ESG (Economic, Social and Governance) investing in 2024: Here’s an investor’s ultimate guide

ESG has become one of the most popular acronyms in the investing world, and a quickly growing trend. Few investors would put their hand up and say they want their investing to have a bad impact on the world around them.

There is evidence to suggest ESG funds perform better than funds without such a focus – for instance, the average Australian share index-ESG strategy was up 13.2% compared to 12% for the broader market according to Bloomberg. Many environmentally conscious investments will only grow in value in the longer term as the world decarbonises.

But many investors have questions. Just what is it and what metrics does it use? How can you tell if your investment adheres to these principles? And what are some of the risks? We seek to answer this question.

 

What is ESG?

Environmental, Social, and Governance (ESG) is a framework used to evaluate a company’s impact on the world beyond its financial performance. ESG criteria help investors assess the sustainability and ethical impact of their investments.

Here is a detailed breakdown of each component:

 

Environmental

Evaluates how a company contributes to and addresses environmental issues such as climate change, biodiversity, pollution and waste. There are many ways to measure an environmental impact includes greenhouse gas emissions, energy use, water usage, waste management, resource conservation, land use and conservation efforts.

 

Social

This involves how a company engages with its stakeholders. Not just shareholders, but its staff and the broader community. Metrics include employee working conditions, employee relations, fair labour practices, the absence of child-labour and forced labour in a company’s operations and supply chain, social development initiatives, as well as diversity, equity, and inclusion.

 

Governance

This involves looking at how a company is governed. To measure a company’s performance look at metrics including a company’s compliance with laws and regulation, how executive pay is structured and aligned with the company’s performance and long-term goals, the rights and treatment of shareholders as well as the diversity, independence, and expertise of the company’s board of directors.

 

Why is ESG important?

In our view, there are four reasons. First, ESG factors help identify and manage risks that could affect a company’s long-term sustainability and profitability. Secondly, investor demand. Investors are seeking out companies with strong ESG practices, as these are often seen as more sustainable and ethical investments. Thirdly, companies with robust ESG practices can enhance their reputation and brand value, attracting customers, employees, and partners who prioritize sustainability and ethical conduct. And fourth, adhering to ESG principles can help companies comply with regulatory requirements and avoid legal issues related to environmental, social, and governance practices.

 

Why has ESG become popular?

There are several reasons. One of the most obvious and important is increasing awareness of environmental issues as well as the potential to profit from technologies and other ventures that can play a part in issues like climate change and resource scarcity.

There is also a rising expectation for companies to act responsibly towards their employees, communities, and society at large. There’s even a term for that: CSR (Corporate Social Responsibility). Investors are drawn to companies that act with social responsibility. It can even help companies perform better because they can identify risks they otherwise might not have, and respond to them proactively as opposed to reacting when something goes wrong. Studies have shown that companies with robust CSRpractices often perform better financially over the long term. These companies tend to be more resilient and capable of adapting to changing market conditions.

 

Millennials are a big driver of ESG investing

From the perspective of ESG fund managers, demand for these specific funds have been driven by influence. Younger generations, particularly millennials, are more conscious of social and environmental issues. They are more likely to invest in companies that align with their values, driving the demand for these kinds of investments. Additionally, large institutional investors, such as pension funds and insurance companies, are increasingly incorporating ESG criteria into their investment strategies to meet the expectations of their stakeholders.

Add into the mix the fact that advances in technology have made it easier to collect, analyze, and report ESG data. Investors now have access to comprehensive information about companies’ performance on applicable criteria, facilitating more informed investment decisions. It is all well and good for all of the demands above, but they would not have gotten as far as they have if we couldn’t measure the relevant data.

 

So how does ESG work in practice?

Mostly it is companies self-reporting. Companies often publish sustainability reports to disclose their ESG practices and performance to stakeholders. However, independent agencies provide ratings and scores to help investors evaluate a company’s or fund’s performance/compliance. The Responsible Investing Association of Australia (RIAA) is one such example.

 

Benefits of ESG Investing

 

Risk Mitigation

As we noted above, companies with strong ESG practices are often better at managing risks related to environmental, social, and governance issues, which can lead to more stable long-term performance. ESG-conscious companies are more likely to adhere to regulations, reducing the risk of legal penalties and associated costs.

 

Enhanced Returns

Numerous studies have shown that companies with robust ESG practices often outperform their peers in the long run. This is due to better risk management and a stronger focus on sustainability and ethical practices. We also observe that implementing energy-efficient and sustainable practices can lead to significant cost savings over time.

 

Improved Corporate Reputation

Companies with strong credentials can enhance their brand reputation, making them more attractive to consumers, employees, and investors. Consumers are increasingly favouring companies that prioritize sustainability and ethical practices, leading to increased customer loyalty and potentially higher sales.

 

Disadvantages of ESG investing

 

Limited Investment Options

Focusing on ESG criteria can limit the pool of potential investments, as not all companies meet the required standards. Certain sectors, such as fossil fuels or tobacco, may be excluded from ‘ethical’ portfolios, reducing diversification opportunities and potentially costing returns. Of course, you can limit your investment portfolio by applying any criteria. In fact, if you wanted to go ‘anti-woke‘ you’re limiting your options even more so than just going ‘woke’.

 

Performance Concerns

ESG investments may underperform in the short term compared to traditional investments, especially during periods of market volatility. They may be more susceptible to shifts in market trends and investor sentiment, affecting their performance.

 

Inconsistent Reporting and Standards

There is no universal standard for ESG reporting, leading to inconsistencies in how companies report their practices and performance. Some companies may engage in “greenwashing,” where they present themselves as more environmentally friendly or socially responsible than they actually are, misleading investors.

 

Higher Research and Monitoring Costs:

ESG investing requires thorough research and ongoing monitoring of companies’ economic, social and governance practices, which can be time-consuming and costly. As well as this, certain funds may have higher management fees due to the additional research and analysis required to evaluate the additional criteria.

 

Conclusion on ESG investing

ESG investing offers several benefits, including risk mitigation, enhanced returns, improved corporate reputation, and positive societal impact.

However, it also comes with challenges such as limited investment options, performance concerns, inconsistent reporting standards, and higher research and monitoring costs. Investors need to weigh these pros and cons carefully and consider their own values and investment goals when deciding whether to incorporate ESG criteria into their investment strategy.

And above all else, investors need to remember that there is no universally agreed set of criteria – what it is, what constitutes an appropriate investment, among others. So in many cases, investors thinking they are conscious on these issue, may ultimately just be relying on their own personal preferences.

 

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