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[Prefer to listen? You can find a podcast version of this article here: E187: ESG Investing Defined – A Beginner's Guide]

As the world becomes increasingly conscious of the impact of our actions on the environment and society, many investors are looking for ways to align their investments with their values.

One way to do this is through ESG investing. But what exactly is ESG investing?

Investing is a nuanced and sometimes complex space and values/impact-based investing is no exception. The space is filled with jargon and confusing terminology that can cause confusion. Additionally, ESG has become politicized which only adds to the issues.

Let’s cover the basics of ESG and discuss at a high level what it is and how it can apply to your investments.

What is ESG?

ESG stands for Environmental, Social, and Governance, and it refers to a set of criteria that investors use to evaluate a company's overall impact on the environment, society, and corporate governance.

ESG investing takes into account not only a company's financial performance but also its impact on people and the planet. Companies that prioritize ESG principles are more likely to have a positive impact on society and the environment, which can lead to long-term sustainable growth.

ESG investing involves analyzing a company's ESG performance and integrating that analysis into investment decisions. This means looking at a company's environmental impact, such as its carbon emissions and waste management practices, as well as its social impact, such as its labor practices and community engagement. Governance factors, such as board diversity and executive compensation, are also considered.

In recent years, ESG investing has become increasingly popular as more investors seek to align their investments with their values. This has led to an increase in demand for ESG investments, which has in turn driven the growth of the ESG investing industry.

Why ESG Investing is Important

ESG investing is important for several reasons. For one, it allows investors to align their investments with their values and have a positive impact on society and the environment. By investing in companies that prioritize ESG principles, investors can support companies that are working towards a more sustainable future.

In addition, ESG investing can also provide financial benefits. Companies that prioritize ESG principles may be more likely to have a long-term sustainable growth trajectory, which can lead to better financial performance over time.

ESG investing can also help investors identify potential risks and opportunities that may not be reflected in traditional financial analysis.

As an example, let's consider the Deepwater Horizon oil spill in 2010 as an example of an ESG risk factor.

• Environmental Risk: The Deepwater Horizon event was one of the most significant environmental disasters in history, leading to massive pollution in the Gulf of Mexico. This resulted in extensive damage to marine and wildlife habitats as well as to the fishing and tourism industries.
• Social Risk: The spill affected the health and livelihoods of people in the surrounding communities. Many fishermen and workers in related industries lost their jobs, causing a significant social impact. Additionally, health issues linked to the cleanup efforts emerged, creating further social harm.
• Governance Risk: The incident also highlighted governance issues at BP. Prior to the event, BP had a history of safety issues, and the disaster raised questions about the effectiveness of its risk management policies and procedures. The subsequent investigations, financial penalties, and damage to their reputation are all tied to governance risks.

These risks and the failure to manage them appropriately had substantial financial and reputational impact on the company. This example illustrates the potential material impact of ESG factors on a company's performance, and why it's important for companies to identify, assess, and manage ESG risks.

Finally, ESG investing can also help drive positive change. By investing in companies that prioritize ESG principles, investors can send a message to companies that they value sustainability and social responsibility. This can incentivize companies to improve their ESG performance and work towards a more sustainable future.

The Growth of ESG Investing

ESG investing has grown significantly in recent years. In 2019, global sustainable investment assets reached $30.7 trillion, up from $22.9 trillion in 2016. This growth has been driven by a number of factors, including increased awareness of the impact of climate change, growing consumer demand for sustainable products and services, and the increasing availability of ESG data.

One of the key drivers of ESG investing growth has been the rise of passive ESG investing. Passive ESG funds track ESG indexes and invest in companies that meet certain ESG criteria. This approach has made it easier for investors to incorporate ESG principles into their portfolios without having to conduct their own ESG analysis.

Another factor driving ESG investing growth is the increasing availability of ESG data. As more companies report on their ESG performance, investors have access to more information to help them make informed investment decisions. This has led to the development of ESG ratings and rankings, which provide investors with a standardized way to evaluate a company's ESG performance.

ESG Investing Strategies

There are several ESG investing strategies that investors can use to incorporate ESG principles into their portfolios. These strategies include:

• Negative Screening: involves excluding companies that do not meet certain ESG criteria from an investment portfolio. For example, an investor may choose to exclude companies that have a poor environmental track record or engage in unethical business practices.
• Positive Screening: involves selecting companies that meet certain ESG criteria for investment. For example, an investor may choose to invest in companies that prioritize renewable energy or have a diverse board of directors.
• ESG Integration: involves incorporating ESG analysis into traditional financial analysis to make investment decisions. This approach considers both financial and non-financial factors when evaluating a company's potential for long-term sustainable growth.
• Impact Investing: involves investing in companies or funds that have a specific social or environmental impact. For example, an investor may choose to invest in a fund that supports renewable energy projects or provides funding for underserved communities.

