A Guide to ESG Investing and How ESG Creates Value
Environmental, Social, and Governance Investing (“ESG”) can be an important risk-management and mitigation tool for long-term investors. As businesses have started nurturing new value-creation opportunities to address ESG, the investment community has been quick to understand that companies with strong and sustainable ESG programs can deliver better returns. Successful ESG investing still relies on all of the basic fundamentals of successful investing but also serves to add an additional layer of evaluation and screening. While a primary factor in ESG investing is financial performance, investors take into consideration a company’s ESG activities and “score” when deciding whether to invest.
ESG investing relies on independent ratings that help investors assess a company’s behavior and policies when it comes to environmental performance, social impact and governance issues. An ESG report assesses how a company’s policies impact environmental, social and corporate governance. It enables a company to be more transparent about the risks and opportunities it faces. ESG reporting encompasses both qualitative disclosures of topics as well as quantitative metrics used to measure a company’s performance against ESG risks, opportunities, and related strategies.
The “E” or environmental factor includes the resources a company needs, including the energy a company takes in and the waste it discharges. Every company uses energy and resources and has risks and opportunities associated with the environment.
The “S” or social factor might focus on the company’s relationship with people and society, or whether the company invests in its community. Areas of evaluation include: customer satisfaction; data protection and privacy; gender and diversity; human rights; and health and safety.
The “G” or governance factor evaluates how a company is run and executive compensation. This component involves how a company’s board and management comply with the law as well as drive positive change. Governance includes everything from issues surrounding executive pay to diversity in leadership as well as how well that leadership responds to and interacts with shareholders.
Over the past two decades, a large body of research has shown that ESG investments have endured downturns better than their conventional counterparts. ESG investments have been found to be more resilient during market downturns that were driven by different types of global crises, including: the financial crises, the COVID-19 pandemic, and the long-term crisis of climate change.
Sustainable investing often focuses on investing with a very long-term view, not solely for short-term gains that can lead to systemic problems and long-term value destruction. A significant amount of research finds that a strong ESG proposition correlates with higher equity returns. Better performance in ESG also corresponds with a reduction in downside risk, as evidenced, among other ways, by lower loan and credit default swap spreads and higher credit ratings, according to a report published by consulting firm McKinsey & Co. in November 2019.
There are different theories as to why companies with strong ESG credentials may be more resilient. According to an NYU Stern and Rockefeller Asset Management study in February 2021, often it comes back to the fact that these companies tend to be better prepared to address material risks – from better governance to policies that help them address social and environmental challenges within their operations.
The linkage from ESG to value creation is strong and direct. According to McKinsey, there are 5 ways to link ESG to value creation at companies. First, a strong ESG proposition helps companies tap new markets and expand into existing ones. ESG can also drive consumer preference. McKinsey research has shown that customers say they are willing to pay to “go green.” Although there can be wide discrepancies in practice, including customers who refuse to pay even 1 percent more, McKinsey found that upward of 70 percent of consumers surveyed on purchases in multiple industries, including the automotive, building, electronics, and packaging categories, said they would pay an additional 5 percent for a green product if it met the same performance standards as a nongreen alternative. Second, ESG can also reduce costs substantially. Among other advantages, executing ESG effectively can help combat rising operating expenses (such as raw-material costs and the true cost of water or carbon), which McKinsey research has found can affect operating profits by as much as 60 percent. Third, a stronger external-value proposition can enable companies to achieve greater strategic freedom, easing regulatory pressure. In fact, in case after case across sectors and geographies, McKinsey found that strength in ESG helps reduce companies’ risk of adverse government action. Fourth, a strong ESG proposition can help companies attract and retain quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. Fifth, a strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities (for example, renewables, waste reduction, and scrubbers). It can also help companies avoid stranded investments that may not pay off because of longer-term environmental issues.
There are many approaches investors can take towards developing and integrating an ESG investment strategy. One approach is screening investments for ESG specific characteristics. Negative screening means excluding one category or sector of stocks from a portfolio. For example, companies associated with tobacco, alcohol, or weapons. Positive screening techniques work to identify and highlight organizations that are actively functioning to further environmentally sustainable and positive social practices, rather than simply avoiding bad behavior. Investors can also implement an ESG strategy by investing based on defined sustainability themes. This approach enables investors to invest in a specific aspect of ESG such as companies focused on environmental solutions (ie. renewable energy, sustainable agriculture) or social issues (gender/ racial equity, diversity, etc.).
ESG investing tends to mitigate risk and create value versus non-ESG portfolios. ESG investments can provide both better financial performance and lowered risk, as well as ways to invest responsibly.
David Rosenstrock is the Director and Founder of Wharton Wealth Planning, LLC. He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™. David lives in New York with his wife and their two very active children.
published by The Environmental Magazine on May 31, 2022