ESG aims to bring non-financial variables into investing, but the concept is complex and sometimes misunderstood. Here’s a brief list of the five essential things every investor should know about ESG investing today.
Both new and seasoned investors have most likely heard about environmental, social and governance (ESG) credentials by now.
ESG aims to bring non-financial variables into investing — issues under this umbrella are known to most stakeholders, and the concept has a place in almost every company presentation these days. However, it can be tough to understand all the details about these far-reaching factors.
With so much discussion around this important but often misused and misunderstood concept, the Investing News Network (INN) has put together a brief list of the five essential things every investor should know about ESG investing today.
1. What is it?
ESG stands for environmental, social and governance. When investors are looking at a company’s operations, they can use these criteria to ensure they are making a socially responsible investment or that they are avoiding financial risk as a result of a company’s practices.
“ESG investing is using an evaluation of how the company performs on relevant environmental, social and governance issues and it ranks them by sector relative to its peers,” Leslie Samuelrich, president of Green Century Capital Management, told INN.
Breaking down the concept into simple terms, the environmental component of ESG considers how a company impacts and takes care of nature as a result of its operations.
“The ‘E’ takes into account a company’s utilization of natural resources and the effect of their operations on the environment, both in their direct operations and across their supply chains,” according to S&P Global. “Companies that neglect to consider the effects of their policies and practices on the environment may be exposed to higher levels of financial risk.”
The social aspect looks at how a company manages its relationships at different levels with different stakeholders ― from its employees to the communities where it operates.
“A number of social factors can affect a company’s financial performance, ranging from short- to long-term challenges,” S&P Global explains. “Social factors to consider in sustainable investing include a company’s strengths and weaknesses in dealing with social trends, labor, and politics. A focus on these topics can increase profits and corporate responsibility.”
Meanwhile, governance considers a company’s leadership and the administrative aspect of operations.
“The purpose of the corporation, the role and makeup of boards of directors, and the compensation and oversight of top executives have emerged as core issues in companies’ corporate governance structures,” says S&P Global.
ESG can be quite complex given all of those elements, said Dana Sasarean, Sustainalytics’ associate director of mining research. Her company, which is an independent ESG and corporate governance research, ratings and analytics firm, uses risk ratings to assess companies.
“There are multiple ways of incorporating ESG in investments,” she told INN. “There’s finance, there’s negative screening, there’s positive screening, there is benchmarking or even impact investment.”
2. Why is ESG becoming popular now?
The roots of ESG investing can be traced back to the 1960s, when this approach was known as socially responsible investing. This type of investing gained traction in the late 1990s, and later on, and as the movement expanded, an approach called impact investing emerged.
“(Impact investing) is an investment approach that seeks to deliver both financial return as well as positive social or environmental impact,” Tania Carnegie told INN back in 2019. “One of the things that is really important is that that impact is intentional, and it’s something that’s being measured and managed throughout the investment period.”
The term ‘ESG’ was coined in 2004, and is considered a type of approach different from socially responsible investing, sustainable investing or impact investing per se.
“Through ESG investing, market participants consider in their decision-making the ways in which environmental, social, and governance (ESG) risks and opportunities can have material impacts on companies’ performance,” S&P Global explains. “Meanwhile, sustainable investing puts a premium on positive social change by considering both financial returns and moral values in investment decisions.”
With increasing worries about climate change, national security, supply chain dependence and diversity, among others, ESG investing has become more and more popular among investors. That’s because investors who use ESG in their decision-making are able to invest sustainably while maintaining the same level of financial returns as they would with a standard investment approach.
“ESG investing has really grown (in the past year) as people become more concerned about how their investments represent themselves,” Samuelrich said. “Also, firms have seen it as a way to keep their clients or grow their client base without necessarily sacrificing returns.”
For Sasarean, changes have been happening gradually in ESG as a lot of programs, initiatives and standards take a long time to be developed.
“(In mining) there’s a lot of focus now on how you turn the table to listen to what’s happening on the ground,” she said. “A lot of companies start working more and more with local advisors, and on-the-ground companies, smaller companies, that are able to guide them and better connect to communities.”
3. How is ESG measured?
Without doubt, ESG is one of the most complex segments of the asset management industry. There are many firms using rating systems to evaluate companies, including Sustainalytics, MSCI and Refinitiv.
