What is ESG investing?
Do you have strong views on the environment, social issues or governance? Then understanding ESG could help you to identify your next investments.
The past two years have seen a huge focus on climate change and other sustainability issues. Unsurprisingly, many ordinary investors are becoming more mindful of where they put their money in order to minimise their own impact on the environment and other sustainability issues.
Fortunately, the financial world has seen an uptick in ESG-focused fund managers. In this article, we discuss what ESG investing is, how it impacts investment performance, and how fund managers incorporate ESG into their decisions.
What is ESG?
When assessing a company’s ESG performance, investors and ESG rating agencies tend to look at two key points. The first is how exposed a company is to ESG issues, such as climate change, poor working conditions or corruption. The second is how well companies manage the ESG issues that they are exposed to. Some risks might be unmanageable: for example, an agricultural business might be highly exposed to changing weather patterns that are out of its control; this may affect its overall ESG rating.
Due to an increased focus on climate change by governments, companies and individuals, fund managers are increasingly incorporating ESG analysis into their investment decisions.
What impact does ESG have on investments?
There are two main impacts that ESG can have on an investment. The first is that some investors believe that companies that perform well in relation to ESG issues will generate better returns. The second is that companies with poor ESG performance are more exposed to risks.
But how can good ESG governance lead to higher investment returns? There is no straightforward answer to this and this issue is hotly debated amongst finance professionals. One way good ESG performance can lead to higher returns is because some funds are “mandated” (instructed by their investors) to only invest in securities with good ESG performance. In other words, investor pressure is directing a lot of capital towards companies with good ESG performance, which ultimately pushes up their stock price.
Another way that ESG performance can lead to greater investment returns is that companies with good ESG practices are fundamentally better businesses. For example, a company that looks after its employees well is less likely to suffer from high employee turnover; similarly, a company with a management team that pays attention to the business’s environmental impact is less likely to be fined for breaching environmental regulations. These factors may increase the business’s long-term value.
Most fund managers that carry out ESG analysis do so in order to minimise ESG-related investment risk. A company that relies on a supplier with poor working conditions will be exposed to the risk of that supplier being shut down by regulators. As mentioned earlier, an agricultural business will be very exposed to climate risk, which might give it a poor ESG risk. These are businesses that an ESG-focused fund manager might avoid.
How do fund managers incorporate ESG into their strategies?
A fund manager that views ESG solely as a way to improve its financial performance (that is, by increasing returns or reducing risk) might invest in companies that manage ESG issues well because these companies might have better long-term value. This type of investor might also avoid businesses that are highly exposed to unmanageable ESG issues (such as the agricultural business mentioned above) in order to minimise their investment risk.
However, an activist investor might deliberately invest in companies with poor ESG ratings in order to influence the company’s management to adopt better ESG policies. An ethical investor might invest only in companies with good ESG practices, even if the company (like the agricultural business example) is exposed to unmanageable ESG risk.
If you were wondering how you get started with investing without compromising on your social or environmental views, then looking into ESG funds could be a great place to start.