In recent years, the use of ESG (environmental, social, governance) investing approaches has exploded, both with institutional and retail investors. You’ve probably heard of it but, as with every investing strategy, it pays to go a bit more in-depth on what exactly it is and how it may affect your portfolio in the future.
What is ESG investing?
Traditional investing philosophies suggest that your investment decisions should rely solely on a company’s ability to generate profits and increase shareholder value, often either through value or growth investing.
Environmental, Social, and Governance (ESG) are for those socially conscious investors that use ESG standards to screen whether they should invest in a company.
Environmental criteria represent a company’s impact on the environment — whether that be their greenhouse gas emissions, waste management, water scarcity, and direct impact on the local and global environment.
Social criteria focuses on the way a company treats its workers and its surrounding community. This may include factors such as human rights, diversity, pay, community relations, ethical product sourcing, child labor, and indigenous reconciliation.
Governance comprises how the company is run, its internal systems, procedures, and practices. Good governance will foster transparency and accountability and make sure that industry best practices are maintained.
Governance factors can include company leadership, whistleblower schemes, business ethics, corporate culture, and methods preventing bribery and corruption.
There’s many different ways to cut and slice ESG criteria to determine which companies one might invest in. In fact, investment firms will often have their own priorities for which factors should be more heavily weighted when making investment decisions.
For example, an investor may wish to preclude companies with exposure to the mining of fossil fuels and rare earth minerals, tobacco, weapons, or those embroiled in human rights and animal welfare controversies.
Instead, they might invest in those which use renewable energy, reduce waste, run ethical supply chains, and have transparent corporate practices.
In the end, it’s up to the institution/individual investor to decide which factors are most important to them when including or excluding investments in their portfolio.
The Positive Effects of ESG Investing
Generally, the positives of ESG investing are two-fold. The first is that by filtering your investments through an ESG lens, you’re more likely to avoid scandals that a company might go through and hurt its share price (e.g. investing in BP before the Deepwater Horizon oil spill).
With ESG investing front of mind, you may be more likely to seek out growing industries such as renewables and exclude those such as coal and oil, the idea being that long-term benefits of these emerging industries outweigh the short-term gain of those in decline.
Additionally, by pushing your investment dollars towards ESG practices, you’re encouraging other companies to head in that direction as well.
Although only time will tell if this strategy will be successful in driving real change toward a common good, you will gain peace of mind that your investments actually align with your values.
Often undervalued, feeling good about how you’re making money can be incredibly important to your long-term happiness — you don’t want to be looking back on your life thinking about what your wealth cost people and the planet.
ESG investing does have some limitations
The main downside of ESG investing is that you are limited in the stocks that you can purchase. You’re sacrificing your ability to invest in areas that may outperform the market.
While the defense industry, for example, tends to outperform the market and can buck recession trends, it’s quite far from having a place on most ESG investment portfolios. Investors essentially sacrifice gains from these industries in exchange for investing in line with their values.
Another major downside is not actually with ESG investing, rather it has to do with the availability of accurate and transparent reporting to investors.
Many company reports lack quality data for investors to make decisions with and often fall into the category of greenwashing. The lack of rules and regulations around ESG reporting means that some reports act more like marketing than actual investment information.
It’s very difficult to know whether a company is just blowing smoke for actually making sustained efforts towards ESG.
For example, in 2018 Nestlé made the claim that they would be using 100% recycled or reused plastics by 2025 and many other companies have made similar claims, yet nearly all of these large companies are set to miss their goals by wide margins, with Nestlé having reduced their virgin plastics use by just 8% in the years since.
A non-discerning investor taking these press releases at face value may end up investing in companies opposite to their values.
The future of ESG investing
At its core, ESG investing is about aligning your values with your investment strategy and that is a deeply personal decision. Not only because your values may differ from the next person but also for all the other reasons that investing is personal.
For example, you may be value-aligned with a long-term investment that may be volatile in the short term — if you’re someone looking to buy a house or retire this may not be the best option even if your values point you in that direction.
Looking forward, the future is uncertain. Many societal shifts need to happen for us to reach our emissions goals and avoid the worst of the climate crisis. These changes must happen across many industries to help create a stable economy in the future.
Current investors (as well as new generations of investors) appear eager to support investment in ESG-aligned companies, and this presents many growth opportunities that also have positive impacts on society and the environment.
If you decide that ESG investing is something you’re interested in, start doing research. Think about what areas of ESG are important to you and look into what companies or funds best align with those criteria.
Don’t just rely on ESG scores — look into what a company is saying about itself and what independent sources are saying in response. If you’re going to invest using ESG strategies, you might as well make sure you know what those investments are actually all about.
About the Author:
Anton Hine, Marketing Coordinator
Anton is PocketSmith’s Marketing Coordinator and is currently completing his BComSci degree in Marketing and Ecology alongside working at PocketSmith. Anton started his investing journey in high school and hasn’t looked back since. He’s a strong proponent of index investing, although he still likes the thrill of individual stocks on the side.
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