Ellen B. Kennedy
There are as many approaches to investing as there are investors. One strategy that has received much attention of late is ESG.
ESG stands for environmental, social and governance. It aims to mitigate the risks a company faces from poor practices in any of these areas. For example, a company that doesn't treat its employees well has a greater risk of strikes or lawsuits. One that doesn't treat the environment well could face fines or costly regulations in the future – not to mention backlash from investors and customers.
ESG is distinct from sustainable investing because it isn't strictly about "doing good."
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The key feature of ESG is that it focuses on metrics that can create or destroy financial value, says Todd Cort, senior lecturer of sustainability at Yale School of Management.
Let's take a closer look at each of these metrics, how ESG can be incorporated into investment decisions, and if it should.
What does ESG mean?
ESG investing breaks these risks and opportunities into environmental, social and governance metrics. What does that mean in practice?
Environmental. An environmental analysis of a company will assess 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.
A mining or industrial company's environmental score matters more overall than that of, say, a software company or bank.
Social. This category covers issues related to employees, supply chain labor, customers and communities impacted by company operations. Some of these categories are especially important in a given industry.
Product safety, for example, is critical to the value of a pharmaceutical company, but less so to that of a publishing company.
Good employee relations are universally important for the retention and protection of a company's reputation.
Governance. Good governance rests on sound ethics and transparency.
ESG investors look for companies that have a track record of clean accounting, sensible executive compensation (bonuses that are tied to long-term company results, for example), and straightforward, timely communication with shareholders.
Each bit of ESG information is typically rolled up into scores assigned by ESG rating companies. In this way, investors can compare companies across industries or geographies.
An example of ESG
There are two broad approaches to ESG: positive screening and negative screening. The former looks for best-in-class companies. This would lead to a portfolio that still holds energy stocks, but opts for the highest-scoring oil company.
Negative screening entails eliminating "bad" companies. Such a portfolio may exclude all oil companies entirely.
"With ESG, beauty often lies in the eye of the beholder," says Robert R. Johnson, professor of finance, at Creighton University's Heider College of Business. Some may consider certain factors socially responsible while others don't.
"For example, some might consider The Coca Cola Company (KO) to be irresponsible because it produces sugary soda that leads to obesity and other health problems, yet it is a prominent holding in many ESG mutual funds and ETFs," he says.
ESG decisions can also be convoluted from a business perspective. Cort gives an example of a business that wants to invest $1 million in water efficiency technology that could save them $1 million per month in a future drought.
"Therefore, the business is taking on a risk that a water curtailment could impact them and that using less water would protect them from that risk," he says.
When incorporating ESG into your portfolio, it's important to look under the hood – be that the hood of a specific company or a fund. You need to look beyond a simple ESG score or label to discern the metrics that truly matter.
"The most effective strategies assess material sustainability factors at a sector-specific level," says Guy Gresham, a global capital markets and ESG expert who formerly served as Group Head of Global Investor Relations Advisory at BNY.
"A technology company's data security practices or an energy firm's climate transition strategy aren't just ethical considerations – they're fundamental business imperatives that directly impact valuation," Gresham adds.
With ESG funds, look at the investment strategy being used to ensure the fund manager's definition of ESG aligns with yours.
Why is ESG controversial?
"ESG has become a lightning rod in the investment world, with critics challenging everything from its methodology to its fundamental purpose," Gresham says.
Critics point to inconsistency in scores and a lack of standardization that bring its validity into question.
"The biggest problem in implementing ESG is that there are no universally accepted principles that constitute an ESG firm," Johnson says. "There are some firms, for instance, that produce sustainable products but have significant governance or labor issues."
This lack of standardization has led to variations in ESG scores for the same firm across rating providers. But standardization frameworks like IFRS Sustainability Disclosure Standards are working to resolve this.
There are also concerns over if it helps investment providers more by enabling them to market products as "ESG" without actually benefiting investors.
"The term has become politicized to represent two extremes," Cort says. One extreme is that it is a "distraction and dereliction of fiduciary duty." The other extreme is greenwashing, where companies mislead investors about their environmental impact.
Cort would argue that both of these are incorrect. "The reality is that ESG is only those environmental and social risks and opportunities that create and degrade financial value," he says. "So, the criticism is not fair because each side of the political spectrum is selecting only the extreme interpretation of a complex field in order to draw their criticism."
Ultimately, much of the controversy around ESG relates to a misconception about its purpose, Gresham says. "ESG is not a social movement disguised as an investment strategy – it's an analytical framework for identifying risks and opportunities that impact enterprise value."
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