Companies have an extensive impact on our lives extending well beyond their immediate operations. In ESG investing (stands for Environmental, Social, Governance), such impact factors are systematically incorporated into the investment decision-making to better predict the investment returns.
There is a range of different perspectives on ESG investing. Some investors claim that ESG investing can bring superior returns. Some want to contribute to more sustainable economies. And of course, there are those who would claim that ESG investing is a poorly-disguised charity. The discussion is on-going and sometimes heated.
To give you a brief overlook, here is a list of ESG-related factors that are thought to impact company’s risk policy, profits and, ultimately, the stock price.
ESG is used commonly in public markets investment strategies. ESG investing is based on that the above factors can impact the share price of a company. As you can see, some of the relations are harder to assess than others (what even is “business ethics”?).
There is no uniform approach to ESG investing process. So differences between various types of ESG approaches can be confusing. For this reason, I’ve put together the most popular ESG investment approaches for your reference.
Exclusionary screening: Excluding entire sectors, companies or countries from a fund or portfolio based on ESG criteria, moral or ethical views, or religious beliefs. The frequent targets for exclusion are companies involved in arms, tobacco and alcohol, gambling, adult entertainment, nuclear power, animal-based foods production, mining sectors. This is a “one-size-fits all” approach: fairly reliable, but ignores context.
Positive screening (aka best-in-class): Investing in companies demonstrating positive ESG performance relative to their peers. Keep in mind, that by using this strategy, you may end up with “controversial” equities in your portfolio due to the fact that these equities demonstrate better ESG performance relative to similar peers.
ESG integration: the systematic inclusion of ESG factors alongside financial analysis of assets by investment managers. This category covers all the proprietary strategies applied by different financial service providers. In most cases, the analysis will be based on the information sourced from the big ESG data vendors: Morningstar, MSCI, Refinitiv.
In practice, investors use a combination of the above approaches. The most frequent process would include exclusionary screening plus ESG performance integration. For example, iShares MSCI KLD 400 Social ETF focuses on companies with mature ESG strategies, while filtering out investments that do not meet CO2 emission quotas (among other things), or that belong to blacklisted industries.
Note that some financial experts would consider impact investing (aka “dark green” investing or active ownership strategies) to be a type of ESG investing. We prefer to view impact investing as a step further from ESG investing. While ESG investing analyses sustainability factors in order to understand their effect on investment returns, impact investing strategies prioritize positive social and investment impact as a specific objective of the investment alongside investment returns.
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To sum up, ESG investing includes environmental, social and corporate-governance information into investment decision-making. These strategies assume that more expansive view of a company’s risks would help us predict the potential returns. By taking ESG factors into account when making an investment, this approach has a positive effect on society and the environment. Remember, however, that ESG framework is not always the best solution for investors willing to maximize their impact.
