Recently, many investors are following ESG to help them with their investments. Why? This is because investors want their money to reflect their values. So with the help of the ESG criteria, they will know what company they can invest in so they won’t have to worry about any financial troubles in the future. Here is what goes on when investors use ESG.
ESG
ESG stands for “Environment, Social, and Governance”, and they are the three criteria that measure the impact of an investment or a company. The data that is contained will help socially conscious investors screen out potentially troubled companies. Therefore, investors can avoid any companies that might bring great financial risk to them.
Environmental criteria measure a company’s performance in handling the environment. This can include energy use, waste, pollution, animal treatment, and natural resource conservation. The criteria can also evaluate how a company handles any potential environmental risk. There have been examples of companies having their stock prices damaged from an incident such as BP’s oil spill in 2010.
Social criteria measures how the company handles its business relationships. This can include employees, suppliers, customers, and the local community. The criteria also ask the following questions. Does the company work with suppliers with similar values? Do they donate any of their profits to charity? Are employees encouraged to participate in volunteer work? Does the company put a high value on the health and safety of its employees?
Finally, the Governance criteria ask if the company has accounting methods that are accurate and transparent. They also ask if stockholders are allowed to vote on important topics. This is done to make sure that companies do not have conflicts of interest with their board members. This also applies to any unfair political contributions to gain favorable treatment or engaging in illegal activities.
Ratings Of ESG
The ratings for ESG are ranked in three categories, Laggard, Average, and Leader. Laggard (CCC to B) is the lowest category, meaning that a company lags in its industry due to high exposure and inability to address these issues. Average (BB to BBB to A), is the middle meaning that a company has mixed results in acknowledging and managing its risks. Leader (AA to AAA), is the highest which means that the company is a leader and is handling their biggest risks.
It should be noted that the company can’t pass every single category in the test. Naturally, investors need to prioritize what is most important to them. Many products from brokerage funds, mutual funds, and Robo-advisers follow the ESG criteria. Betterment and Wealthfront are examples of Robo-advisers that use the ESG criteria.
ESG can sometimes be used with other investment strategies including sustainable investing, impact investing, conscious capitalism, shareholder activism, and socially responsible investing. Companies such as JPMorgan Chase and Wells Fargo feature a review of their ESG approaches in their annual reports.
One of the biggest reasons why ESG has become very popular is due to Millennials. Many have a sense of social responsibilities and it shows in their purchases, investment portfolios, and the organizations they work for. Because of the large number of Millennials in the US, businesses are rethinking the way they work by incorporating ESG strategies and making public stands on issues.
Example:
Here’s an example of an investor using the ESG criteria; one investor is looking to invest in one of two companies he is interested in. But he needs to evaluate each company before he begins to invest. According to the Environmental criteria, both companies pass the criteria with an AA as they are praised for their handling of natural resources and energy.
However, the Social criteria are where company 1 falls short with a B rating. Company 1 has recently been involved in a scandal where they haven’t followed CDC’s guidelines for businesses making the place unsafe for workers. As a result, many of the employees have tested positive for COVID-19. This disturbs the investor as he highly values health and safety when it comes to investing in a company. This raises major doubts about the investor’s chances of investing in Company 1.
Company 2, on the other hand, has done the opposite. They have followed the guidelines and ensured that their work environment is safe by requiring employees to have health checks, wear masks, and practice social distancing. Company 2 has also invested in improved ventilation systems and cleaning equipment. As a result, there have been much fewer cases of COVID-19 for Company 2’s employees with their ESG rating being AAA. This impresses the investor and he gains interest in investing in Company 2.
Governance criteria further show company 1’s shortcomings. The recent scandal was due to the disputes between the board members on how to handle the pandemic in the workplace. Some dispute that the pandemic won’t leave an effect on the workplace, while others disagree. Once again the inner turmoil of the company casts a larger doubt into the investor’s mind about company 1 leading him to invest in Company 2.
Pros for ESG: Helps investors know which companies are worth investing in. Helps bring awareness to any social issues in the world right now. This gives businesses a way to rethink their business models and take a stand on social issues. It reflects the values of an investor when picking a company. Allows companies to know what they can work on. Millennials are leading the way for ESG investing.
Cons for ESG: An ongoing risk for ESG is there is a lack of standards in the industry. This may lead to some ESG firms to use the area for marketing purposes rather than a disciplined ESG investment strategy. Companies may leave out their ESG attempts and drop their sustainability data becoming more stakeholder-centric. The standards of a good performance in ESG will vary from age group to age group, the younger ones accept underperforming investments as long as they invest in high sustaining companies. Young investors are inexperienced with handling major economic downturns and they could abandon any of their investments should a downturn occur.
ESG Data and investing have become a new form for investors and companies. It helps investors know what companies would bring success while also addressing the numerous social issues. On the other hand, companies would be able to know what they should prioritize in improving. While it may become mostly a Millennial driven industry, it has been reshaping business models and creating products that implement ESG strategies.
Expert Tip:
As a potential ESG investor, you should always analyze ESG data so it consistently aligns with your investment techniques, moral and ethical views.
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References
Chen, J. (2020, November 03). Environmental, Social, and Governance (ESG) Criteria. Retrieved November 19, 2020, from https://www.investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp
Rotonti, J. (2020, October 05). Your Guide to ESG Investing: Socially Responsible Stocks. Retrieved November 19, 2020, from https://www.fool.com/investing/stock-market/types-of-stocks/esg-investing/
MSCI. (n.d.). ESG Investing: ESG Ratings. Retrieved November 20, 2020, from https://www.msci.com/our-solutions/esg-investing/esg-ratings
