Photo courtesy Raimond Klavins on Unsplash.
ESG stands for environmental, social, and governance and is considered responsible investing in a just society.
ESG investing can be utilized by responsible citizens to research the businesses based on some qualitative aspects which are not present in the financial statements, like identifying the impact of climate change on the balance sheet; or perhaps the business ethics. It is one of the vital investment methods in responsible investing and is gaining traction.
Increasing research is showing that this process can minimize portfolio risk and generate competitive returns. Combining ESG investing with conventional stock analysis is known as ESG integration. ESG funds are the funds that invest in equities and bonds of companies once they are assessed based on environmental, social, and governance factors.
The three components of ESG investing are:-
E is for environmental
The environmental criteria analyses factors that demonstrate a company’s impact on the Earth in both positive and negative ways. The continuous reduction in forest cover, rising global temperature, and increasing pollution of air and rivers are several ways by which humans are neglecting the environment. This has resulted in erratic rains, droughts, and flooding. How the company deals with these environmental issues is one of the aspects here.
It can include research on-
· Compliance with government’s environmental laws.
· The meeting of greenhouse gas emission goals by the company.
· Optimum use of water, its conservation, and reduction in water pollution.
· Contamination of land with disposal of hazardous waste.
· Recycling of important resources and increase in the use of renewable energy like wind and solar that is beneficial for the environment.
· Plans and policies for keeping the environment safe and healthy.
Company websites that contain broad details could be helpful for ESG investors. The goals are useful when supported by numbers and metrics that demonstrate progress is being made in sustainability standards. Let us consider an example-Nike is a company that meets the environmental criteria of ESG. Its sustainability report uses the GRI framework, SASB, and Sustainable development goals (SDG) of the United Nations that provide valuable data to the investors.
S is for Social
Social criteria explore the company’s business relationships like-
· Do the suppliers of the company hold identical values as that of the company?
· The history of consumer protection issues and customer service responsiveness.
· Does the company donate a percentage of its profits to the local community and encourage its employees to perform volunteer work. Let’s consider an example- In many companies, employees take steps in emergencies to help society in certain bad situations like floods.
· Employee payment and perks, training and development, health and safety.
To find out information on social aspects, ESG investors should explore sustainability reports that use standards like GRI or PRI. Even media reports may contain facts and information on how companies treat their employees.
G stands for corporate governance.
Corporate governance relates to the company’s shareholder friendliness, the constitution of the board of directors, and the way business is run. It is about the integrity and honesty of the management that helps in wealth creation for investors.
· Constitution of the board of directors and how diverse the board is with any conflict of interest in their selection.
· Remuneration of executives also taking into account their perks.
· Transparency of accounting methods.
· Involvement of shareholders in voting on important issues; transparency of communications with minority shareholders, the company’s history at the stock exchange, and dealings with the other regulatory bodies.
· If any political contributions are made to obtain favorable treatment.
Investors should decide what is important to them as no company can pass all the tests in every category. For example, Boston-based Trillium Asset Management ESG criteria are to exclude companies with exposure to coal mining, corporate governance issues, workplace discrimination, and other companies that generate part of their revenues from weapons.
In the ’70s Milton Friedman popularized the shareholder value theory which argued that the company’s only social responsibility was to maximize shareholder value i.e. to generate money for the shareholders holding the stock.
This could prove to be harmful as the businesses can run into serious trouble if the management is only concerned with short-term profit measures. If this philosophy trickles down the company’s culture, the employees will make poor decisions or even unwarranted dealings to keep the management happy in the short term resulting in lawsuits or investigations.
Investment strategies related to ESG Investing
· Socially Responsible Investing–
Around the time of Friedman’s statement, emerged socially responsible investing (SRI) which emphasizes strategies relating to sustainable, responsible, and impactful investing.
· Impact investing-
It comes under socially responsible investing. Investors put their money in companies that have a positive environment and social impact.
· Conscious capitalism–
Conscious capitalism is a socially responsible economic philosophy having four principles that include a higher purpose, stakeholder orientation, conscious leadership, and an aware culture.
