What is ESG Investing and the Factors that influence its Growth?

When it comes to investing, we are probably used to gauging financial ratios such as Price-to-earnings (P/E) ratio to EBITDA margins (Earnings before interest, taxes, depreciation, and amortization). Yes, all these ratios are crucial for investors to analyse the financial performance of an investment that would affect its risk and return. However, issues that are difficult to measure in terms of monetary value and do not form part of the traditional financial metrics, are crucial because they would also affect the risk and return of those investments.

Hence, they are known as environmental, social, and governance (ESG) issues. Investors should consider assessing the same stocks through ESG factors alongside financial factors to aid them in their investment decisions.

There is no one exhaustive list when it comes to ESG issues. ESG issues can be interlinked, and it is rather challenging to classify an ESG issue as solely environmental, social, or governance issue as seen below. But generally, this are some issues in each pillar that you might be familiar with.

Source: Fidelity International, PRI, 2018

Various labels, but all are addressing the same issues

You may have heard of various labels that are used to describe investments surrounding ESG issues, which spans from the traditional Socially Responsible Investing (SRI) to Ethical and Impact Investing. They are also often used interchangeably by professionals, and clients alike but, distinct differences still exist among them. From a professional context, it will affect how the client portfolios are chosen and tailored accordingly and which type of investment is suitable to meet their respective needs and social impact goals.

Socially Responsible Investing (SRI): It uses crucial ESG criteria to select the companies for investment, typically using a negative screening approach to filter companies that produce/sell harmful substances, such as tobacco, alcohol, and gambling, etc. Ultimately, for clients who invest in SRI, making a profit is still crucial while balancing and not going against their moral principles.

Ethical Investing: Investments are chosen and ruled out based on their personal beliefs, morals, and values. Somewhat similar to SRI, they do not participate in certain industries (Eg: firearms). The main difference with SRI is that ethical investing tends to focus on issues that produce a more personalized result. However, SRI uses a detailed checklist/set of parameters to select and assess investment decisions.

Impact investing: It is an investment strategy that selects companies/industries that contribute towards social or environmental benefits. Example: Impact investors would prefer to support electric cars, renewable energy, and other causes they feel is worthwhile. The most important thing to note is that these investments offer financial returns that align with the individual investor’s conscience, which is indeed a win-win situation.

COVID-19 has helped to further emphasize and direct attention to arising social issues. Many of these issues have been further amplified by the pandemic, while others that were lesser known have risen, leading investors to be aware of such issues. Examples: Occupational Health and Safety in workplaces, ethical and fair purchasing methods /procurement, supply chain issues, and digital rights such as privacy. Beyond the pandemic, other crucial social issues were also highlighted, and you might have heard them before, such as human rights, mental health, and access to healthcare for all.

Climate Change: Route to Net Zero

Climate change is a major theme that's frequently discussed in ESG investing, as governments worldwide have stepped up with their climate-related measures and regulations. Companies and investors have pledged to achieve net-zero emissions by the end of the decade, which will soon be the standard practice for all as time passes by. All sectors involved, including those that emit a lot of greenhouse gases (Eg: Energy consumption in Buildings, Transport, and Industry), will be part of the transition towards the low-carbon economy because companies have started to acknowledge the risks and opportunities connected to tackling against climate risks.

Various firms will look into this space and capture new business opportunities while promoting themselves as future climate leaders. For investors wise, they will most likely integrate climate risk into their voting policies, being proactive towards voting against the management if they are not addressing the issues on hand.

Source: Climate Watch, the World Resources Institute (2020)

Governments’ climate advisors and authorities have proposed legally binding “carbon budgets,” which align with national targets of “net-zero” emissions by 2050. UK has recently hosted the United Nations Climate Change Conference (COP26) this year, but most countries still fall far short of the Paris Agreement requirements.

Hopefully, by the 2030s, we will see a phase of markedly sharp drops in emissions as high-carbon technologies, such as gasoline and diesel cars, are being phased out. The target is to reach a completely decarbonized power system by 2035. Countries are also now aware that they need to account for their share of international aviation and shipping emissions.

ESG Disclosures

There are lots of disclosure and reporting frameworks being implemented by different companies. It may lead to less reporting from companies with fewer resources, to begin with. Disclosures on environmental and sustainability factors must be standardized for all to facilitate a better flow of information retrieval and reporting standards.

Currently, existing reporting standards are available for companies that serve as a blueprint/guideline to implement in their mandatory reporting. It also aims to meet the needs of the investment community while addressing them as accurately as possible.

You can refer to Sustainability Accounting Standards Board (SARB) and the Task Force on Climate-related Financial Disclosures (TCFD). Discrepancies in individual ratings still exist, but everyone is working towards increasing the assurance and accuracy of disclosures to enable more transparent ESG ratings in the years to come.

Data and Technology

Data and Technology have the great potential to drive insightful changes, such as the ability to measure, calculate, and monitor ESG factors accurately while assessing their impact on a long-term scale. Nonetheless, this task would not be straightforward and quick to realize. As the landscape is ever-changing, agile, and flexible tools are required to handle and address the changing data sources, standards, and reporting mechanisms.

A feasible solution would be the ability to draw in many different forms of data to analyse them and present them in a clear view. Rather than fragments of information/data that are available today. I believe that right now, due to such demand, Fintech firms have emerged and are deploying artificial intelligence (AI) to break down such data surrounding ESG issues.

This would benefit the company’s reporting, and financial performance while bringing smiles towards the investors and the public. The ultimate goal is to deliver actionable insights consistently while moving the industry towards ESG’s standardized future.

To conclude, this is a general overview of ESG investing and the factors that would influence its growth. There are other factors and information that I may have missed out on while keeping it as relevant and concise as much as possible.

Feel free to comment and share your opinion and perspectives below!

Disclaimer: The opinions expressed here are based on my research and for educational purposes only. It does not serve as a piece of investment advice. Readers should do their due diligence and plan out their financial goals first before investing in any financial products.