ESG Investing has become fashionable in the last few years. However, much of it is not new. In this guide, we analyze what ESG investing is, its pros, as well as the risks involves in it.
- What is ESG Investing?
- Size of the ESG Investment Market
- How ESG Investing really works
- Positive aspects of ESG Investing
- Risks of ESG Investing
- How to Invest in ESG and Sustainable Investments
What is ESG Investing?
ESG investing, also commonly referred to as sustainable investing, takes into account social, environmental and governance criteria when making investment decisions. As a result of that, we can say that ESG investors give as much or even more importance to these criteria than more traditional financial metrics such as corporate profits and growth.
There are many investment strategies that can be categorized as ESG, as ESG has become a very fashionable word with which to associate many different types of investment strategies.
Next, we will discuss what each of those letters represent:
Investing according to environmental criteria is often referred to as sustainable investing. It is about putting the future of the environment and the planet first, and tries to combat problems such as climate change.
As you can imagine, sustainable investing emphasizes two things: pollution and energy sources.
When it comes to pollution, we will focus on the level of emissions or waste generated by a specific sector or company. We would then try to avoid investing our money in sectors with high levels of emissions, such as maritime transport.
On the other hand, if our priority is the development of renewable energy sources, we will invest our capital in companies that produce solar, wind or hydrogen energy. Some governments even issue sustainable debt, known as green bonds, to finance infrastructure projects that aim to develop these alternative energy sources.
Before ESG investing became so popular, environmental aspects were not entirely ignored. In fact, they were part of a company’s risk analysis. After all, a company that heavily pollutes the environment is more likely to receive fines and penalties. Remember the oil disaster caused by BP in 2010, when a huge amount of oil spilled into the Gulf of Mexico.
The S stands for social criteria. There are many different things that can be categorized as social.
On the one hand, some investors do not invest their money in sectors that they do not consider positive for society. Some examples would be tobacco, alcoholic beverages, gambling, or defense.
On the other hand, social criteria can also be measured for individual companies. In this sense, we do not discriminate based on what the company does, but according to its internal policies and practices.
Some criteria that investors look at are things like working conditions for employees, how many accidents have taken place in their plants, the number of women on the board or senior management positions, or whether the company donates to charitable causes.
In the past, social aspects were also part of a company’s risk profile. For example, a company with poor working conditions is more at risk of suffering strikes and production halts.
Finally, governance is also of great importance. Governance refers to how the company is managed. One of the main reasons for paying attention to the governance policies of a company is to ensure that its senior executives do not take advantage of shareholders.
Shareholders are the owners of the company. Senior executives, including the CEO, work for shareholders. However, the effective power of management is often greater than that of shareholders. Therefore, good governance is key to ensure the company is being well run.
Some aspects we will pay attention to are the number of years the CEO has been in office, whether there are board members who are not simultaneously directors of the company, the turnover within the board of directors and, of course, internal practices designed to prevent corporate corruption.
Often, external metrics such as a company’s credit rating depend partially on the quality and effectiveness of governance policies.
Governance considerations have been important for a long time. Many studies indicate a strong correlation between the quality of a company’s governance and the future investment returns for shareholders.
Size of the ESG Investment Market
The size of the ESG investment market has not stopped growing since the 1990s. And everything indicates that this trend will continue well into the future. While it is difficult to find out exactly how much investments are managed according ESG criteria, some organizations try to estimate that.
The US SIF Foundation surveys the most important money managers in the United States on a regular basis. One of the things they ask is whether they take ESG criteria into account when making investment decisions. The graph below shows how much money is managed according to ESG metrics or where ESG considerations are taken into account:
As you can see, in 2020 there were about $17 trillion that could be considered to follow ESG critera. In 1995, it was just over $600 billion. Consequently, the market has grown 25 times in just 25 years. The growth since 2012 has been astounding.
In fact, according to the Swiss investment bank Credit Suisse, Europe has the largest ESG capital market in the world, closely followed by the United States:
Regardless of our opinion about these efforts by supranational institutions, it is undeniable that ESG investing has a lot of momentum and will continue to grow over the coming years.
How ESG Investing really works
The asset selection process for investment funds, both active and passive, that take ESG considerations into account can work in two different ways:
Inclusions and Exclusions
This is the easiest way to invest according to ESG criteria. It is simply based on inclusions and exclusions.
On the inclusion side, we would look for investment funds that focus on certain economic sectors and activities. Some examples of that would be companies that manufacture solar panels or develop hydrogen technology.
We could also invest in green bonds whose proceeds were used to finance the development of sustainable projects. These green bonds can be issued by governments or private corporations, including oil producers working on the energy transition.
On the other hand, investment funds that focus on exclusions tend to be more diversified. For example, some funds invest in all companies of the S&P 500 stock index, except those that manufacture weapons, tobacco or alcohol.
