Just what is Environmental, Social, and Governance (ESG) Investing? What does it mean to me?
Environmental, social and governance investing has been getting a lot of attention over the past couple of years. This investment trend was first identified and named in the early 1970s. Since then, especially in the last ten years, ESG has grown exponentially. That growth has been most significant among younger investors. Estimates suggest that growth will continue into the next decade.
Then, at the beginning of this year, a number of Republican state legislatures began to attack ESG investment criteria as a version of “woke capitalism.” One particular measure includes a lawsuit pursued by 25 Republican state attorneys general trying to stop money managers at public pension funds from considering ESG risks and benefits while making investment decisions. This lawsuit was launched to counter a new measure introduced by the US Labor Department. A measure that simply allows retirement funds to look at ESG investment scores. It doesn’t make them do it.
Following in this vein, Governor DeSantis signed a bill on May 2 that bars Florida state officials from investing money in any type of investment that has been identified as ESG. And municipalities are prevented from seeking out ESG-mandated capital for funding local projects. Although similar to many other Republican pieces of legislation in recent months, it is considered to be the most drastic yet. I’m not sure this is an achievement Florida really wants.
There is a problem with this approach, especially in Florida, where climate change is having a massive impact. How can a municipal government get funding for repairs to buildings and other infrastructure caused by storms like last year’s Hurricane Ian if environmental issues are banned from any investment assessments? Hmm… Last month the National Hurricane Center tagged damage from the storm in Florida at $109 billion.
That is on top of the billions state pension boards predict they will lose by being prevented from investigating ESG options among their fund administrators.
What Is Environmental, Social, and Governance (ESG) Investing?
But none of this should prevent you from looking into ESG investment options. Environmental, social and governance (ESG) investing strategies can offer investors like you a scorecard for making decisions on investment options when you begin to build your investment portfolio.
ESG criteria simply offer additional factors to consider in your investment decision-making process. ESG analytics provide a snapshot of the efforts and experience of companies on these three fronts. These investment analyses offer ESG scores to examine in addition to a review of general business performance and traditional financial analysis.
How does Environmental, Social, and Governance (ESG) Investing Work?
Investors often want to review and compare the degree to which companies and investment funds strive for standards when defending the environment, pursuing socially progressive measures, and meeting governance criteria. ESG reporting allows them to do that. While imperfect, ESG ratings have meaning (more on ESG’s evaluation issues later).
As the name makes clear, there are three basic ESG criteria that analysts look for.
Environmental concerns are generally the easiest to identify. Corporate decision-making and investment decisions can provide a straightforward picture of what environmental risks a company is willing to take.
The risks a company is willing to take can be positive and negative. Take, for example, the automotive industry. Ford, Toyota and Tesla can all be reviewed for their efforts at introducing electric vehicles into their lineup.
Tesla would score well on this front. But they are also an excellent template for understanding that none of these criteria can be reviewed in isolation. Elon Musk’s ongoing difficulties at Twitter will have an effect on the value of Tesla stock. In fact, they already do.
On the other hand, Ford and Toyota have both been building cars for a long time – the old-fashioned way. Ford was founded in 1903, and Toyota in 1933.
The Toyota Prius was one of the earliest hybrids and easily the most popular. But now the company is being criticized for “its cautiousness on investing in fully electric vehicles.”
Ford recently announced a $3 billion loss for its EV division, aptly named Ford Model e. This was part of an announcement about how they will report business success going forward — with separate divisions for their commercial vehicles and internal combustion cars. And while a $3 billion loss might seem significant, it should be noted that the other two divisions earned $6 and $7 billion, respectively. And that Ford has identified this as a cost of getting the new division up and running.
A couple of years ago, Chartered Professional Accountants Canada produced a report entitled “The Rise of the Social Pillar: An Introduction to the ‘S’ in ESG.” It makes for an interesting read.
In the introduction, the CPA Canada report states that:
Discussions of social factors examine how an organization manages relationships with, and supports resilience of, its employees, suppliers, customers and the communities it operates in, and how these groups impact operations (CPA Canada & A4S, 2021). However, it is not just about how organizations manage these various relationships, it is also about their actions to address social issues.
The report goes on to list examples of those social factors:
- human rights
- health and safety
- employee engagement and satisfaction
- indigenous peoples and communities
- diversity, equity and inclusion
- ethics and security
They certainly look like good examples of corporate social responsibility and factors that socially conscious investors would consider when making investment decisions.
While governance factors might appear to be the most difficult to define, they can most dramatically impact a company’s reputation and subsequent stock value. This is also the point where a company’s management philosophy can often be most clearly defined.
