ESG is a growing trend in the investment world, but only 1% of assets under management use ESG as a primary factor in investment considerations. What exactly does ESG mean and how are companies integrating this practice?
The acronym itself stands for Environmental, Social and Governance. Companies use ESG as a risk assessment strategy incorporated into both their investment decision-making and risk management processes. These factors are often clear indicators of a responsible, well-governed company. Examples of ESG are:
- Manage resources and prevent pollution
- Reduce emissions and climate impact
- Execute environmental reporting/disclosure
- Avoid or minimize environmental liabilities
- Lower costs and increase profitability through energy and other efficiencies
- Reduce regulatory, litigation and reputational risk
- Promote health and safety
- Encourage labor-management relations
- Protect human rights
- Focus on product integrity
- Increase productivity and morale
- Reduce turnover and absenteeism
- Improve brand loyalty
- Increase diversity and accountability of the Board
- Protect shareholders their rights
- Report and disclose information
- Align interests of shareowners and management
- Avoid unpleasant financial surprises or “blow-ups”
ESG standards are becoming a larger part of the alternative investment world, including the impact investment space. ESG issues are not only central to measuring the sustainability and non-financial impacts of an investment, but can have a material impact on the long-term risk and return profile of investment portfolios.
According to oekom’s Sustainability Financial Performance Research Study, investors receive a “double dividend” in the form of a better rate of return with lower risk. The study found that companies that incorporate ESG standards prove to be more conscientious, less risky and therefore more likely to succeed in the long run. Socially responsible investors use ESG screens as a tool to confirm that investments are in compliance with local laws, as well as committed to sustainable and ethical business practices.
Firms like Blackrock and Vanguard have not only incorporated ESG into their compliance and legal risk-mitigation strategies, but also into their investment strategies. Traditional investments like public equity, however, are not the only investments being screened with ESG factor. Investors in alternatives, and alternatives fund managers, are likewise using the ESG framework for assessing risk in the investment decision-making process.
The board of Wellington Management, an investment management firm based in Boston, explained their motivation for using ESG, “ ESG integration is simple: to increase financial returns while upholding the fiduciary duty to incorporate any known risks into the investment process.”
ESG standards provide another level of due diligence, which is in the best interest of shareholders. When the UN launched UNPRI in 2006 and watchdogs like Bloomberg and MSCI started tracking ESG, it became abundantly clear that this was not a short lived fad.
ESG weeds out unsustainable companies with outdated practices and harmful side effects, while also minimizing risk for investors as they invest in more responsible companies with a greater likelihood of succeeding in the long run.