Environmental, Social, and Governance: What is ESG and why does it matter in investing?

Environmental, Social, and Governance. These three words genuinely have the potential  to impact the world with positive change. Known as ESG, it is a framework used by companies to focus their attention, drive their strategy, and measure their performance in the three key areas of environmental impact, social issues, and ethical standards of company operation.

What is ESG?

Climate change, social inequality, and unethical company operations are just a few of the issues facing the world today. More and more companies are recognizing the negative impact that industry and business can have on the planet and its people, and are driving change to turn that negative impact into a positive one.

Investors are talking with their wallets, realizing that what is good for the environment and good for people can also be good for business. What is ESG investing?

ESG investing means considering more than money when evaluating an investment opportunity, by looking beyond the bottom line and focusing on how a company runs, how it treats its people and its stakeholders, and how it impacts the environment.

Companies with an ESG agenda can be attractive to ethical investors, impact investors, socially responsible investors, sustainability investors, and other investor categories who are seeking to put their money to use in positive, impactful ways to really make a difference in the world.

As a simple example, if an investor had decided to make an investment in the energy sector, they may choose to allocate their funds to a company that manufactures wind turbines rather than one that drills for oil, because of the different environmental impact of those two choices.

Bearing in mind the potential positive financial outcomes of investing in companies with an ESG focus, and the added benefits to the planet and its people, it seems appropriate to at least consider the opportunity that ESG investing represents. The approach that is right for you really comes down to whether you are a “hands-on” or a “hands-off” investor.

ESG factors and strategy

There are a range of issues that can fit within the ESG definition. Examples include:

• Environmental: Climate change, water pollution, water scarcity, greenhouse gas emissions, fossil fuel reduction, carbon footprint, renewable energy, deforestation, and air pollution.
• Social: Poverty, hunger, diversity and inclusion, employee safety, mental health, employee engagement, data privacy, employee treatment and compensation, ethical supply chain sourcing, customer service performance, and consumer protection.
• Governance: Ethical standards, leadership effectiveness, executive behavior, board integrity, executive compensation, political contributions, lobbying, hiring practices, shareholder rights, and risk management.

There is no single ESG strategy to suit every company and every investor. There is extensive scope for companies to focus on different areas across the wide ESG spectrum, depending on their market sector and their product or service offering, and can extend beyond the primary business of the company. For example, a company manufacturing flooring material might decide to source their timber from sustainable bamboo farms instead of logging forests, but they might also decide to package their product using compostable corrugated cardboard instead of petroleum-based plastic.

The beauty of an ESG strategy is that it can be progressive, where a company starts with an initial focus on making positive change in obvious areas that can have the greatest impact. Once they solve one big challenge and build experience, confidence, understanding, and commitment, they can progress to other issues throughout their entire operations and supply chain to make incremental changes to accumulate greater positive impact.

Examples of ESG in action

Propel(x) provides opportunities for people to invest in technology startups many of which have an ESG impact. Propel(x) has some great examples on their platform of companies with an ESG focus, such as:

• Primus Power, which manufactures stable, non-toxic, long-life, high-capacity batteries to harness energy from sustainable sources and support a smart energy grid
• True Algae, which provides technology and systems to grow microalgae that has a multitude of uses including natural, organic, non-chemical fertilizer
• Repurpose, which produces compostable tableware in an effort to solve the problem of plastic waste
• Seatrec, which designs and manufacture eco-friendly energy harvesting solutions for ocean applications
• Rellevate, which provides payday advance funding in a socially responsible way for workers who need immediate access to their funds rather than having to wait for their paycheck.

Private Placements are a high-risk investment. An investment in these offerings is speculative and an investor could experience an entire loss of principal. Private investments are highly illiquid and risky and are not suitable for all investors. Investments in early-stage private companies should only be part of your overall investment portfolio.

How does ESG investing work?

ESG investing can be through direct investment in specific ESG stocks, meaning companies that have a particular ESG agenda, strategy, or focus.

Another option for ESG investing is through ESG funds, by accessing a fund that only invests in companies with recognized and quantifiable ESG credentials. There are a growing number of these funds available in the marketplace, such as exchange-traded funds (ETFs) that filter investments by their ESG characteristics, for example the list shown here.

Another strategy for ESG investing can be by omission, meaning to avoid companies with a poor ESG rating, such as those involved in fossil fuels, tobacco, mining, or old forest logging.

Looking at venture investing, there are organizations with a sustainability focus, such as Prime Coalition, the CREO syndicate, DBL Partners, and others who invest only in companies that are involved in combating climate change.

How to evaluate corporate ESG performance

If you have decided to include ESG as a factor in your investment decisions, the big question is how to evaluate a company’s ESG performance? There is no universal ESG score that all companies use, so it does require some research and due diligence to determine a company’s ESG status and performance.

A number of organizations are working on or have developed ESG rating systems, such as the World Economic Forum (WEF), International Business Council (IBC), the Sustainability Accounting Standards Board, the Global Reporting Initiative, and the Task Force on Climate-related Financial Disclosures. The United Nation’s 17 goals for sustainable development are also a useful benchmark tool to learn more and evaluate company commitments to sustainability.

