environmental, Social, and Governance, “and refers to the three key factors when measuring the sustainability and ethical impact of an investment in a business or company.” Many socially responsible investors use these non-financial factors when analyzing and evaluating companies, including to note any possible ESG violations and determine additional areas and opportunities where its principles can be applied. Although companies increasingly disclose information in their annual reports or in a separate sustainability report, ESG measures are presently not usually included in required financial reports.

To make it simpler to incorporate ESG factors into the investment process, many organizations—including the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the Task Force on Climate-Related Financial Disclosures (TCFD)—are working to develop new standards and define materiality.

Important Lessons of ESG Investing:

  • By investing more than $649 billion in ESG funds in 2021, ESG investors are becoming a powerful force in financial markets.
  • ESG investing often involves identifying investment opportunities that combat climate change, including investing in the renewable energy sector.
  • Many ESG funds also look for companies that offer competitive compensation packages to their employees and executives.

Learning about ESG Investing:

ESG investors often favor different types of investments.

  • The E in ESG refers to investors who are environmentally conscious and therefore favor investments in green and alternative energy companies.
  • A second group of ESG investors (S) support social justice and therefore look for companies that address and try and solve problems involving economic equality, diversity, and human rights.
  • A third group of ESG investors (G) focuses on company management practices. This group looks for companies that limit executive compensation and institute policies that provide employees with a good work-life balance in their professional and personal lives.
Millennials as a group are relatively more concerned about impact issues, and therefore often strongly support ESG causes. Learning about ESG investing strategies will help you better understand what millennial investors are looking for when deciding which companies to invest in and support.

Consider these three ESG investment opportunities:

1. Climate Change

Almost 90% of climate scientists agree that human activity is causing climate change. But many hurdles, political and practical, have prevented wealthy nations from addressing climate change. Progress is nonetheless happening, and climate change offers ESG investors a good business opportunity while helping a critically important cause.

In the U.S., possible climate change solutions like cap and trade laws are politically controversial because of how much they can negatively affect nonrenewable energy industries, including those involving oil and coal. But any energy shortfall caused by reducing oil and coal consumption could be filled by renewable energy sources like wind, solar, and nuclear power. ESG investors are hopeful that laws addressing climate change will be enacted should research investments in these and other alternative energy sources. See: Inflation Reduction Act post. 

2. Equal Pay
Women in the U.S. still only earn about 78% of what males do for the same employment. Many ESG investors therefore understandably want to invest in companies that actively advance equal pay for women as well as other gender equality issues. The good news is that there are an increasing number of companies that do so.

3. Executive Compensation

Millions of people were hurt by the Great Recession of 2008. Their pain was exacerbated by the fact that many of the corporate officers responsible for the recession had exorbitant executive compensation packages. Despite their actions, some of these corporate officers received millions of dollars and other benefits in severance after losing their jobs.

Many companies are thankfully now more committed to ensuring that the compensation packages for their corporate officers are more reasonable. Many corporate officers also voluntarily reduced their own compensation packages. These developments have created more investment opportunities for ESG investors who believe that excessive executive compensation harms workers and the economy.

How Did ESG Investing Begin?
While there have always been ethical issues involved in investing, ESG most likely started in the 1950s and 1960s, when union pension funds started looking for investments that would produce both social good and steady returns. Demand for more ethical fund management arose along with mounting calls to divest from South Africa’s apartheid state.

What Differentiates Impact Investing from ESG Investing?

Unlike ESG investing, impact investing prioritizes investments that produce social good regardless of whether they generate a quantifiable profit. ESG investing instead prioritizes investments that emphasize both positive social and environmental impacts and produce economic returns.

What is the Market for ESG Investing?

According to Reuters, approximately 10% of global fund assets are made up of ESG funds. ESG-focused funds received approximately $649 billion during the first 11 months of 2021, a significant increase from prior years.

Conclusion

As more funds look for investments that can provide positive social benefits and produce profits, sustainable investing is becoming a more powerful force in the capital markets. Companies that adhere to strict environmental standards and also compensate and treat their employees fairly will likely continue to attract more investors.

For a deeper dive into ESG investing, listen to The Zenergy Podcast interview with Shari Friedman (MD of Climate & Sustainability at Eurasia Group) and Vivek Pathak (Global Head of Climate Business at the IFC). 




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