Environmental, Social and Governance (ESG) investing is a type of investment that prioritizes optimal environmental, social and governance factors or outcomes. It’s also often referred to as socially responsible investing, impact investing or sustainable investing.
ESG investments are considered a sustainable way of investing as they are made with consideration of the environment and human wellbeing as well as the economy.
While ESG is by no means a new method of investing, the increasing awareness and prominence of corporate social responsibility (CSR) and social sustainability has led to an increase in awareness about ethical participation in the market.
How ESG works
Investors assess a company based on ESG criteria, which focusses on a broad range of behaviors. Each behavior is broken down into environmental, social and governance, examples of environmental criteria includes a company’s energy consumption, waste, pollution and treatment of animals.
The release of a set of United Nations guidelines, called the Principles for Responsible Investments (PRI), in 2006 is often accredited for bringing ESG investments into the mainstream.
Social criteria may look at the company’s business relationships in terms of whether their suppliers or partners hold the same values as the company, whether they donate to their local community or whether they provide a safe working environment for their employees.
When assessing governance, investors may want to know that a company uses transparent accounting methods, aren’t involved in illegal or unethical practices and give stakeholder the opportunity to vote on important issues.
No company will be perfect and conform to all of the criteria, but investors will know which are the most important to them and will assess potential investment opportunities on this basis.
Types of ESG
While avoiding sin stocks such as tobacco, alcohol and weapons have traditionally been considered a core element of ESG investing, investors in ESG also look at a broader range of issues.
Advantages of ESG
The advantages of ESG include:
Better returns
Sustainable mutual and exchange-traded funds have been found to deliver better returns than traditional funds. JUST Capital ranks companies based on ESG factors and the JUST U.S. Large Cap Diversified Index (JULCD) includes the top 50% of companies in the Russell 1000 based on those ranking.
Since its inception in 2016, the index has returned 15.94% on an annual basis compared to the Russell 1000’s 14.76% return.
Lower risk
Sustainable and ESG funds have consistently shown a lower downside risk compared to traditional funds, particularly during turbulent markets. It is widely considered among investors that ESG funds have lower exposure to risk and potential losses.
Disadvantages of ESG
The disadvantages of ESG include:
Ethics may cloud judgement
When ESG investing is a primary objective for investors it can cloud their judgement and they may choose to invest in companies that align with their values instead of investing in those that are likely to make them a profit.
Takes more research
ESG investing undoubtedly requires more research as an extra layer of criteria is introduced.
Not only does the company need to be profitable and showing growth to prove they are worthwhile in investing in but they also need to mirror the investor’s values. This sometimes requires intensive research as companies that claim to be socially or environmentally responsible may not be.