ESG is the new favourite word in Finance, why?

Experts have been constantly warning the world of climate change. 

The global climate is going through extreme changes and the increase in global temperatures along with the depletion of the protective ozone layer are causing the ice caps to melt and ultimately, increasing the sea level. The need for an environmental change now is paramount that even the Metronome digital clock located along the south end of Union Square in New York City has been reprogrammed to illustrate a critical window for action to prevent the effects of global warming from becoming irreversible. Along with environmental changes, societal changes like abolishing racism, gender equality and greater minority rights are gaining pace.

The Black Lives Matter movement is one of the most recent and most popular movements to end racism in western countries. The movement is still popular especially amongst athletes and celebrities. Environmental and social causes have become so important that they have now entered the field of finance with a concept known as ESG investing.

Environmental, Social & Governance (ESG) criteria refers to set of factors that look into the business operations, and referred by socially conscious investors to screen potential investments. 

It is also called sustainable investing or responsible investing.

Environmental criteria includes a company’s waste management policy, efficiency of energy use, natural resource utilization and treatment of animals. Investors may also analyse the potential harm the company’s practices might have on the environment, historical environmental accidents, etc.

Social criteria looks at the company’s business relationships and the demographics of the workforce including supplier core values, CSR activities, employee working conditions, employee disputes, etc.

Governance criteria includes accurate and transparent accounting policies, investor voting rights, impartial selection of board members and compliance of legal trade practices. 

No single company may pass the requirements in every category, and therefore investors got to decide what is most vital to their approach.

There are various ways to approach ESG investing.

Negative Screening – It refers to excluding certain companies from consideration for the portfolio given their activities related to violation of human rights, environmental concerns or even corruption within the organisation. Negative screens are frequently applied on weapons manufacturers, nuclear power producers or companies that use child labour.

Positive Screening – Rather than excluding companies, investors attempt to identify companies with positive ESG practices and include them in their portfolio. Examples include companies that generate renewable energy, health and lifestyle products, recycling, etc.

Full Integration – This refers to the use of ESG factors and scores in fundamental analysis. ESG practices are included in the estimation of important fundamental variables.

A few other methods to incorporate ESG practices in investing include thematic investing, adding a risk premium after ESG considerations, green finance, green bonds, active ownership, etc.

Conflicts may arise while using ESG considerations to select securities as portfolio managers always look for more returns, but with ESG considerations in place they may have to resort to low return securities.

Some investors believe that by following ESG criteria they may be able to avoid companies whose practices signal a potential risk factor like oil spills, toxic waste, etc. In many cases, companies that are awarded high ESG ratings also are those that are actively at work on creating useful innovations within the world of sustainability – which could bring excellent choices when it involves building a profitable portfolio. It also provides investors with a dual opportunity of generating profits and standing up against practices such as  climate change, gender inequality and general malpractice by providing a boost for companies that operate in a far more sustainable manner. 

A major drawback of ESG investing is the obvious lack of diversification opportunities, since the number of companies that actually follow ESG practices are very few.

The most important advantage of ESG consideration is that it’s popularity is growing exponentially. The belief that climate change is soon to occur has led to an increased reception of environmental practices globally. Governments and other socially active agencies across the world have been pushing towards environment and societal friendly norms. 

ESG investing has become so popular that in April 2019, the S&P Dow Jones Indices launched the S&P 500 ESG Index, that maintains similar industry groups as the S&P 500, while excluding companies that do not fit the criteria. The problem of ESG returns being considerably lower than those of traditional companies is not entirely true as data from BlackRock Investment Institute show that ESG equity portfolios have the ability to deliver comparable returns and may slightly underperform a standard market portfolio over a short-term period, but do outperform the expectations over longer periods. ESG investing also provides some amount of protection against volatility in the market.

Nobody can deny the fact that the world is experiencing climate change. Racial discrimination still exists in many parts of the world along with corrupt practices from officials. ESG investing is one way in which a simple investor can do their bit to preserve the environment and protect the discriminated. It is our obligation to give back to society and through ESG considerations, society has given us the opportunity to help in these causes and still benefit. In the end it is the world we all live in and it is now in need of protection.