When a company gets caught “breaking the rules” for short-term gain, this reflects poor corporate behaviour — behaviour that can adversely affect corporate reputations when uncovered. Historical examples of this might include exploding gas tanks in the Ford Pinto, Volkswagon’s decision to fake diesel emissions results, or the recent court case between Fox News and Dominion Voting Systems.
Pros and cons of ESG investing
Proponents of ESG investing present the argument that ESG gives additional insight into corporate direction and subsequent financial success.
Opponents of ESG argue that “the sole purpose of a firm is to make makes money for its shareholders” — the essence of the monetarist philosophy of economist Milton Friedman. Anything else is wasteful and counter to the success of the firm.
That said, let’s go deeper into these arguments and how they play out in creating and maintaining your investment portfolio.
Pros of ESG Investing
As you can probably guess, I believe that ESG principles should play a fundamental role in building your investment portfolio. And a review of actual ESG investing demonstrates its success.
For instance, a recent study published by the Harvard Law School Forum on Corporate Governance stated that:
A majority of investors (60%) report that ESG has already resulted in higher yields in their investment performance, compared with non-ESG equivalents. ESG investing has witnessed rapid growth in recent years.
And because the most active sector participating in ESG investing is made up of younger professionals, that rapid growth is expected to continue.
I think much of this success lies in the fact that ESG factors into selecting investments with a greater likelihood of success going forward. Growing concerns about business-related environmental impacts generally contribute to corporate results that reflect their environmental outlook. And social and governance factors offer an increased possibility of negative publicity when unflattering examples of behaviour are uncovered.
Cons of ESG Investing
It seems to me that criticisms of ESG investing come from a couple of basic assumptions:
- It reflects the belief that “the sole purpose of a firm is to make makes money for its shareholders.” Something that is directly counter to the wider view that ESG offers. The success of ESG demonstrates that this opinion is shortsighted. Something you don’t want in your investment portfolio.
- That ESG is rooted in “woke capitalism” and, as defined in the point above, this is lousy economics.
The article “Anti-ESG movement dials up the drama in the US”, which I used to introduce this post, lays out the arguments for and against the lawsuit trying to counter the recent Department of Labour directive. According to the lawsuit’s critics, it “reveals a distinct lack of legal sophistication at best, and understanding at worst.”
The proponents of the Department of Labour directive point out that it allows money managers to consider ESG, but they don’t have to. In addition, funds like the Indiana Public Retirement System estimate they could lose $6.7 billion over the next decade if they avoid fund managers using ESG in their investment strategies.
ESG investing vs. socially responsible investing vs. CSR
ESG investing is one idea among many that exist within the realm of responsible investing. While ESG investment strategy seeks to quantify investment choices, socially responsible investing (SRI) is the actual process of making those investment choices with the companies themselves. Corporate Social Responsibility (CSR) reflects the active pursuit of the corporate behaviour that ESG and SRI embody. CSR includes factors like:
- comparisons of executive pay and overall wages within the companies involved
- taking environmental responsibility for environmental issues like carbon emissions, or wastewater contamination
- committing to the improvement of local communities through equitable hiring and fair wage practices
- avoiding the use of political contributions to generate unduly positive conditions for the individual company (some might call this bribery)
Why does ESG investing matter, and how does it work?
At its core, ESG investing matters because it helps to encourage companies to act responsibly. And it allows you, as the investor, to seek out responsible investment opportunities and practice ethical investing.
You can pursue ESG investing opportunities by examining ESG metrics and investing in entities that demonstrate positive ESG performance along with positive financial performance. While this might seem like an overwhelming commitment of time and energy, there are ways to make these decisions easier. And over time, you will learn to recognize the signs that indicate positive ESG investment opportunities.
Types of ESG Investments
The range of ESG investments offered to investors by asset managers and mutual fund companies doesn’t look much different from any other category of investment vehicle. As you begin your journey into the world of ESG investing, you can be forgiven if you think your journey begins and ends right here. But if you are sincere in your intentions to use ESG criteria to invest ethically, then there are some extra details to consider.
How Do I Know Which Investments Are ESG?
Finding investment opportunities identified as ESG might be the easiest part. Ensuring they fit your definition of ESG investments could be the most confusing.
At first glance, your ESG investment portfolio won’t look all that different from your traditional investment portfolio. Most mutual fund companies and brokerage firms offer mutual funds and exchange-traded funds tagged as ESG.
In fact, this is where the Department of Labour lawsuit begins. But it should not be where your ESG journey should end.
No doubt you have heard of greenwashing. Even if you haven’t, greenwashing is the process of dressing up a company or investment opportunity as an investment with positive environmental benefits. This can include similar social and corporate governance claims as well.
Understanding and Avoiding Greenwashing
I see a lot of stuff on the internet that rails against greenwashing — from both sides of the argument. Some will argue that greenwashing undermines society’s efforts to achieve Net Zero and reverse climate change. And yes, I think they are partially right.
