ESG Investing

What Is ESG Investing?

ESG (environmental, social and governance) investing is a process that takes nonfinancial factors into an investment decision, rather than simply an asset's estimated financial return. ESG is also sometimes known as socially responsible, sustainable and mission-related investing, although they are not identical.

Rather than simply avoiding or boycotting companies for moral or ethical reasons, such as shunning companies that make or sell tobacco, alcohol, firearms or pornography, ESG investors believe that broader factors directly influence a company's financial performance. Companies that fail to take ESG factors into consideration may also subject themselves to increased financial risk.

Example of ESG Investing

For example, companies that manufacture cigarettes or guns are often subject to lawsuits or negative publicity, which can affect their sales and profitability. Similarly, corporations that make poor choices when it comes to how they treat the environment could face negative financial consequences in terms of fines and higher expenses. And companies whose management is insensitive to or ignores workplace diversity, worker health and safety, equitable pay, or privacy and data security could fail to hire the most talented employees or attract more customers or investors.

Origins Of ESG Investing

Although the basic principle goes back several decades, the term ESG was first coined in 2005 in a landmark study entitled "Who Cares Wins."^[1] That study resulted from the Who Cares Wins conference, which "first brought together" institutional investors, asset managers, research analysts, consultants and regulators to examine the role of related "value drivers in asset management and financial research."^[2]

Since then, some major stock exchanges have come out with their own ESG guidelines, such as the "Principles for Responsible Investment (PRI)." More than 1,600 members representing more than US$70 trillion assets under management follow these principles.^[3]

Many mutual funds and exchange-traded funds use ESG criteria, and this form of investing was estimated to total more than US$20 trillion in assets under management in 2018.^[1]

Moreover, two-thirds of institutional investors surveyed by RBC Global Asset Management in 2017 said they "use ESG considerations as part of their investment approach," and 25% said they "expect to increase their allocation to managers with ESG-based investment strategies within one year."^[4]

Does ESG Investing Hurt Or Improve Returns?

While ESG investing may be considered a noble pursuit since it means "putting your money where your mouth is," there has long been a debate over whether moral considerations hurt investment performance. In other words, do investors miss out on better returns by not investing in certain companies that don't follow ESG principles? Conversely, do ESG-friendly companies underperform compared to their non-ESG counterparts?

According to the RBC, there has been a "growing body of research that suggests companies" that follow ESG principles "may in fact be helping their bottom line."^[5]

For example, a 2015 report by Oxford University and Arabesque Asset Management found "a remarkable correlation between diligent sustainability business practices and economic performance." The report found that "companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into cashflows" and that "prudent sustainability practices have a positive influence on investment performance." The report "ultimately demonstrates that responsibility and profitability are not incompatible, but in fact wholly complementary."

A 2015 study published by the Harvard University Law School Forum on Corporate Governance and Financial Regulation found that: "a corporate sustainability strategy can be an effective way to manage risks, reduce environmental impacts, improve efficiencies, and lower costs. As evidenced by examples from a number of leading companies, a sustainability strategy can also pave the way for product innovation and new sources of significant revenue growth."

"While empirical research on the link between corporate investment in ESG and firm performance is far from undisputed, several studies led by respected institutions have shown that a company can be rewarded for adopting these practices: higher profits and stock return, a lower cost of capital, and better corporate reputation scores are the key benefits enjoyed in return for this type of investment," the study concluded.

Summary

ESG (environmental, social and governance) investing takes nonfinancial factors into account, rather than simply an asset's estimated financial return, in the investment decision. ESG is also sometimes known as socially responsible, sustainable, and mission-related investing, although they are not the same.

Rather than simply avoiding or boycotting companies for moral or ethical reasons, ESG adherents believe that a company's hiring practices, environmental policies and corporate governance procedures can affect its financial performance. Some research suggests that companies that adhere to ESG policies outperform those that don't.