What is ESG and why is it important? ESG, which stands for Environmental, Social, and Governance, is a set of criteria that rates how socially conscious and sustainable a company is. Environmental criteria consider how a company performs with respect to nature and sustainability.
The social criteria examine the quality of the relationships with employees, suppliers, customers, and communities.
Finally, governance inspects a company’s leadership and corporate behavior. These three aspects are analyzed, and a company is then given a rating based on its collective performance. As investors become increasingly conscious about where they invest their money, ESG criteria prove to be an extremely helpful way for investors to find companies that operate in a manner that matches their own moral standards.
Investing based on how strong a company performs with respect to ESG is becoming a growing trend among investors, especially those of a younger age. At the beginning of 2018, investors held an estimated $11.6 trillion in assets that were chosen due to ESG criteria, which was up from $8.1 trillion just two years prior.
Younger investors are much more aware of the social impact of their assets and are striving to create positive change along with profitable investments. Dave Nadig shows the changing investment landscape as he writes, “We’re in the middle of a $30 trillion intergenerational wealth transfer from baby boomers to their children. And those kids – not really millennials only, but people from 25 to 40 years old – simply think about their investment decisions differently.” The trend of socially conscious investing seems to be backed by a deep fundamental change in the thought process and priorities of the investor.
Along with the ability to match investors with companies who are socially responsible and share similar values, a company’s ESG rating has been proved to be correlated with how well a company is run. For example, a study by Harvard Law found that companies with low ESG ratings are far more likely to be poorly run and less sustainable. While companies that perform well with respect to ESG criteria have a higher ceiling for profitability as well as lower tail and systematic risk. Having a high ESG rating protects a company from possible changes in government regulations. In addition, market shifts, and the moral qualms of investors who are becoming less and less likely to invest in companies that have a poor social impact.
While looking at ESG is a great addition to the socially conscious investor’s toolbox, it is best used simply as another way to analyze a company’s potential growth. Research from the International Monetary Fund (IMF) states, “We don’t find conclusive evidence that sustainable investors underperform or outperform regular investors for similar types of investments.” While the profits of funds that invest in exclusively socially beneficial companies don’t necessarily differ from traditional funds, analyzing a company’s ESG rating is a great tool for an investor to discern more sustainable and thoughtful companies from the rest of the pack.
Moreover, how does a company’s thoughtfulness or sustainability affect its investors?
Keeping a diverse set of investments and judging a company based on many factors, including ESG, is a great recipe for financial success and a positive social impact.
From a company’s standpoint, it can be unclear if adopting ESG friendly practices is financially worthwhile. Since it is typically highly profitable companies like Microsoft and Home Depot that lead the way with ESG ratings, it can be difficult to differentiate how much profit companies can gain from operating with the ESG values. For companies on the smaller side, changing part of their business plan and perhaps sacrificing the cheapest option for a better ESG rating may not seem financially worthwhile.
However, several studies from outlets such as Harvard Law and MSCI have shown that if properly advertised, implementing ESG criteria attracts more investors as well as customers.
With additional revenue brought into the company, revenue can flow back into the ESG initiatives, creating a sustainable and progressive cycle. BNP Asset Management found companies with high ESG ratings to have lower operating costs as well as higher-performing share prices.
Additionally, investors are becoming less likely to trust their assets with a company that has a poor ESG, limiting its access to capital. The Harvard study found, “Firms that get in trouble as a result of ignoring eco-friendly practices may be distracted by the regulatory headache (higher costs) and customers may avoid the firm (lowering revenue). If one does not treat employees right, this could lower morale, increase turnover and therefore lower productivity.” This shows even more of the difficulties that can surface with a lack of social conscientiousness, as the number of problems that can haunt a company’s profits and sustainability rise substantially if ESG criteria is failed to be met.
The rising popularity of this style of investing also cannot be understated.
S&P Global writes, “In recent years, the uptake in using ESG data in the investment community has been notable. For instance, the number of financial institutions signing up to the Principles for Responsible Investment has been increasing year over year, with over 2,250 signatories in 2019.” The consistent increase in the number of public companies attempting to be recognized for their positive social impact is yet another sign of the growing emphasis.
Additionally, investment and asset management firms are becoming very aware of a company’s social impact, as industry titans such as BlackRock and Wellington have made significant investments where their assets are socially conscious, even dedicating trained professionals in ESG to their investment teams.
Moving forward, ESG will be of considerable importance to public companies as they attempt to create the image of being morally sound and sustainable, appealing to the new age of investors and consumers who care greatly about a company’s social impact.