ESG—one facet of sustainable investing—has quickly become a key differentiator for investors, one that can tip the scales in many cases between similarly positioned companies, or even help shore up an otherwise disadvantaged prospect.
Given the rise of this framework and the sway that it can have on market decisions, companies and investors alike are taking an interest in this tool and the insights it can provide into investment opportunities.
What is ESG?
What does ESG stand for and how does it relate to the broader category of sustainable investing? ESG—or “environmental, social and governance”—is a framework used to evaluate a company’s risk exposure, management capacity and opportunities for value creation in multiple fields relating to social and environmental sustainability, legal and regulatory compliance and ethical business practices. An organization’s ESG performance is assessed across topics such as environmental impact, internal and external dynamics, treatment of workers and transparent and legal use of funds, among many others. ESG scores assign numerical values to performance for each category and can point to strengths and weaknesses in a potential investment, serving as an indicator of future performance and liabilities.
When considering ESG, it is important to note the distinction between ESG as a company-level risk management mechanism and ESG as an investment framework. The former serves as the basis for the latter, which seeks to use ESG-related data in addition to more traditional financial metrics as a means of evaluating possible investments
The benefit of including an ESG investing framework into the assessment of an investment is that it considers material non-financial risks that may be missed by a purely financial-based analysis. Given this position, ESG is most effective when used alongside other criteria and frameworks to evaluate investments. Though entities may label themselves as ESG private equity firms or something to that effect, ESG should not be seen as an investment strategy on its own but serves as a complement to one.
Why is ESG important?
An analysis of ESG factors can signal a company’s focus on a wide variety of societal issues, while also being an actionable tool for investors to use to measure and anticipate potential risks and opportunities to create value. If a company scores low in its environmental competency due to repeat environmental regulatory violations, potential investors would be wise to question the company about their steps to ensure that the chances of further events will be mitigated.
If said company were to cause an environmental crisis, such as an oil spill, a major contamination event or something of similar magnitude, they could very well to face repercussions from multiple parties, which could negatively impact one’s investment through reputational harm, litigation costs, regulatory penalties and cleanup costs.
By the same token, low scores in the “social” or “governance” fields could indicate the possibility of events such as strikes, employee health and safety crises, or the discovery of illegal dealings. The three titular aptitudes of ESG—environment, social and governance—represent some of the most common and impactful sustainability-related pitfalls a company is likely to encounter, making this framework a valuable addition to any sort of preliminary or ongoing investment research.
By performing an ESG risk analysis in advance, investors can assess scenarios such as the ones listed above to make a more informed decision about whether a company’s risks overwhelm the investment case or whether the price on the asset will still lead to a profitable investment, even if these risks manifest. As evidenced by these examples, ESG can cover a valuable subset of information that can’t be extracted solely from traditional sources such as company financials. Many portfolio managers will say that the best way to make money in the long run is to avoid big losses. The ESG framework is designed to identify the potential for big losses by providing a more holistic view of a company.
Why is ESG so popular?
With the ESG data market reaching $1 billion in 2021 and continuing to grow at a 20% annual rate, it’s clear investors see it as valuable, but what accounts for this recent interest? One of the foundational causes behind ESG’s current momentum is the increased regulatory pressure to disclose ESG-related data in places such as the United States and European Union. This push has been compounded by an increased affinity for ESG metrics and analytics from investors and advisors, who are actively seeking more data and using it in new and increasingly varied applications.
As more market participants utilize ESG metrics and scores in their analysis, one interesting trend is the wide variety of uses they are finding for it. For example, while some are purists and only want to invest in companies with good ESG profiles, others will see a poor score as an opportunity for upgrades and profit. Some activist investors will go so far as to engage with company management to seek improvements in the company’s policies and practices. This approach may lead to the company getting a better ESG score, which will attract purists and potentially improve the valuation of the company – a profitable outcome that started with a “bad” ESG company.
ESG standardization and adoption
Though ESG has seen significant traction in recent years, there are some that worry about its implementation and viability as a widely used standard. This outlook stems from the concern that ESG scores are too narrow to account for the nuances of different regions, industries, etc., and would leave some parties at an inherent disadvantage. According to these arguments, sectors like oil would automatically be expected to receive poor ESG scores, so a portfolio of strictly good ESG scores could be unbalanced from a sector diversification perspective. This result could diminish the utility of the framework and the willingness to adopt it.
In 2018, the Sustainable Accounting Standards Board (SASB) established a common framework for ESG reporting across all businesses. Through the involvement of asset managers, allocators, companies and other relevant parties, they were able to define ESG in financially material terms specifically outlined for each of 77 industries.
Another important characteristic of the SASB’s ideation is that ESG standards are specific to each industry, but universal across regions. This means that it can vary based on the demands and intricacies of each industry, while also remaining applicable to a global audience.