An example of a rating system in action is that developed by the WEF IBC mentioned above, who have published a White Paper titled Measuring Stakeholder Capitalism Towards Common Metrics and Consistent Reporting of Sustainable Value Creation prepared in collaboration with the “big-four” accounting firms Deloitte, EY, KPMG, and PwC. The IBC has also published a Community Paper titled Stakeholder Capitalism Metrics: The Investors’ Case which acknowledges that Investors are increasingly using environmental, social and governance (ESG) considerations to identify material risks and growth potential, leading to better-informed investment decisions. The paper also identifies the lack of mandated global standards, and seeks to provide a mechanism for companies to build their ESG capability and improve their ESG reporting. More information on these papers is available here. The WEF IBC approach is to use a set of standardized business-critical metrics to consistently assess and quantify ESG performance. These metrics are structured around four core pillars, being People, Planet, Prosperity, and Principles of governance. The recommendations set out a baseline of 21 core metrics and disclosures that represent the most universal ESG factors (independent of industry sector) for all companies in all sectors to report against. As of July 2021, eighty global corporations have committed to using these metrics, which is driving momentum towards a convergence of adoption of consistent ESG reporting standards.

Another important body to consider in the ESG landscape is the industry group Principles for Responsible Investment (PRI), which claims to be the world’s leading proponent of responsible investment and outlines six key principles for responsible investment, which align strongly with an ESG agenda. An initiative led by the then United Nations Secretary-General Kofi Annan resulted in the PRI  being launched in 2006, and in 2021 includes more than 4,000 signatories from the investment industry.

Strong corporate and financial performance of companies with an ESG focus is an indicator of strong leadership, potentially because of the long-term nature of some ESG programs, which can take years to implement.

How ESG investing is growing and changing

Indications are that ESG investment is no longer a niche sector but may be approaching the “new normal”. Companies are recognizing the importance of ESG factors in their business operations and the effect this can have on attracting investors.

The Global Sustainable Investment Alliance (GSIA) is an international group of sustainable investment organizations working to further the cause of global sustainable investing. The GSIA publishes a biennial report mapping the state of sustainable investment in major global financial markets. Some highlights from the Global Sustainable Investment Review 2020 (GSIA) include the following:

• Sustainable investment is a major force shaping global capital markets and is influencing companies seeking to raise capital
• Sustainable investment across the United States, Canada, Japan, Australasia, and Europe has reached US$35.3 trillion in assets under management, having grown by 15% in two years and equating to 36% of all professionally managed assets across regions covered in the report
• The industry is in transition, with rapid developments resetting expectations of sustainable investment
• There is a global acceleration of an international sustainability agenda driven by international agreements such as the Paris Agreement and the United Nations Sustainable Development Goals, both of which are calling out the important role of finance
• The most common sustainable investment strategy is ESG integration.

Is ESG investing right for you, and what is a good approach?

The choice of whether to incorporate ESG ratings and performance into your investment decisions is a personal one, depending on your own individual circumstances, requirements, goals, and principles. But the evidence is mounting that an ESG focus does not necessarily come at the expense of strong financial returns. In fact there are strong indications that ESG investing can achieve positive, or at the very least, neutral returns relative to the market. A detailed study by The Motley Fool found “plenty of evidence that companies prioritizing ESG issues actually generate superior long-term financial performance across a range of metrics and that a significant amount of research suggests a positive correlation between companies that do good and companies that do well financially.” The study quotes a number of well-respected financial leaders and commentators who believe that ESG investing can lead to better stock returns, or at least to not have a negative impact on returns.

Bearing in mind the potential positive financial outcomes of investing in companies with an ESG focus, and the added benefits to the planet and its people, it seems appropriate to at least consider the opportunity that ESG investing represents. The approach that is right for you really comes down to whether you are a “hands-on” or a “hands-off” investor. The hands-on approach of direct investment means doing your due diligence on specific companies and their ESG credentials, which requires research and building knowledge and awareness around the issues before you make your decision. The more hands-off approach would be to pick a managed fund or ETF with an ESG focus by looking at their returns, history, time in the market, and investment strategy.

Picking a sustainable portfolio

As with all areas of investing, balance is critical when picking a sustainable portfolio, to ensure you have a strong diversity of investment assets. For example, it would not be advisable to invest all your money into a single company, or indeed a group of companies all focused on one ESG sector, such as the water treatment industry.

It is important to consider the wider market, and the broad ESG sector as a whole, to ensure an appropriate spread of investment allocations. It is also important to identify your own personal drivers in the investments you make, to identify what means something to you and where you want to invest your funds and for what reasons.

ESG as an indicator of strong leadership

Strong corporate and financial performance of companies with an ESG focus is an indicator of strong leadership, potentially because of the long-term nature of some ESG programs, which can take years to implement. Indications are that the leadership needed to drive an ESG agenda also reflects well on the overall management of the company and the objective of being a good corporate citizen.

Benefits and risks of ESG investing

One way to illustrate the benefits of ESG investing is to consider the “triple bottom line” approach, where a company measures its social and environmental impact in addition to its financial performance by assessing it against the “three P’s”, being Profit, People, and the Planet. The evidence is mounting that robust ESG credentials can positively impact financial returns.

The potential risks of ESG investing relate primarily to issues associated with standards and reporting. The lack of globally accepted standards and variation in reporting between different countries, market sectors, and companies can make it difficult to accurately compare ESG ratings in a robust manner.

As with any investment, history is no guarantee of future performance, and any investment decision must balance the risk against the potential return.

If you’re particularly interested in startups with an ESG focus, you can find more information here on how to start angel investing and how to find opportunities for angel investing on platforms such as Propel(x).

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