What is ESG?: An overview
Environmental, social, and governance factors and considerations are growing increasingly important across all aspects of corporate life. From reducing carbon emissions, constructing well-diversified boards to appropriate IT security infrastructure, companies around the world are being held to account by governments, employees, customers, and investors.
The Environmental pillar includes, but isn’t limited to:
- a company’s track record or efforts on climate change issues and carbon emissions
- air and water pollution
- energy efficient waste management
- water scarcity
- biodiversity and deforestation.
The Social pillar includes:
- gender and diversity policies
- safety and quality controls
- human rights
- labour standards
- privacy and data security
- employee engagement.
- board diversity
- corporate ethics
- executive compensation
- bribery and corruption policies
- lobbying activities and accounting practices.
Why is this important?
Increasingly, investors expect companies to demonstrate that they’re well-run businesses, with strong environmental, social and governance policies in place.
As ESG awareness grows, investment managers are taking note of these dynamics, and accounting for them in their investment processes. And the industry is working to incorporate ESG considerations and analysis into its practices.
We’ve observed that this isn’t just about meeting growing investor demand—instead, fund managers are incorporating ESG because they believe it can improve their overall investment process and results.
As stakeholders hold public companies to higher standards for corporate behaviour and performance, these issues become central to a company’s sustainability and ethical impact.
How do you get started?
So, how can you consider ESG when you’re investing? It’s important to note that ESG means different things to different people. Some investors won’t want any exposure to certain industries for moral, ethical or values reasons (tobacco, alcohol, gambling, weapons), while others are more concerned about knowing that the companies they’re investing in have appropriate policies and structures in place.
Historically, ESG approaches have excluded companies within industries like gambling, weapon manufacturing, thermal coal, etc.
Today, there are different approaches an investment manager can take. Some of the most notable and with the largest assets under management are:
- Values-based or preferences-based: a large category, with many different options having been created to meet investor needs
- screening out or excluding certain stocks
- Impact or thematic investing: mission-driven companies searching for solutions to large-scale environmental and social issues
- Corporate engagement: shareholders can influence companies by through shareholder action by communicating with boards or voting as a shareholder.
- ESG integration: mitigating risk – analysing the risks associated with investment opportunities from an ESG perspective
As ESG considerations grow, more investment managers are offering preference-based portfolios. One challenge to these is finding one that aligns to your own values and preference as well as your level of conviction. For example, an investor may be against tobacco companies, but does that mean they also want to screen out the likes of Wesfarmers (owners of Coles and one of Australia’s largest companies) that sell tobacco products.
By contrast, ESG integration funds seek to build portfolios that reflect sustainability factors from a valuation and investment opportunity perspective.
Going forward, we expect conventional funds to move into the broader ESG integration group, and more ESG integration funds to move towards impact investing.
ESG incorporation and ESG preferences-based portfolios have plenty of room to grow. Assets under management and flows, though both higher than ever before, remain small compared with the overall investment universe. Investment managers are recognising the fiduciary benefits–not to mention satisfying investor demand—that come from incorporating ESG considerations.
For more information, watch Morningstar’s Bianca Rose explain ESG risk integration here.
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