The other way ESG can be part of the investment process is by integrating ESG metrics into the investment criteria.
In this sense, each company receives a rating or score. Based exclusively or partially on that, the fund manager will determine how much money they will allocate to each company.
Therefore, instead of only looking at a company’s market capitalization, growth prospects, or the economic outlook, we will also pay attention to the ESG rating it received. The better ESG metrics are, the more money we will invest in that company.
The difficulty of following this methodology is that it is often difficult to determine which criteria should be part of an ESG score, how they should be weighted, and who is responsible for calculating them. Investors have heterogenous opinions about what is most important.
The graph below indicates how much money is invested applying different types of methodologies for integrating ESG criteria:
As you can see, ESG investing can include many different things.
Positive aspects of ESG Investing
Now that we have discussed what ESG and sustainable investing is, and how it is done, let us focus on its positives:
Invest in what we believe in
The main benefit of considering ESG criteria when making investment decisions is that we have the option to invest in what we believe in.
In addition, ESG investing can offer quite a bit of flexibility. While it is true that only topics like the environment or certain social aspects are mentioned in the financial press, both of which could be a matter of debate, ESG investing also includes many things that most people would agree on. For example, not investing in companies that manufacture weapons.
Minimize Certain Risks
As we have already mentioned, although ESG investing has become fashionable in recent years, most metrics considered ESG nowadays were already analyzed in the past. They were part of the risks that existed when investing in certain companies and sectors.
For this reason, ESG investing allows us to minimize certain risks, specifically those associated with potential environmental scandals or fines, production stoppages due to labor strikes, or failures in the governance of a company that make it possible for a handful of executives to take advantage of it.
Potential to profit from a growing trend
Finally, another advantage of putting our money into ESG investment strategies is that this market is set to grow significantly in the future. As a result, regardless of whether the companies that rank highest in terms of ESG will make profits or grow, money inflows will continue. From a pragmatic point of view, we can take advantage of that by positioning ourselves in that trade.
Obviously, if we only invest in ESG to benefit from that trend, we will have to monitor the market on a regular basis to know when to move on to another investment.
Risks of ESG Investing
Despite its allure and reputation, ESG investing also carries some risks:
Most Financial Risks remain
While it is true that paying attention to ESG criteria can minimize certain risks, especially in the form of unexpected negative events, most of the risks of investing in the markets remain.
Therefore, following ESG criteria is no guarantee that we will not experience large losses eventually. For this reason, it is still necessary to diversify our portfolio and know where our capital is invested.
Excessive Exposure to Certain Sectors
A big problem with investing exclusively in ESG-friendly assets is that our portfolio can end up being excessively concentrated in a few economic sectors.
These sectors can be activities that are considered key for the future, such as renewable energy production or technology companies, or more traditional sectors whose companies rank highly in terms of ESG metrics. Both these things can be highly dangerous.
First, investing in sectors that are future-oriented is no guarantee for positive returns. A sector can grow simply because money is being invested there, and governments promote it
But for it to be a good long-term investment, capital must generate positive return. Oftentimes, technological advancements that have revolutionized our lifestyle in a positive way, including rail or air transportation, have turned out to be very poor investments.
When it comes to investing in traditional sectors with good ESG ratings, the financial sector tends to be overrepresented. After all, financial services have very low emissions, and companies in the sector tend to adapt quickly to social changes.
However, the financial sector faces important challenges in the upcoming decade.
Companies taking advantage of ESG Metrics
This is probably the biggest risk of ESG investing: putting our capital in companies that take advantage of ESG scores to capture investment flows.
If the weight of a company within a passive investment fund is determined by ESG scores, the company can deprioritize profits and growth and focus exclusively on improving its ESG metrics.
These better ESG metrics will translate into a higher ESG score, which will lead to greater inflows of passive investments. That will be great for the company’s executives who will be able to collect their bonus. However, it will be disastrous for those investors who invested their capital in a company that may not be profitable.
Higher Management Fees
One of the disadvantages of sustainable and ESG investment funds is that they usually have higher management fees. This is especially true when compared to ETFs tracking major global stock indices.
While management fees on ESG funds are probably not outrageous, we still need to factor them in when assessing what type of net returns we can expect in the future.
Of course, as ESG investing grows even more over the upcoming years, we can expect more ESG funds to come into the market. The higher competition should lead to lower management fees.
How to Invest in ESG and Sustainable Investments
The easiest way to invest in ESG or sustainable assets is to do it through an investment fund. This will allow us to delegate the task to a professional.
ESG funds are very varied. As we have discussed throughout this article, we can either focus on funds that have strict exclusions or inclusions for certain sectors, or funds that base their decision-making process on ESG criteria.
It should be noted that most ESG ETFs available contain stocks. However, there are also a few fixed-income funds that make it possible for us to invest in green bonds and other forms of sustainable debt.
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