ESG Investing Explained
Posted: June 2019
Investing responsibly is a broad statement. There are no set rules or guidelines about how an investor should incorporate ESG principles in their investment decision making. It is up to the individual asset owners to interpret their fiduciary duty and choose which process, or combination of methodologies, best fits their objectives. For many investors today, earning a long-term return on investment is no longer the only important criterion used to evaluate a company. In 2018, investors and asset managers evaluated ESG in nearly $12 trillion worth of assets, an increase of almost 40 percent since 2016.
What is ESG exactly? Well, ESG investing is not the same as a socially responsible investment strategy, although there is overlap between the two approaches. SRI aims to provide both a financial return and an ethical return, while ESG emphasizes financial return while acknowledging that ESG pillars have an impact on the financial health of a company.
ESG investing takes a holistic approach and focuses on anything that could have an effect on a company’s financial performance. An ESG investing strategy can be applied to any company, in any industry.
What Is Meant by ESG Investing?
ESG investing is the belief that environmental, social and governance components can have an impact on company success and market returns.
Evaluating the pillars of ESG doesn’t necessarily mean that an investor rules out a company that has a history of struggling in one area or another. Nor does it mean that a company will not have issues with environmental concerns or social scandals in the future. Instead, what ESG investing is, an opportunity to look at a company through a different lens and to use that perspective to determine whether or not the company is likely to provide excellent long-term, risk-adjusted results for its investors.
Environmental, Social, and Governance
The three pillars within an ESG investing approach are environmental, social and governance. Within each pillar, management firms and investors can evaluate a variety of criteria or specific issues to determine how an individual company performs.
1. Environmental Pillar
The environmental category is a fairly broad one, and companies can be analyzed based on their performance or track record with a range of issues. For example, climate change has been a leading environmental issue considered by shareholders, money managers and institutional investors.
Other environmental issues that could be a risk for a company’s long-term financial stability and health include:
- Its use of or dependence on fossil fuels
- Its use or management of water and other resources
- Whether it uses renewable energy or not
- Its use of hazardous materials and its disposal practices
- Its pollution levels
Analyzing the environmental pillar of a company doesn’t only focus on the negative or areas of risk. It also emphasizes areas where a company has an opportunity and evaluates how a company responds or uses that opportunity. Environmental opportunities can include committing to:
- Switching to renewable sources of energy or fuel
- Using processes that conserve resources or minimize pollution
- Minimizing carbon footprint or going carbon neutral
- Renewing or restoring the planet, such as by planting trees
- Developing or pursuing clean energy opportunities and initiatives
- Encouraging good stewardship of the earth among employees
Although environmental aspects can be a consideration when evaluating the potential of investing in any industry, they might have a different materiality and weight for companies in the industrial, energy and utility sectors.
2. Social Pillar
How a company approaches the social pillar of ESG and issues can also play a substantial role in the evaluation of its long term potential and risk. One of the most significant social issues for money managers was conflict risk, followed by human rights.
As with environmental, the social pillar of ESG can be examined and monitored based on the risk they present to the company as well as the opportunity they provide a company. For example, a company that has factories or plants in areas of conflict or a contested territory might have a higher risk of financial or reputational difficulties in the future.
On the other hand, companies can choose to harness social concerns and issues as a way to improve their relationships with customers, suppliers and communities. For example, a company can develop a program that seeks to increase employment opportunities for underserved groups or a program that aims to support people who might be facing hunger or who otherwise have limited access to resources.
Other social issues that can be evaluated include:
- Product safety concerns
- Worker satisfaction or exploitation
- Union relationships
- Stance on various health-related issues, including controversial topics such as drug abuse and reproductive choice
- Supply chain transparency or opacity
- Employment equality or opportunity, gender diversity
- Human rights
- Religious opinions or values
- Animal rights or animal testing
- Gambling and other vices
- Privacy issues
Social issues can affect companies in all fields but might be of particular importance to consumer-facing companies, such as retailers, restaurants and healthcare providers.
3. Governance Pillar
While the environmental and social factors examine how a company’s behavior affects the world around it, governance evaluates how the company operates as a whole. Evaluating the governance of ESG requires monitoring and reporting on how a company performs. This also includes the company’s executive and employee compensation.
