What is ESG Investing?
ESG investing is an investment strategy which includes environmental, social, and governance (ESG) risks and opportunities in the investment decision-making process. ESG investing can be thought of as adding an extra layer of analysis compared with traditional investing analysis, since the more traditional approach often focuses on company and industry analysis.
ESG investing is becoming more important to the investment community for two reasons. Firstly, there has been significant growth in demand by pension funds and retail investors for their assets to be managed using an ESG strategy. Secondly, there is increasing evidence that incorporating ESG in an investment strategy improves portfolio returns. There are several ESG investing styles, depending on the investors’ priorities and their stock selection approach.
Key Learning Points
- ESG investing is an investment strategy that includes environmental, social, and governance (ESG) risks and opportunities in investment analysis
- ESG investing is becoming more important due to significant growth in demand for ESG investment funds and evidence of higher returns from ESG-based portfolios
- There are several ESG investing styles. Broadly, these can either be top-down (based on a specific ESG theme) or bottom-up (starting with a list of potential stocks that meet ESG criteria)
- ESG investing styles can also be based on values (doing good for society or the environment) or value (get a better return by minimizing ESG risks)
ESG Investing Explained
ESG risks are summarized by the categories below:
- Environmental risks
- Social risks
- Governance risks
Environmental risks arise from a company negatively affecting the environment through climate change, pollution, waste, or exploiting limited natural resources.
Social risks result from a company negatively affecting people or society (this includes employees, customers and the wider community). Examples of social risks include lack of health and safety procedures for employees or non-adherence to product safety protocols.
Governance risks relate to concerns from how a company is owned and managed, as well as the company’s exposure to legal and regulatory risk. Examples of governance risks include the quality of management or non-compliance with industry regulation.
Examples of ESG risks include:
- The impact of climate change regulations on the future profitability of oil and gas firms;
- Risk of antitrust regulations or restrictions on data usage disrupting the operations of technology companies; and
- Reputational damage from poor labor practices eroding a company’s brand value.
One of the major challenges with ESG analysis is that different sectors and industries are exposed to different risks; for example, the ESG risks for an oil and gas company are very different to the ESG risks for a technology company. ESG analysis therefore needs to focus on the risks which are material to the company and sector.
ESG Investment Styles
ESG investors can use a number of different approaches (‘investment styles’) when conducting ESG analysis. The most common approaches are summarized below:
In this approach, investors include or exclude certain companies from their list of investable companies, based on the company’s activities or characteristics. For example, investors may exclude all tobacco companies from the list of companies that it is able to invest in.
This approach involves selecting companies that perform well in terms of ESG metrics relative to their industry peers. This approach avoids the need to exclude certain sectors, thus reducing the risk of underperformance of a portfolio due to lack of exposure to specific sectors.
This is an approach where investors integrate the key ESG risks into their financial forecasts and valuation of a company. This approach therefore treats ESG risks as an extension of traditional investment analysis and therefore the investment decisions is based on an assessment of risk adjusted returns rather than ethical concerns.
This approach involves identifying themes that are important to investors. For example, if investors want to invest in clean energy, analysts will identify businesses that meet this criteria.
This approach involves investing in companies that are likely to generate a benefit for society. The idea is to generate both business and social returns.
Example: ESG Investment Styles
We have been asked to use the following information to determine which of the following FTSE 100 companies to invest in if the investment strategy uses:
- Ethical screening to exclude all tobacco companies and weapons manufacturers.
- Best in class screening to include companies with an ESG score above sector average score.
Investment Strategy 1: Ethical Screening
This is a relatively simple screening. Based on the information given in column C, we will exclude any companies involved in tobacco and aerospace and defense. If you can see in column H, we have added a “No” against companies falling in these two categories.
Investment Strategy 2: Best in Class Screening
For this strategy, we can use the IF function in Excel to determine which companies’ ESG score (column F) is higher than the sector average (column G). For example, BAE Systems’ ESG score of 90.0 is higher than the sector average (82), so we can see a “Yes” next to it.