What is an ESG fund?
The importance of ESG has not only led to the increasing adoption of ESG standards, but also products called ESG funds. Like other ETFs and mutual funds, ESG funds represent a portfolio of investments with some guardrails around what types of investments may be included. For “ESG funds” (as mentioned above, ESG is a framework additive to any investment process, so the idea of ESG funding becomes meaningless when one considers that material non-financial risks can be part of the analysis of any type of investment), their main intention is to differentiate themselves by taking ESG performance into account when allocating capital, though except for perhaps some ESG ETFs, this will only be one of the factors being considered prior to investment.
Despite being connected by a common framework, there are many areas in which ESG funds may diverge. For example, the weight given to assessments or scores relative to other factors can vary from fund to fund, as can fund standards for what qualifies as ESG. Some may only invest in “clean” companies, while others hope to profit from an improving ESG profile.
Furthermore, different funds may choose to focus on different components of ESG in their investments. You may find that one fund favors companies with a strong environmental commitment, while another only targets those with balanced scores in all three categories. Some fund managers will still insist they have been “doing ESG” for a long time because they have been evaluating corporate governance after corporate disasters such as Enron.
Regardless of their differences, many are coming around to the belief that by adding in ESG considerations to a fund’s investment process, investment returns will have a truncated downside return pattern because material risks have been spotlighted, assessed and hopefully mitigated.
How do companies use ESG?
With ESG gaining acceptance among LPs, GPs and service providers, many private businesses have also begun to leverage ESG strategy and associated data to attract investors. When capital is scarce, companies seeking investment have an incentive to look as attractive as possible to potential investors. By doing what they can to improve their ESG profile, they can improve their chances of securing investments from the growing number of investors adopting ESG approaches.
Meeting ESG KPIs can be a key factor in improving external relations, but it can also support internal development efforts. For example, efforts to reduce negative environmental impacts by cutting water and energy consumption will also likely lead to reduced operational costs, effectively addressing both ESG and profit margin concerns at once. On a similar note, efforts to create and maintain safe working facilities can cut down on the need for maintenance, lower worker compensation costs and can lead to greater employee retention and morale. In other words, the company becomes more sustainable with better focus on mitigating these risk factors.
What is an ESG metric?
PitchBook recently added new ESG data integration features in the form of public company ESG scores from Sustainalytics. These will allow users to easily view company-level ESG risk profiles and the factors that contributed to the scores. This feature also offers options to see how a company compares to industry averages and see the best ESG scores within a given space.
What does ESG stand for?
ESG stands for environmental, social and governance, the three categories into which corporate sustainability concerns broadly fall.
What are examples of sustainable investments?
Sustainable investing is a broad field that can be broken down into a variety of related categories and practices. Examples of sustainable investments include ESG, green investing, SRI and impact investing. Each of these frameworks or modes of sustainable investing prioritizes different metrics or objectives, such as ESG’s focus on risk mitigation or SRI’s emphasis on societal improvement.
What is the difference between ESG and Impact?
ESG is distinguished from Impact in that it is concerned with inward-facing, or internal, risks and opportunities and how they affect company performance. ESG covers a vast variety of topics, including energy management, ecological impacts, data privacy and security, product quality and safety, labor practices, supply chain management, and business ethics, among many others. Impact refers to an intent to use investment capital to create positive environmental or social impact on the external world while still seeking to accumulate wealth through investment returns. Impact investors may target a multitude of categories, including health, education, energy, or real estate and affordable housing.
What is the difference between ESG and SRI?
ESG is a framework for evaluating companies, while socially responsible investing, or SRI, typically describes an investment philosophy that screens out investments that conflict with an investor’s mission or values.
What is the difference between CSR and ESG?
Corporate social responsibility, or CSR, is a belief that companies must act in the interest of the public good. Though ESG and CSR may lead to similar outcomes like better working conditions and better environmental policies, the motive behind ESG is risk mitigation and doesn’t necessarily reflect any moral commitment.
What is an ESG score?
An ESG score is a measurement of a company’s risk exposure, risk management, and value creation across ESG topics. It is used to reflect material non-financial risks and identify focus points to analyze when assessing the value of an investment.
What is a good ESG score?
Different agencies will use different scales to measure ESG, but examples include MSCI, which rates on a scale from 1-10, 10 being the highest, with the average company hovering somewhere around 5. In contrast, Sustainalytics scores companies from 1-40, with a lower score being more desirable.
What is greenwashing?
Greenwashing is the use of misleading branding or statements that give the impression that a company or firm is practicing sustainable investing. Given its connection to sustainable investing, they are commonly mistaken for each other, causing some investors to apply the term incorrectly.