ESG Investing: The Impact of ESG on Portfolio Returns
Conscious consumerism is now one of the biggest value-driven goals for anyone involved in a financial transaction. The idea of spending to support your values is now a fundamental principle that drives everyday consumers and influences the decisions of companies and governments, large and small.
For instance, over the last decade, the push for more responsible spending has prompted a large number of companies and institutions to focus on creating and implementing net-zero or carbon-neutral commitments—an effort to reduce greenhouse gas emissions.
As consumers gradually grew alert and kept on demanding climate action, adopting Environmental, Social and Governance (ESG) measure became one of the most important factors when it came to investing in businesses.
To help, here’s a primer on ESG investing: What it is, how it works and how to get started as an investor.
What is ESG and Why Is It Really Important?
Over the last few years, a variety of global events created more awareness regarding environmental impact, social policies and governance issues. The result is that more investors began to search for companies with ESG strategies and action plans that are aligned with their ESG investment values.
At the same time, companies became aware that they had to be more public about their values. Businesses couldn’t disregard the importance of ESG in a time where fear dominated and the future uncertain.
As the companies realized the depth of their new environmental and social responsibility, and the power of their governance, the ones who acted in alignment with them weren’t hit by the new conditions that grew out of a pandemic-ridden world, but actually managed to grow even bigger. This showed how important it was to set ESG goals and act to achieve them. The investment value on brands was tied to how determined they are to have a positive impact.
When explained in basic terms, ESG goals are set to draw a future action plan and strategy by corporate businesses to disclose their relations in the three areas of ESG. The areas and the topics they pertain to can be counted and clearly defined by Sustainability Knowledge Group as:
- Environment: climate change, carbon emissions, air and water quality, deforestation, energy efficiency, waste management, pollution, biodiversity, natural resource conservation.
- Social: customer satisfaction, data protection and privacy, gender and diversity, employee engagement, community relations, human rights, labour standards.
- Governance: Board composition, audit committee structure, bribery and corruption, executive compensation, lobbying, political contributions, whistle-blowing policy.
ESG (Environmental, Social and Governance): A set of criteria used to set the standards of how a company, institution or group manages and conducts business.
When these factors are considered, ESG is of utmost importance when investing as it helps investors use their money to make the world a better place and promote long-term sustainability.
Your Environmental Glossary
There are a variety of terms used when it comes to ESG investing and sustainable values.
To help, here’s a quick cheat sheet that defines the most common terms used in ESG.
Essentially means a person, business or entity has no carbon footprint (meaning no greenhouse gas emissions).
Free from contamination, dirt or pollution.
Produced or developed without inhumane testing on animals.
Showing concern for the environment.
An advocate for the environment and for the theory of environmentalism.
A theory that advocates for the preservation, restoration and/or improvement of the natural environment.
An expression coined by environmentalists as a way to describe surface actions that cover non-ESG actions, products, policies and activities.
Energy that can be replenished or renewed through natural ecological cycles or through sound management practices.
The ability to maintain or avoid the depletion of natural resources in order to maintain ecological balance.
How to Measure ESG Performance
There are many approaches when it comes to measuring ESG performance. Although it’s said to be hard to do, it certainly isn’t impossible to see how well ESG goals perform by simply following these four steps:
Step 1: Determine What Should Be Measured
ESG is a pretty broad concept. As a crucial first step, you should focus on what you will be prioritizing in your performance analysis.
Both external and internal drivers will shape what a company’s priorities are. If it works in a sector infamous for pollution in all known human history, and environmental performance report may be focused on. If an industry comes under fire for executive compensation, the social side of things could use some prioritizing instead.
Step 2: Identify Key Risks
Draw a risk framework that pinpoints and can track ESG threats and failings. Sharply defining ESG risks and the set action plan will help you see the strengths and weaknesses of an ESG goal strategy.
Step 3: Implement A Vigorous Measurement Program
With no indication of what best practices in ESG looks like, organizations might have a hard time benchmarking their performance. This can be resolved with standardized reporting. But businesses are mainly on their own when devising their ESG performance measures and working out how to track them.
