What is ESG Investing?
Integrating ESG factors is a risk management tool used to achieve a certain social or environmental goal along with earning financial return. ESG refers to the inclusion of Environmental, Social, and Governance risks and opportunities into the financial analysis and investment decisions. (US Sustainable Investment Forum, 2014.)
The ESG methodology considers the following:
Environmental Factors screen to overweight companies involved in positive environmental activities (i.e. pollution reduction, clean energy, and recycling), and to exclude companies involved in detrimental environmental practices (i.e. hazardous waste, substantial emissions, sale or production of coal or oil, and nuclear power production).
Social Factors screen to overweight companies providing social benefits (i.e. charitable giving, diversity, work/life balance, employment for the disabled), and to exclude companies involved in controversial or negative social activities (i.e. alcohol, tobacco, weapons, and child labor).
Governance Factors screen to overweight companies with positive corporate governance practices (i.e. transparency in reporting, strong employee relations, and product safety), and to exclude companies with poor governance or management (i.e. excessive management compensation, health and safety concerns, and reckless accounting practices).
Must one sacrifice returns to reflect ESG values in a portfolio?
In recent years there has been a proliferation of investment solutions to reflect ESG factors in investment portfolios.
The MSCI KLD 400 Social Index was launched in 1990 to help socially and environmentally conscious investors by providing a benchmark focused on companies with outstanding ESG ratings and excluding companies whose activities have negative social or environmental impacts.
Though there have been periods in which the KLD 400 Social Index has underperformed, over time the index has tracked the broader market closely and has provided competitive returns.
Lower risks and higher returns?
As environmental, social, and governance factors gain attention, regulatory and other incentives provide additional support for ESG companies.
As fines for breaking environmental and governance regulations become more significant, ESG screening can help reduce portfolio risks.
In the article below, "The Important Role of Capital Markets in Driving Sustainability", NASDAQ CEO, Adena Friedman, considers the important role that exchanges and capital markets can play to create new incentives and disclosures to promote better ESG practices.