Others will point to greenwashing as proof that everything to do with climate change is just “woke capitalism.” They will argue that climate change is not important and that greenwashing is just an attempt to make it look legitimate. This is what feeds the various efforts at anti-ESG feedback going on in the US right now.
I would like to present a third definition. Like everything else in life, greenwashing is not just black and white (colouring puns aside). Greenwashing exists along a sliding scale that you must interpret for yourself. The real significance of greenwashing lies in the intentions of the presenters. And it is also a factor to consider outside of the environmental framework.
Allow me to explain. Let’s go back to our discussion of electric cars and the manufacturing companies getting involved in EVs. Tesla is the company that people identify most closely with EVs, but that position is slipping. And until Elon Musk decided to dabble in Twitter, his reputation and that of Tesla were pretty good, even though the company was often criticized for their efforts to move its manufacturing facilities from California to Texas. In that sense, Tesla has taken a beating, and critics identify the company as one that doesn’t really adhere to ESG goals and standards.
Toyota, on the other hand, has been involved in producing hybrid cars for over twenty-five years. The Prius was first introduced in Japan in 1997 and has been in active production ever since. But now, some critics are complaining that Toyota is not moving fast enough into the EV marketplace. My sense is that they are using caution moving forward. After all, increased EV acceptance is dependent on proper EV infrastructure, while EV infrastructure (read charging stations) will only succeed if there are EVs on the road to use them.
Much of this is true for Ford as well. While Ford is making significant investments in EV development and production, they are also continuing to produce cars with internal combustion engines running on fossil fuels.
The intentions behind greenwashing are an essential part of the puzzle
So while we can all look at the imperfect efforts of these three manufacturers, I think we can defend each of them for their commitment to EVs. But other examples of greenwashing deserve more scrutiny. Canada’s oil and gas sector has begun a campaign to promote its commitment to combatting climate change. Most environmentalists criticize their efforts as insincere, and I would agree.
The importance of corporate commitments to addressing ESG factors lies, as always, in the sincerity of that commitment. Is it something you talk about in your marketing material, or do you seriously address it in the boardroom?
The Definition of ESG isn’t consistent or universal
Another confusing part of ESG investing is the different ways that analysts review ESG efforts. As you begin your ESG journey, you are permitted to be confused by the different assessments made, based on the same basic ESG data.
Two of the biggest entities in the field of ESG analysis are Sustainalytics and MSCI. One review of the two firms describes the different ways they each interpret the data:
MSCI packages its ESG scores in a different manner. Unlike Sustainalytics’ “negligible, low, medium, high and severe” risk categories, MSCI decides whether a company is “laggard, average or leader” and subcategories further with letter-based rankings that span from CCC to AAA.
The industry understands that greater consistency is required. Efforts are underway to try and correct the differences and come up with a consistent understanding of the issues. Much of this work is being led by the Sustainability Accounting Standards Board. Let’s hope this problem begins to diminish over time as our ESG experience matures and grows.
Choose to DIY or get some help
Like traditional investing, ESG-based investing can be a DIY experience or something you pursue with your investment advisor. Only you will know what works best for you. And in the end, your success will depend on the quality of the information and advice you can get your hands on.
I want to find my own ESG investments
Congratulations on beginning this journey into socially responsible investing using ESG investment principles. As you are almost certainly aware, plenty of websites present and review ESG data. Sustainalytics and MSCI (Morgan Stanley Capital International), the two firms I highlighted before, are probably the best-known companies providing ESG-based investment analysis. And while their information may seem hard to understand at first, they do offer a good place to start.
I want help with ESG investing
If you already have a financial or investment advisor, you might want to start by having a conversation with them. If you don’t think that is going to work out, either before or after your conversation, there are other avenues you can peruse.
Some organizations represent advisors committed to responsible investment principles in Canada and the United States. In Canada, you can find someone to fit your needs in their RI Marketplace. In the United States, you can look through the online directory at US|SIF.
Know your own ESG criteria
Although ESG investment strategies have been shown to be at least as profitable as traditional investment, personal ethics almost always draw investors’ attention. And that’s okay.
As you begin to consider your options as an ESG investor, you need to examine what initially drew you here.
It’s not a difficult journey. And you will feel much better about your investments if you know what gets you excited or makes you uncomfortable.
Your personal ESG criteria might include:
- An aversion to animal testing
- A commitment to the environment
- An interest in benefitting disadvantaged communities, either in your own country or elsewhere in the world
- An unwillingness to participate in guns or other weapons
- And the list goes on
SRI and ESG investing make room for those concerns because they are what draws many investors to the general field of responsible investing.
The important thing is, keep going. It’s worth it.