Growth in ESG Investing with an increase in interest during the pandemic–
ESG and SRI are fast gaining the attention of financial institutions and everyday investors. Morgan Stanley’s Institute for Sustainable Investing conducted studies in 2017 and found that 86% of millennials are interested in sustainable investing in companies or funds that aim to generate market-rate returns while pursuing social and environmental impact.
The pandemic has increased social inequality and has pushed many people into poverty. It has served as a reminder of the fragility of our existence and led people to demand a global response on medical issues as well as those about climate change. The millennials will invest in companies promoting social and environmental issues and are at the forefront whether in the use of electric cars or promoting clean water.
According to Bloomberg, the Global ESG assets will exceed $53 trillion by 2025 and that would be more than a third of funds under management that would be around $140.5 trillion. Some of the best ESG research companies are Bloomberg, MSCI, S & P Dow Jones Indices, and Refinitiv. The score is considered on 100 points scale and the companies that score higher are considered better performing on the ESG criteria. These ESG rating companies take into consideration things like financial management, corporate sustainability measures, resources, employees, annual reports, board structure, and compensation.
Nifty ESG Index and some ESG stocks in India-
The Nifty 100 ESG index contemplates the performance of companies in the Nifty 100 index as related to the ESG score. This index has outperformed the parent Nifty 100 index on various timeframes like 1 and 3 years. The top three mutual funds in India based on ESG investing strategy are SBI Magnum Equity ESG, Quantum India ESG Equity, and Axis ESG.
Society too expects the businesses to be more responsible towards the ESG criteria. The companies not following these criteria could lose importance thereby risking capital flows. The project ‘NEW’ launched by Asian paints aims at minimizing the impact of operations and fostering biodiversity. Havells India has eliminated the use of Kr-85 isotope from its lighting range and the company has four zero water discharge facilities and two renewable energy initiatives. Ultratech has started using a low carbon strategy in its business to align with the climate change goals. There are many companies now that have already started acting on the ESG investing strategy.
SEBI the market regulator in India has made it binding for the top 1000 listed companies to follow the ESG model beginning 2022, known as Business Responsibility and Sustainability Reporting. This creates a universal platform for regulatory insights on ESG and reflects the Global cooperation that would be required to achieve ESG goals.
Pros and Cons of ESG Investing-
· If you emphasize values, you can pick a socially responsible fund and walk the talk as you are putting your own money. By practicing values you will be at peace with yourself.
· If you are committed to socially responsible investing you can withhold money from companies that are not behaving. This may force them to shape up. This is like punishing them. No change would happen in a society if you don’t take a stand.
· It rewards companies that are doing the right things by investing more money and this can be responsible for a change in the long run.
· By investing in socially responsible companies which align with your values; you will be happier when the companies will give good returns over time. Everyone will benefit as a result.
· When you invest in socially responsible companies you might have to give up on high returns. Ethics will become more important than performance. In the short term, it may not be good.
· If you focus only on social investing you may be leaving many strong investments. As an example, you learn of a new company, whose performance regarding social responsibility is not good, but creates new innovative products and also new jobs. If you miss this opportunity you may lose on some financial gains.
· Many companies just create an image of being socially responsible, but in reality, they are not. They create the right image through marketing and people simply believe them.
· ESG ratings often display a size bias that gives larger firms better ESG scores on average. This is because the larger companies have much more resources to develop and report on their ESG activities. Investors may find themselves starved of mid-cap and small-cap companies.
· There is a lack of market standardization when it comes to naming ESG investing and also a lack of standardization in ESG data collection, impact measurement standards, and reporting methodology which adds to the complexity for the investors.
If you are passionate about things that matter to you and want to invest in companies that match your morals, then ESG investing is the right fit for you. Search for companies that match your ambitions and beliefs and when they perform it would be rewarding for you. You can even invest in ESG mutual funds, brokerage firms, and Robo advisors that offer products employing ESG criteria. We can rightly say that ESG investing has become an important part of investing process.