4min read
Published on: Jul 8, 2024
Environmental, social, and governance (ESG) factors have historically been a sideline concern for many finance teams and their companies. However, they have become a major reason people invest in some businesses before others nowadays.
There has been growing support for the concept of stakeholder capitalism and recognising the importance of creating long-term value among businesses. It is a commitment that, surprisingly to some, has remained strong despite the economic pressures that have risen from the COVID-19 pandemic.
According to a 2022 PwC report, ESG-focused institutional investment is expected to increase 84% to $33.9 trillion by 2026. Stakeholder capitalism is a philosophy based on the belief that companies have an obligation beyond simply providing shareholders returns. It suggests that companies should be mindful of and responsive to their impact on society and the environment. This can involve creating secure jobs, embracing sustainable practices, serving customers loyally, cultivating long-term supplier relationships, paying fair taxes or working to minimise the adverse impact on the environment.
Environmental, social, and governance (ESG) factors in the past felt like a sideline concern for many finance teams and their companies. The rise of ESG investing shows no signs of slowing down, with Bloomberg reporting global ESG assets will top $53 trillion by 2025. But why the sudden surge? And what, exactly, are the benefits of ESG investing? Below, we uncover the concept and benefits of ESG investing, how ESG investing works, and the top ESG investing trends.
ESG investing (also known as “socially responsible investing,” “impact investing,” and “sustainable investing”) refers to investing in businesses or startups that prioritise optimal environmental, social, and governance (ESG) factors or results. It is based on the growing assumption that environmental and social factors increasingly affect organisations' financial performance.
This form of inclusive capitalism is not new–it started in the 1950s and 1960s–when religious and ethical beliefs influenced investment decisions. This time, it is closely linked with climate change, diversity and human rights issues. The growing popularity of corporate social responsibility (CSR) and social sustainability has increased investor awareness about ethical participation in the market. Pre-pandemic examples of the move away from pure shareholder capitalism include the Davos Manifesto from the World Economic Forum (WEF), the Business Roundtable’s Statement on the Purpose of a Corporation, and the Embankment Project for Inclusive Capitalism report created by the EY organisation and the Coalition for Inclusive Capitalism.
ESG investing may have officially entered mainstream investing discourse following the release of the Principles for Responsible Investments (PRI) in 2006. The PRI is a set of United Nations guidelines for incorporating ESG factors into business policy and strategy. With over 2,000 signatories, it is widely considered the official point of reference for all ESG investing.
To assess a business based on ESG metrics, investors look at a broad range of behaviours and policies. ESG investors seek to ensure the companies they fund are responsible stewards of the environment, good corporate citizens, and led by accountable managers based on three different criteria:
Investors evaluate corporate climate policies, energy use, waste, pollution, natural resource conservation, and animal treatment. Considerations may include direct and indirect greenhouse gas emissions, management of toxic waste, and compliance with environmental regulations.
Includes evaluating a company's relationships with internal and external stakeholders. Does the company donate a percentage of profits to the local community or encourage employees to volunteer? Do workplace conditions reflect a high regard for employees’ health and safety?
This ensures that a company uses accurate and transparent governing models, pursues integrity and diversity in choosing its leadership, and is accountable to shareholders.
ESG investors may require assurances that companies avoid conflicts of interest in selecting board members and senior executives, don't use political stances to get preferential treatment, and don't engage in illegal conduct.
There is no definitive taxonomy of ESG metrics. They are often interlinked, and it can be challenging to classify an issue as only environmental, social, or governance-related.
These ESG factors can often be measured (e.g., what the employee turnover for a company is). Still, it can be difficult to assign them a monetary value (e.g., the cost of employee turnover for a company).
Image: Win turbines in a green field, by Freepik
Environmental
Considers the environmental impact:
Social
Considers people and social impact:
Governance
Considers uniform standards for running a company:
In recent years, there has been a rise of ESG investing trends around the globe as organisations and individuals increasingly recognise the interdependencies between social, environmental, and economic issues.
