Environmental, social and governance (ESG) criteria are standards by which a company’s operations are judged so that socially conscious investors can screen them for potential investment.
What does ESG mean?
The environmental aspect requires research into how a company is impacting the Earth in both positive and negative ways. Companies that score highly here will be judged on their climate change policies, their greenhouse gas emissions and targets, water-related issues such as usage, conservation and waste disposal, recycling practices and so on.
While any one of these might signal a company’s good intentions, they would only merit being considered ‘E’ if they met the broad range of criteria and backed it up with data demonstrating their commitment.
For the social component, investors should look at how companies treat their employees and whether they lobby for or against social justice issues. Companies that score highly for ‘Social’ will treat their employees well, have a high level of employee engagement as well as high diversity and inclusion. Ethical supply chain sourcing also matters here such as using conflict-free minerals or responsibly sourced coffee and food.
‘Governance’ relates to the board of directors and company oversight. Investors want to invest in companies that disclose fair executive compensation including benefits and perks, demonstrate diversity on the board of directors or in management, have transparency in communicating with shareholders and so on.
Much of this information can be found by reading sustainability reports, and analysts will spend a lot of time dissecting companies before judging them to be worthy of an ‘ESG’ label.
Positive and negative screening
However, just because you’re on an ESG strategy does not mean you’re not going to have exposure to contentious businesses. You could have the highest scoring oil company which has worked hard to meet all the criteria and reach the highest ESG scores but you’ll still have a fossil fuel company in your portfolio. Investors therefore need to be aware that ESG is not a guarantee that their ethical preferences will be met. Be aware also that stocks are screened in different ways.
Investors who use positive screening will concentrate on industries and stocks that are considered ‘best-in-class’ on specific ESG criteria compared to their peers. This means the companies might not have the highest environmental scores, but that they are actively trying to improve them.
Negative screening involves excluding stocks and sectors such as all tobacco producers, oil and munitions companies, or companies with very low ESG scores. This made negative screening one of the original forms of values-based investing.
Many investors incorporate a bit of both positive and negative screening in their approaches, where they ignore stocks to which they are morally against while also choosing the best stocks in companies that are making a difference.
Greenwashing and how to avoid it
The growing trend towards ESG has ultimately led to companies wanting to cut corners. Greenwashing involves engaging in marketing and public relations activities that make a company appear to be aligned with ESG objectives. It’s a growing challenge for advisers and fund managers to keep on top of and ensure their portfolios don’t include any greenwashing. The challenge for advisers to keep on top of it to ensure their portfolios don’t contain funds that have potentially overstated their green credentials.
Luckily, standardised reporting methods and initiatives exist to promote clarity on ESG ratings:
- The Global Reporting Initiative: a global independent standards organisation that helps governments, organisations and businesses understand issues such as climate change, corruption and human rights.
- Sustainability Accounting Standards Board: this helps businesses around the world identify, manage and report on sustainability topics.
- The World Benchmarking Alliance: this focuses on creating benchmarks to identify keystone companies whose contribution is vital to achieving sustainable development goals.
With a wealth of research out there, fund managers and investors need to do their due diligence to make sure their investment choice suits their needs and is aligned to their philosophy rather than simply a managed risk.
A greener future
A 2019 sustainability report by BlackRock found that sustainable investing is no longer the niche area it once was - the report goes as far to say that it’s going mainstream: “Assets in dedicated sustainable investing strategies have grown at a rapid pace in recent years. This demand looks poised to accelerate — driven by societal and demographic changes, increased regulation and government focus, and greater investment conviction.”
“This is an area of investment which is growing all the time,” says Tom Sayers, Head of Investment Solutions at Parmenion. “Demand is growing too, and we expect this to continue well into the next decade until companies ultimately follow ESG criteria as the standard.”
If you would like to find out more about ESG funds and their future, please contact your Financial Adviser.