Facing shifting consumer attitudes, increased geopolitical volatility, and mounting calls for environmentally-friendly solutions, the application of environmental, social, and governance (ESG) standards for socially conscious investing has become more popular than ever.
Gartner found that 85% of investors consider ESG factors to be a major determinant of whether they invest in a company. And, while the pressure on businesses to implement corporate equity and sustainability initiatives grow, organizations who fail to act on these programs are increasingly seen as risky investment propositions.
As stakeholders and stockholders alike place a growing emphasis on ESG initiatives, it has become clear that alignment with these standards—or the lack thereof—will serve as a leading predictor of a company's long-term success.
If you are thinking about applying ESG criteria to your own investment strategy, this overview offers four key pillars to this methodology.
An Overview of ESG Investing
ESG criteria are an evolving set of standards for a company’s operations that socially conscious investors use to screen potential investments and their related risks. Investopedia has deﬁned each of these three standards as follows:
● Environmental criteria look at a company’s overall impact on the environment, including energy use, waste, pollution, and the treatment of animals. This also includes any existing or emerging environmental risks and how they are being addressed.
● Social standards serve to evaluate the company’s business relationships, including those with employees, customers, and the communities it operates within.
● Governance relates to a company’s leadership and decisions surrounding executive pay, audits, internal controls, and shareholder rights. Within these criteria, investors are looking for transparency and equitable practices.
There are several reasons ESG criteria have become increasingly important considerations for stockholders. From a ﬁnancial perspective, these standards can be used as a tool to avoid companies whose practices signal a risk factor. As we look toward the past, both BP’s 2010 oil spill and Volkswagen’s 2015 emissions scandal serve as examples of how poor ESG alignment can lead to signiﬁcant losses.
ESG: An Evolving Set of Standards
It’s important to note that ESG investing principles are not static. Instead, they evolve and change in response to environmental factors, geopolitical trends, and consumer attitudes, requiring investors to adjust their own outlooks and portfolios accordingly.
A current example of this phenomenon can be seen following Russia's invasion of Ukraine and the resulting plummet of Russian companies' stocks. However, the impact of this event is not limited to Russian companies alone. Forbes also has reported that the invasion and ongoing crisis have also caused many investors to question the inclusion of defense companies in their portfolios.
As the invasion of Ukraine continues to unfold, it has led to a widespread conversation surrounding best practices for ESG investing. Investors are no longer just assessing a company’s isolated actions, but instead are also considering both the environment and industry in which businesses operate.
If you are considering using ESG criteria to evaluate companies in your own portfolio, remember that not every organization will perform ﬂawlessly across each category. Instead, it is up to the individual investor, and his or her advisor, to develop an approach that balances both ESG-related risk factors as well as what is most important to them.
The Four Pillars of ESG
Constantly assessing ESG criteria against today’s market and emerging risk factors can overwhelm even the most experienced investor. Instead, many recommend using a standardized methodology in an effort to make the process more straightforward.
If you are beginning to evaluate your own holdings against ESG-related risks and opportunities, consider the following four pillars as useful guidelines:
1: Identify Strategic Leaders
Start by determining which companies can be considered to be strategic leaders in the marketplace. These can be deﬁned as organizations that have positioned themselves for sustained success through innovation and an alignment to stakeholder needs.
2: Evaluate Financial Integrity
After you have identiﬁed potential investments that have a proven history of innovation, evaluate the company’s ﬁnancial integrity. Although a commitment to ESG can serve as an indicator of long-term health, it is equally important to determine if there is a strong foundation for growth and whether the company is reasonably valued.
3: Review Available Data and Compare to Peers
In today’s Information Age, investors will only continue to have access to an increasingly large amount of ESG-related data. Industry leaders are not only expected to align with these criteria but also to disclose quantitative proof of their ongoing commitment to these initiatives in near- to real-time. Although this inﬂux of information can appear overwhelming, it serves as a valuable resource for ESG-minded investors.
Rather than considering a company’s performance in isolation, it is essential to compare its actions to its peers. Review any available materiality-based benchmarks, external information, independent news sources, and competitive analysis to determine whether a company is meeting the industry standard for ESG performance.
4: Assess Your Portfolio Continuously
The best approach to ESG investing is a dynamic one. It is essential to continuously reevaluate the companies in your portfolio. Emphasize rating how organizations perform against their peers as well as how they perform compared to their own past metrics. As leaders continue to place a higher emphasis on ESG initiatives, it is likely that such industry benchmarks will continue to increase.
If you’re ready to get started with ESG investing, or have questions about your existing investments, contact us at Integrity Financial Planning today.