“It’s really challenging to ‘grade’ a certain company, just because there’s no universal metric that applies to every company,” Federico Gay of Refinitiv told INN. When looking at mining, “a polymetallic mine cannot be compared against a mine that only produces one metal.”
At Refinitiv, ESG scores are provided on a company-by-company basis; they are divided by industry type and data is considered for more than 150 unique metrics, for all three ESG pillars.
For its part, Sustainalytics uses risk rating assessments — most mining companies fall into the medium range, and quite a few are in the severe rating.
“Our approach to ESG risk rating starts with assessing a risk exposure, and then we deduct a managed risk out of that in order to reach an unmanaged risk value — this is the core of our risk rating,” Sasarean said. “We combine on the risk side a low, medium or high risk exposure with weak, average or strong management, and the result goes onto a scale that goes from negligible and low to medium, to high and severe.”
Data has increased the amount of information available to investors, but standardization of reports is still a working progress. This is true in particular in mining, where processes to extract and refine metals can be quite diverse, in addition to size of companies and location of projects among others.
“When looking at raw data, the differences between the different commodities are noticeable at plain sight,” Gay explained. “So in order to understand the results, a working knowledge on the different processes necessary to obtain different metals and having an idea of the scale of each operation really helps in understanding the data.”
He added that reporting is improving every year, and that requires constant learning from readers.
4. How to invest with an ESG focus
As mentioned, applying an ESG approach to investing allows investors to use tools to measure the risks of a company in a particular sector. This is why ESG ratings and benchmarks are essential for investors looking to apply this strategy in the stock market.
Boston-based Green Century Capital Management uses ESG ratings as one part of how it selects companies for its three mutual funds. Since 1991, the firm has used ESG to invest in companies leading their sector.
“ESG is one tool,” Samuelrich said. “It does not mean that your portfolio is making a demonstrable impact in the world. It’s more about the performance of your portfolio.”
If investors are looking to have a moral alignment in their portfolios, they need to do screening, and to have an impact, investors need to do shareholder engagement, which are layers on top of ESG ratings, she added.
According to Samuelrich, data has helped show that investing in a responsible way or using an ESG approach to investing does not necessarily translate into decreased returns, and in some cases it may even increase performance.
“I think that data is what has actually opened up the floodgates into ESG,” she said. “Because if that’s the equation, if you’re not necessarily sacrificing returns, and you might actually have some risk protection and are increasing your performance, why not? Why not use it, apply it to your investments?”
Similarly, Sasarean said it is difficult to see any downside for investors looking at ESG.
“Oftentimes, investors are actually overlaying this information on top of their own standards. So oftentimes, I think it’s not necessarily the end-all game, it’s almost like a validation.”
5. Is ESG investing here to stay?
Looking at what could be ahead for this investing strategy tool, Samuelrich said ESG is coming into the mainstream as larger firms in the US apply it to their existing funds, or even launch new products that are ESG focused.
“It’s not standard yet,” she said. “But it’s making a lot of progress so that companies are paying more attention to what investors are looking for and their ESG ratings.”
For Samuelrich, ESG makes sense from a risk management point of view and it may potentially increase returns. “So I think it will keep growing, and more and more firms will start applying it.”
Similarly, Gay said this trend will continue and investors’ appetite for “greener” mining will only increase.
“Currently we are seeing how some companies’ sustainability reports are often announced with a greater enthusiasm than their financial reports,” he said. “While investor scrutiny increases, I’m confident the mining industry will adapt and migrate to standardized metrics, while also providing more details on the ESG results.”
For her part, Sasarean said many of the issues covered under the ESG umbrella are not new for investors in mining. For research providers like Sustainalytics, it’s about having wider coverage and being able to measure everything and fit it into a standard.
“So the ability to go through all these sources and have a certain confidence level that a category one and two and three, and four and five, it’s systematic across the board, it’s very valuable,” she said. “Now it’s about being able to translate a language that’s well understood by investors, that’s risk versus management.”
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Securities Disclosure: I, Priscila Barrera, hold no direct investment interest in any company mentioned in this article.
Editorial Disclosure: The Investing News Network does not guarantee the accuracy or thoroughness of the information reported in the interviews it conducts. The opinions expressed in these interviews do not reflect the opinions of the Investing News Network and do not constitute investment advice. All readers are encouraged to perform their own due diligence.