Other government issues that might be considered when evaluating a company include:
- Political activity and donations
- Tax strategy
- Bribery and corruption
- Board diversity
- Antitrust violations
- Material risks and disclosure
As with environmental and social considerations, governance can be applied to all types of companies.
How an ESG Investing Strategy Works
Investors who use an ESG investing strategy analyze the three pillars when making a decision about whether or not to invest in a particular company. They also continually monitor the company’s performance based on those three pillars, as the pillars continue to play an important role in evaluating a company’s risk and return. There is no one “right” way to practice an ESG investing strategy.
Some of the methods investors and asset management firms might use when incorporating an ESG investing strategy include:
- Using information about ESG pillars when qualitatively and quantitatively analyzing a company
- Engaging with the company concerning ESG pillars that are relevant to that particular company
- Influencing company behavior through shareholder voting rights
- Monitoring an entire portfolio for overall ESG risk, such as evaluating the carbon footprint of all the companies in the portfolio
- Asking companies to disclose information on ESG pillars that affect them or, in the case of smaller companies, compiling that information for them
Many investors who are committed to using an ESG investing strategy have signed the United Nations Principles for Responsible Investment (UNPRI). The six principles are as follows:
- A promise to incorporate ESG pillars into investment analysis and during the decision-making process
- A promise to be active owners and to include ESG concerns in ownership practices and policies
- Asking for disclosure regarding ESG pillars by the companies invested in
- Encouraging others in the investment industry to accept and implement the Principles
- Committing to work together to increase the effectiveness of the Principles
- Reporting any progress and activities concerning the implementation of the Principles
The six principles are voluntary and might evolve as time goes on. They are meant to provide investors with a menu of possibilities when it comes to incorporating the ESG pillars.
Importance of Company Engagement in an ESG Investing Strategy
What is ESG as an investment approach? Investors who take an ESG investment approach apply what they know about the ESG pillars that are relevant to a company when making investment decisions. An ESG investing strategy does not necessarily mean that an asset management firm won’t invest in a company based on its social, environmental or governance track record. Instead, it is meant to allow investors to generate long-term and stable returns while effectively managing risk.
An asset management firm might connect with the management team of a company in an attempt to encourage positive change where needed. Engaging with a company can be particularly beneficial if ESG issues have led to a lower than average ranking or if new issues have come up that have caused the company’s rating to drop.
Among the actions an asset management firm might take to engage with a company include encouraging disclosure and transparency, asking for more details or information to fill in any gaps in the firm’s database and discussing a company’s rating with it and identifying brainstorming ways to improve.
THB Asset Management uses active engagement with companies as a part of our decision-making process. By actively engaging with companies, we can form relationships and take matters on a case by case basis.
Importance of Reporting as Part of an ESG Investing Strategy
Reporting opens at the beginning of January each year. Signatories have a three-month window to submit their report and can start preparing for reporting in November, when the PRI releases its reporting frameworks in PDF versions.
THB has established procedures to ensure continuous monitoring and reporting practices with all parties involved in our ESG process. Maintaining an open dialogue with portfolio holdings, clients and all relevant organizations such as the UNPRI is integral part of our monitoring and reporting framework. THB is a signatory to the United Nations Principles for Responsible Investment (UNPRI) and Montreal Carbon Pledge.
As such, we externally report our responsible investment activities and are annually assessed by the PRI Association:
- Quarterly internal review: our investment committee evaluates ESG integration processes, company ESG ratings, carbon footprint of portfolios and engagement activities with portfolio companies.
- Annual public disclosure: as a PRI member, we are required to report all responsible investment activities on an annual basis which allows us to receive feedback and improve our performance.
- Data assurance: both internal and third-party company ESG ratings are monitored to ensure all of the latest information is incorporated.
THB Asset Management recognizes the connection between long-term shareholder value and high-quality companies. We are a signatory of the UNPRI and the Montreal Carbon Pledge. If you are interested in learning more about what is ESG, US Small Cap, US Micro Cap, US Mid Cap, or International Micro Cap, please contact us today.