What is ESG?

ESG is a generic term given to non-financial factors (Environmental, Social and Governance) that can have a material impact on firm's valuation. On the environmental side of things, that could include climate change, energy and water management, air emissions and waste generation. For social issues, that could include human rights standards, labour practices, health and safety, customer privacy, and workplace diversity and inclusion. Governance issues often times has to do with board independence, succession planning, incentive systems and minority shareholder rights.

ESG investing aims at incorporating these Environmental, Social, and Governance issues as part of an investment decision-making process. The focus is on long term value creation and accounting for negative externalities (Eg. BP oil spill, Takata airbag recalls, Boeing MAX 737 crashes, Volkswagen Emissions scandal and Satyam and PNB scams).

Not every issue will be relevant for every company and what really matters is the materiality of those issues. Environmental issues may be more important to manufacturers and energy intensive companies and less important to the technology sector. Organizations such as the Global Reporting Initiative and the Sustainability Accounting Standards Board develop a “Materiality Map” that helps investors better understand what issues are most important by industry and sector.

There exist four main approaches to ESG: portfolio screening, ESG integration, impact investing, and active ownership.

1)   Portfolio screening: Investors include or exclude companies depending on their particular views or personal beliefs. Common industries in an exclusion list generally comprise alcohol or tobacco or fossil fuels.

2)   ESG integration: An investor complements traditional investment management with ESG issues, both in terms of risk and opportunities, to help improve investing decision making and outcomes.

3)   Impact investing: Investors are looking at how they can make a positive, measurable societal or environmental impact while still generating a level of return. As an example a fund may be established to specifically invest in renewable energy projects.

4)   Active ownership: This involves a high level of engagement with investee companies to encourage or discourage, good or bad ESG practices, respectively. An investor will use his ownership in the company to bring forth shareholder resolutions or look to engage with the company on material ESG aspects.