ESG Investing: A Trend You Need to Know
Originating in the mid-2000s, ESG has quickly come to be considered an essential aspect of investing. At once a trend and a political phenomenon, the consideration of Environmental, Social and Governance factors in portfolio management has significant implications for investors and for business in general, which must be understood.
The concept’s origins lie in the 1950’s and 60’s movement of Socially Responsible Investment, SRI. SRI is characterised by screening strategies, excluding what are known as ‘sin stocks’ which conflict with the set of values held by the investor. This can be effective in causing social change. A massive disinvestment campaign toward South Africa caused a dramatic capital flight in the 1980’s, successfully putting pressure on the Apartheid regime. This was aided by the zeitgeist of the time, and the widespread adoption of the ‘Sullivan Principles’ by corporations, which required the encouragement of non-discrimination.
However, most moral causes aren’t as easily defined and widely supported. Efforts by some to avoid things like alcohol companies were obviously less successful. This form of investing has also drawn academic criticism. Milton Friedman decried socially responsible practices such as this, suggesting that such strategies would function as a ‘tax’ of sorts on shareholders. Indeed, artificially narrowing the range of options for a portfolio logically has to impact returns. Additionally, where the wider market isn’t united by a set of Sullivan-equivalent principles, exclusion can only cheapen stocks for ‘sinful’ investors, making its effective impact doubtful.
Today’s ESG is different, as a result. Instead of a simplistic avoidance strategy, investors are incorporating Environmental, Social and Governance factors into their financial analyses, aided by ESG rating agencies like MSCI and Sustainalytics. This system has distinct advantages for investors. Poor ratings in ESG dimensions imply a greater risk that an investment might sour; a less sustainable business for instance is more vulnerable to climate change, while one that treats its workers poorly is more likely to face strikes. These risks can be reduced significantly through ESG inclusive analysis. ESG factors additionally can add value to a company; companies that better engage employees see lower turnover and higher profitability. Evidence suggests that this investment strategy can lead to out-performance in the medium to long term as a result.
Its advantages aren’t all quantitative. Optimistic commentators consider this an antidote to benchmark-driven investment which puts pressure on companies to compromise their long-term value and the benefits they provide stakeholders in pursuit of short-term shareholder returns. Millennials are more concerned than previous generations with the ESG issues, and the strategy is narrow and concrete enough to allow investment principles to condense around it, such as the UN Principles for Responsible Investment. It has been able to have political effect as a result, encouraging decisions like the Business Roundtable’s recent stakeholder-oriented redefinition of the purpose of a corporation, which would have been impossible without ESG research legitimising such actions.
Challenges still remain, of course. Finding information on ESG factors remains difficult due to a lack of universal disclosure standards. Investor pressure for regulatory action by organisations such as the EU and SEC are changing this, but it remains especially a problem in emerging markets – ironically, the place where it is most needed to assess investment risks. Additionally, ESG strategies are very young and have yet to be tested in an economic downturn.
Despite these challenges, the relevancy of ESG factors will only increase in the near future, with the increasing intrusion of climate change into people’s lives, and with millennials’ lack of faith in status quo capitalism. Additionally, it provides potential and material benefits that are too useful for investors to ignore. Understanding ESG therefore is and will remain important for understanding trends in business and governance.
Gabriel Victor