Key ESG Metrics and Factors

When evaluating a company's ESG performance, there are several key metrics and factors to consider. These include:

Environmental Metrics

• Carbon emissions
• Energy efficiency
• Waste management
• Water management
• Biodiversity

Social Metrics

• Labor practices
• Human rights
• Diversity and inclusion
• Community engagement
• Product safety

Governance Metrics

• Board diversity
• Executive compensation
• Shareholder rights
• Anti-corruption policies
• Ethics and compliance

ESG Investing vs Traditional Investing

ESG investing differs from traditional investing in several ways. While traditional investing focuses primarily on financial performance, ESG investing takes into account a company's impact on the environment, society, and corporate governance. This means that ESG investors may choose to invest in companies that prioritize sustainability and social responsibility, even if those companies may not have the highest financial returns in the short term.

ESG investing also involves a different approach to risk management. Traditional investing may focus primarily on financial risks, such as market volatility or credit risk. ESG investing, on the other hand, may also consider non-financial risks, such as reputational risk or regulatory risk.

Finally, ESG investing can also provide investors with a way to diversify their portfolios. By investing in companies that prioritize ESG principles, investors can gain exposure to industries and sectors that may not be represented in traditional investment portfolios.

ESG Investing Opportunities

There are several ways to incorporate ESG investing into your financial plan. These include:

ESG Mutual Funds and ETFs

ESG mutual funds and ETFs are the primary and most popular way to incorporate ESG. These are investment vehicles that invest in companies that meet certain ESG criteria. These funds may use negative screening, positive screening, ESG integration, or impact investing strategies to select investments.

The availability and popularity of these mutual funds and ETFs continue to grow and are making ESG investing more accessible than ever.

Green Bonds

Green bonds are debt securities that are issued to fund environmentally friendly projects. These projects may include renewable energy infrastructure, sustainable agriculture, or water conservation projects.

Community Investing

Community investing involves investing in funds or projects that support underserved communities. These investments may focus on affordable housing, community development, or microfinance.

Impact Investing Funds

Impact investing funds focus on investing in companies or projects that have a specific social or environmental impact. These investments may include renewable energy projects, sustainable agriculture, or healthcare initiatives.

How to Get Started with ESG Investing

If you're interested in getting started with ESG investing, here are some tips to help you get started:

Define your values

Before you start investing, it's important to define your values and determine what kind of impact you want to have with your investments. This will help you identify which ESG factors are most important to you and guide your investment decisions.

Research ESG investments

There are many ESG investment opportunities available, so it's important to do your research to find the ones that align with your values and investment goals. You can start by researching ESG mutual funds and ETFs, green bonds, and impact investing funds.

Evaluate ESG performance

When evaluating ESG investments, it's important to consider a company's ESG performance. This may involve reviewing ESG ratings and rankings, as well as analyzing a company's environmental, social, and governance metrics.

Consider your risk tolerance

Like any investment, ESG investments carry risks. It's important to consider your risk tolerance and ensure that your ESG investments align with your overall investment strategy.

Monitor your investments

Finally, it's important to monitor your ESG investments regularly to ensure that they continue to align with your values and investment goals. This may involve reviewing ESG performance metrics, as well as staying up to date on any news or developments related to your investments.

For a more in-depth overview of getting started with ESG investing, see our webinar: How to Evaluate and Select Socially Responsible Investments.

ESG Investing Challenges and Risks

While ESG investing offers many benefits, it's not without its challenges and risks. Some of the key challenges and risks of ESG investing include:

Limited ESG data

While ESG data is becoming more widely available, there is still a lack of standardized ESG reporting. This can make it difficult for investors to compare ESG performance across companies and sectors.

Greenwashing

Greenwashing refers to the practice of companies making false or exaggerated claims about their environmental or social impact. This can make it difficult for investors to accurately evaluate a company's ESG performance.

You are likely noticing that many “big name” financial institutions are putting the ESG label on their funds in an effort to follow the trend. However, there are many established but lesser-known funds that have been built on a foundation of ESG from the start.

Higher fees

ESG investments may sometimes carry higher fees than traditional investments, which can impact investment returns. This is a trade-off that many investors are comfortable with because of the alignment with ESG values.

Limited diversification

ESG investments may be concentrated in certain industries or sectors, which can limit diversification opportunities.

Performance trade-offs

While the data is inconclusive, investing in companies that prioritize ESG principles may result in lower financial returns in the short term, although there is evidence to suggest that ESG investments can provide better long-term financial performance.

Ultimately, there is no guarantee that ESG investments will perform better or worse than their traditional counterparts.

Conclusion

ESG investing offers investors a way to align their investments with their values and have a positive impact on society and the environment. By incorporating ESG analysis into investment decisions, investors can support companies that prioritize sustainability and social responsibility, potentially leading to long-term sustainable growth.

So what is the real impact? While the question is sometimes controversial, there is evidence to suggest that ESG investing does make a difference in the world. For additional data that cuts through the noise and delivers the facts about ESG, see 10 things to know about ESG and sustainable investing from US SIF: Sustainable Investment Forum.

While ESG investing offers many benefits, it's important to do your research and consider the potential risks and challenges before making investment decisions. With careful planning and evaluation, ESG investing can be a powerful tool for creating positive change and achieving investment goals.