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Stocks & Bonds

ESG Investing: What Does It All Mean

Sustainable or values investing is mindful of three types of issues -- environmental, social and governance.

Illustration by Ana Yael

Plenty of companies reflect some of the environmental, social or governance qualities that characterize sustainable investing. Unilever, for example, is lauded for setting a target to be carbon positive by 2030, by which time it hopes to cut its use of fossil fuels and rely only on renewable energy sources. In addition to making strides in reducing its greenhouse gas emissions, Cisco Systems gets kudos for employing an above-average percentage (38%) of senior executives who are women. But no firm wins high marks on all measures. “There’s no perfection,” says Erika Karp, of Cornerstone Capital.

See Also: What You Need to Know About Values Investing

To get a sense of the qualities that define ESG investing, see the categories below. The groups are distinct, but they’re also connected, something that becomes crystal-clear when ESG principles break down. Consider Volkswagen’s 2015 emissions scandal. The company’s admitted cheating on emissions tests broke environmental laws. Customers lost trust in the brand, an important social factor. And the incident revealed a lack of oversight and ethical decision-making at the top, a major governance misstep.

Environmental

Of the three categories, this is the easiest to define. Anything related to the environment falls here, from the size of the company’s carbon footprint to its impact on the atmosphere and ecosystem, globally and locally. It boils down to how big an impact the company makes on the environment and how well it manages that impact. A beverage company, for instance, may get extra scrutiny because its business is water-intensive, but it can win points if it manages its water usage efficiently. Ultimately, a mining or industrial company’s E score matters more overall than that of, say, a software company or bank.

Social

This category covers community and employee relations, including human rights abuses and discrimination, community impact and involvement (does the company support local nonprofits?), employee treatment, and occupational health and safety. The category is broad, says Linda-Eling Lee, of MSCI, but the most important components are product safety and human resources.

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Product safety is integral to a customer’s trust in the brand. Think food safety at a restaurant company or data security at a social media or financial-services firm.

To see if a company is a good steward of human capital, MSCI looks for a happy workplace. Is the company a sought-after employer? What kinds of policies and programs are in place to attract and retain workers? Is there upward mobility at the firm? Do people stay at the company for years? Companies that score well on these questions have a competitive advantage over others, says Lee. Studies show that contented workers tend to be more productive and efficient, which helps a company’s bottom line.

Governance

Of the three categories, says Cornerstone Capital’s Karp, “governance is first among equals,” in part because it applies to all companies, no matter the industry. Arguably, corporate governance should matter to all investors, not just those interested in ESG investing. “The essence of corporate governance is whether the board of directors is representing the best interests of its shareholders,” says Ric Marshall, of MSCI. Good governance is a mix of ethics, diversity and transparency and is exemplified by a diverse board of directors and executive ranks; clean accounting; sensible executive compensation (a payout that is tied to long-term company results, for example); and straightforward, timely communication with shareholders.

See Also: 5 Mutual Funds that Win with ESG