Market disruption and uncertainty caused by the pandemic in 2020 led many investors to turn to ESG funds for increased resiliency. The first three months of 2020 saw $45.6 billion flow into these funds globally. $30.7 trillion currently sits in sustainable investment funds worldwide, and it is predicted this could rise to around $50 trillion in the next two decades.
More investors want to fund organisations and products that promote sustainability and comply with emerging regulations. This demand has been met with increased action on ESG issues in the business world and progressively higher returns on investment for ESG funds due to their resilience against conventional market disruptions. Plus, portfolios incorporating ESG and sustainability often perform better long-term than those that don’t.
For example, US financial services firm Morningstar found that over 10 years, 80% of blend equity funds investing sustainably outperform traditional funds. They also found that 77% of ESG funds that existed ten years ago have survived, compared with 46% of conventional funds.
This boom in ESG investing can be attributed to a range of factors. As supply chains become more complex, there is a broader awareness of social, labour, and human rights issues and risks for the business world. Growing concern for environmental issues such as climate change also influences investor decisions. The heightened engagement of groups previously less involved in traditional investing—particularly young people and women—has also contributed to the ESG investing boom.
To reflect these evolving societal values, organisations must adopt forward-looking ESG practices to remain competitors in their industry and contribute to the common good. Sectors that are slow to uptake these changes receive increasing criticism and pressure from stakeholders, investors, and concerned citizens alike. Legal obligations are also expected to tighten for these industries as time passes.
In May 2021, a Dutch court ruled that Royal Dutch Shell must cut greenhouse gas emissions by 45% by 2030. In the same week, ExxonMobil and Chevron faced pressure from their shareholders to reduce their contributions to climate change. These events will likely spark further transformations within these industries.
ESG investors help inform the investment choices of large institutional investors such as public pension funds. ESG-specific mutual funds and ETFs reached a record $480 billion AUM in 2023. Brokerage and mutual fund companies offer exchange-traded funds (ETFs) and other financial products that follow ESG investing strategies.
Socially responsible investing (SRI) is an investment strategy highlighting one ESG facet. SRI investors seek companies that promote ethical and socially conscious themes, including diversity, inclusion, community focus, social justice, and corporate ethics, regardless of background.
Businesses need to recognise and embrace the shift occurring in the investing world. The term “investor” no longer solely refers to a select group. Instead, investing is increasingly understood as a tool to vote with one’s dollars, attracting a diverse range of people around the globe. The range of factors investors consider when making decisions has become much broader, reflecting this gradual diffusion of more progressive and holistic ESG values into the investing arena.
Issues such as climate change and COVID-19 have demonstrated the fragility of business-as-usual approaches and highlighted the importance of organisational resiliency.
Shareholders and stakeholders expect a transition towards more environmentally, socially, and economically sustainable business activity to support future generations. Organisations must build their adaptive capacities by considering an increasingly more comprehensive range of metrics in their business operations and long-term strategies. By identifying ESG benchmarks which are material to them and setting robust targets against these, organisations can set themselves up for success.
ESG investing is no longer just a trend; it’s a key component of responsible and forward-thinking financial strategy. Companies must integrate the ESG framework at the core of their DNA to stay ahead of regulations and competition. In another perspective, organisations that fail to comply with environmental or social factors may struggle to deal with regulatory, legal, or reputation issues later.
As mentioned above, there are plenty of ESG benefits to consider. From improved portfolio performance and risk management to fostering innovation and positively impacting global challenges, ESG is the key to long-term profitability and a positive reputation for your brand.
While there are hurdles to overcome, such as the lack of standardised ESG metrics and risks involved with greenwashing, the potential for making positive changes in the financial landscape is enormous. By leveraging ESG principles, businesses reap massive economic returns and contribute to a better world for all.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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