Every tier of a company—the board, management and operational teams—needs to collaborate on devising these measures. It must also ensure that such measures translate to reality or there is no point in coming up with an ESG performance program.
Step 4: Don’t discriminate between the micro and the macro
This approach may either make you miss performance improvements or prompt a failure in determining the big picture.
How Does This Impact Portfolio Performance?
Having the opportunity to integrate ESG factors into investment processes fully takes time and requires a few rounds of trial and error. A good number of variables are involved in the process, and approaches vary between organizations and even teams.
Without differentiating amongst investors, the first thing to focus on is to get senior management buy-in when it comes to the benefits of integrating ESG factors into investment processes. If the senior management of a company doesn’t believe that ESG has anything to add when it comes to value, they will most probably not invest in resources to work on any. This will impact the long-term quality of their brand in the eyes of potential investors.
How Is ESG Policy Implemented?
According to a KPMG report with the title “Integrating ESG Into Your Business” published in 2020, there are three crucial steps in ESG policy implementation:
1. Getting the Basics Right
- Creating a sense of purpose for business that fosters ESG development with top management’s buy-in,
- Focusing on the top priority issues that make the greatest impact on the business and stakeholders.
2. Strengthening the Core
- Building proactive ESG governance with sufficient board oversight and identifying and addressing ESG-related risks,
- Developing vision-led and goal-driven sustainability strategies,
- Developing a robust data management system for progress tracking and target setting.
3. Communicating the Efforts
- Communicating the sustainability report vision and performance with company stakeholders regularly,
- Developing and publishing a sustainability/ESG report annually in line with local and international reporting standards,
- Engaging a third party to conduct independent assurance on the sustainability/ESG report and data.
How to Get Started with ESG Investing
Once you start investing and know what industries you want to support with your hard-earned money, you can start creating your portfolio. Use the following steps to determine your best ESG investment options:
- Read reviews from independent research firms such as Morningstar. These reviews can show you how a company or fund scores in terms of ESG investing factors, and whether these values fit with your ESG goals.
- Determine what investments you will hold. For example, will you invest in individual stocks of companies that focus on or practice ESG goals or will you select exchange-traded funds (ETFs) that follow ESG values?
- If you don’t want to manage your own ESG investment strategy, consider working with a financial planner or portfolio manager. Actively managed funds—either an ETF, mutual fund or pooled fund—mean a portfolio manager selects specific stock and bond holdings that align with ESG values.
Due Diligence Required by Investors and Financial Advisors
ESG is a broad and growing field that means different things to different investors. The first step in developing a socially responsible investment portfolio is to understand what you hope to achieve.
Investors who aim to invest based on ESG factors are led by a desire for returns as well as a need to follow their values.
For example, a client may wish to promote environmentally sustainable commerce or support companies that explicitly incorporate social responsibility into their governance systems. Or a client may want investments that are compliant with Sharia, the sacred law of Islam.
The good news is there are more options for all types of ESG-driven investors. For instance, there are now more Sharia-compliant investments and ESG values are now found in almost every type of investment product.
One of the most popular strategies is portfolio screening, which can take two, basic forms.
Negative screening excludes some companies or sectors from the possible investment universe based on certain criteria relating to the company’s policies, actions, products, or services (such as eliminating companies that manufacture tobacco products).
Positive screening specifically includes some companies or sectors in the investment universe based on the company’s meeting certain standards (such as seeking out companies with strong diversity programs).
Another approach is the best practices classification, where an advisor or investor chooses companies in a particular sector that ranks highly on one or more environmental, social, governance or ethical criteria, as well as the financial criteria.
A more active approach is to become a shareholder advocate. Using shareholder status, an investor can monitor management, initiate constructive dialogue about its business practices and influence managerial behaviour through proxy voting or direct engagement.
Although this active approach may not be feasible for the typical investor, investors can choose investment managers, pension funds and mutual funds that use this approach as part of their investment strategy. Keep in mind that active management does come with an extra cost—and this cost will show up in the fees.
