- ESG stands for Environmental, Social, and Governance, and it’s a score that investors take into account before putting money into a specific company.
ESG stands for Environmental, Social, and Governance, and it’s a score that investors take into account before putting money into a specific company. Investors use these criteria to screen how a company could perform in the future, how valuable it is, and what impact that company has on society. ESG investing is also known as sustainable investing or impact investing.
ESG was launched by the United Nations as a way to encourage social responsibility but, in less than two decades, it became one of the most important things that investors ask about before adding company stock in their portfolio. Mutual funds, brokerage firms, and even robo-advisors now have products that use ESG criteria, so this isn’t a trend likely to go away anytime soon. Young investors, in particular, have shown that they care about the social and environmental impact of the stocks they invest in, which in turn has pushed companies towards taking more sustainable decisions.
But how influential are ESG criteria really? Should you place them at the forefront of your portfolio, or are they just an extra factor to keep in mind after taking into consideration other things? First, let’s have a closer look at how ESG criteria is calculated and why it matters in today’s investing landscape.
What are the ESG criteria?
ESG investing has three core components: environmental, social, and governance.
Environmental criteria refer to the company’s impact on the environment. This includes things such as the kind of energy they use, where they source their materials, how the manufacturing processes affect the environment, and their overall carbon footprint. Recycling is also included here: how does the company dispose of hazardous waste? Do they use special equipment to dispose of cardboard, plastic, and more? Do they actively try to reduce the amount of waste sent to the landfill? Do they make their packaging from recycled materials? According to a Forbes study, 92% of consumers trust brands that are environmentally conscious, and this is bound to reflect on stock price too.
Social criteria refer to the company’s relationships – not just with business partners but also with the local community. For example, investors often check who the company’s business partners are and whether they share the same values. It’s also important for the company to offer safe and reasonable working conditions to all employees, encourage volunteer work, and give back to the local community.
Governance criteria refer to the company’s accounting methods and the voting process for shareholders. Ideally, companies should also avoid conflicts of interest, they shouldn’t be engaged in any kind of illegal activities, and they shouldn’t rely on political help to conduct their activities.
Of course, these criteria can vary depending on the sector and the size of the business but, generally speaking, following ESG criteria means avoiding companies that operate in high-risk or controversial sectors (i.e., coal mining, tobacco, weapons, and companies that have been involved in controversies regarding animal rights, workplace safety, product safety, or bad environmental practices.
The impact of ESG in the current investment landscape
Analysts argue that ESG investing is more than a buzzword and that its evolution will be directly proportional to the growth in public awareness on social and environmental topics.
According to a recent study, ESG investments received a whopping $51 billion from investors in 2020, which is double compared to 2019 and an absolute record. Also, Morningstar revealed that ESG funds accounted for one-quarter of the money that flowed into all US stock and bond mutual funds in 2020. Analysts also estimate that the interest in ESGs will grow even more in the following years. In 2020, society was shaken by environmental and social movements and, as those continue, it’s normal for ESGs to become an even hotter topic.
Many people believe that companies should disclose ESG information when going public, and investors have also supported SEC efforts to mandate ESG-related disclosure.
So, does ESG criteria have a positive role in an investor’s portfolio? Initially, they did not because they limited the range of company stock that was eligible for investments. However, things are different today. Apart from having ethical values, ESG criteria are now practical as well. If major events such as the Volkswagen scandal and the BP oil spill are any indication, paying attention to ESG factors before investing can help avoid many bad decisions or at least association with businesses that follow questionable practices.
There seems to be a difference between how professionals and individuals see ESG. For example, Wall Street is more likely to take them into account. Meanwhile, the standpoint of individual investors vary. While they do show concern for a company’s environmental, social, and governance values, investors are more likely to leave them behind in times of economic uncertainty.
Still, there is more ESG fund choice than ever before. According to Morningstar, the number of sustainable funds that US investors could access in 2020 grew by 400 – that’s a 30% increase compared to the previous year. However, Europe is the region with the most ESG funds – 76% of the world’s total. The Biden administration also made it easier to invest in sustainable funds for 401(K)s. Starting from October 2021, sustainable funds are no longer rarities in 401(K)s because the Biden administration dropped the restrictions for incorporating ESGs into evaluations. As a result, ESG funds are expected to become the default investment option for 401(K)s. Fees have also been dropping, so this is an extra incentive for people to invest sustainably.
A Morgan Stanley study also found that 85% of investors are interested in sustainability. Not surprisingly, 95 of Millennials want to invest in sustainable funds, and their conditions will eventually outweigh trade-off concerns.
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