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ESG describes the three areas that characterize a sustainable, responsible, and ethical investment: environmental, social and governnance. The term has become commonplace in corporate boardrooms and in turn, it’s an important area to understand for your commercial awareness.

ESG: Environmental

The environmental aspect of ESG concerns the conservation of the natural world. The environmental criterion considers the environmental risks a company might face in its day-to-day operation, and evaluates the steps the company is taking to manage and mitigate these risks. The E in ESG is arguably the most important, with 88% of One Trust’s global respondents ranking Environment as the highest priority.

Factors assessed include:

  • The company’s contribution to climate change through global production
  • The company’s resource depletion, as well as ownership and treatment of contaminated land
  • The company’s contribution to deforestation
  • The company’s use and protection of water and marine resources
  • How the company disposes of its waste
  • How the company manages its pollution and toxic emissions
  • The company’s compliance with governmental environmental regulations
  • The company’s supply chain

That said, there is currently no standardised approach to the calculation or presentation of the Environmental metric. In the UK, guidance can be seen through EU Regulations, but ultimately investors can draw from a variety of data sources to determine how responsible any given investment may be.

ESG: Social

The social concept of ESG focusses on considering other people, and relationships between the company and wider world. The social criterion is based on the idea that companies have a responsibility – to their own employees, and to the societies in which they operate.

Factors assessed include:

  • The working conditions and labour rights of the company’s workforce
  • Initiatives the company has employed to promote diversity and inclusion
  • The company’s understanding and commitment to upholding human rights
  • The approaches taken towards data protection and privacy
  • The company’s supply chain

The social criterion therefore goes beyond ‘negative screening’ or ‘ethical investing’ whereby investors simply exclude certain industries such as weapons manufacturing, alcohol production or fossil fuels extraction from their portfolio. ESG investing considers the company’s operation more broadly.

ESG: Governance

The governance aspect of ESG surrounds the standards used for running a company and ‘active corporate governance’.

Factors assessed include:

  • The rights and responsibilities of the management of the company
  • The composition of the board and internal control
  • Transparency and openness in shareholder contracts and shareholders’ voting possibilities
  • The accuracy and transparency of accounting methods
  • Executive compensation
  • Bribery, lobbying, political contributions, and corruption
  • Whistleblower schemes
  • The company’s supply chain

The G in ESG can often be overlooked with analysis quick to focus on climate change and societal implications. However, it is important that companies understand their decision-making governance risks. Poor governance practices have come under fire in some of history’s largest corporate scandals. Examples include the Theranos scandal and Facebook’s misuse of user’s data.

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ESG Investing

Where companies do not ensure good business practice on ESG, they increasingly face financial and reputational repercussions. One recent example is the halving of online fashion retailer Boohoo’s share price following allegations of labour rights abuses in supply chains.

One of the most important commercial topics for companies to consider is ESG investing, which has seen a surge in popularity. In 2018, ESG funds saw around $5.4bn in inflows. This has risen dramatically, with ESG funds raking in over $21bn in 2021’s first quarter alone. American investment management firm BlackRock has predicted that by 2030, ESG will exist as its own investment category worth $1trillion.

Sustainable Finance

Sustainable finance is any type of financial service or instrument which integrates the ESG criteria to give a better outcome. Sustainable finance is most commonly seen through bonds and loans.

Bonds: (funds come from the investor market)

  • Green Bonds are financial instruments specifically earmarked to raise money for climate and environmental projects. They often come with tax incentives so can be attractive to investors. The World Bank has issued 164 green bonds since 2008, worth $14.4bn in total. 33% of the World Bank’s green bonds have been used to fund renewable energy and efficiency projects; 27% goes towards clean transportation, and 15% towards sustainable agriculture and land use. More broadly, green issuances reached a record $270bn in 2020 thanks to an increasingly climate-aware market. Renewable energy has been a focus here in the UK with increasing numbers of government subsidies to fund solar and wind energy projects.
  • Blue bonds are issued where the funds are committed to marine or water projects, such as sustainable fish stock, protection of coral reefs, reducing acidification or investing in transition.
  • Social bonds are financial commitments to important social impact projects
    Sustainable bonds are issued in alliance with the UN Sustainable Development Goals. The capital can be used to provide energy efficient, low-cost housing for people with restricted access to the housing market

Loans: (funds come from the bank)

  • Green loans invest in environmental or climate projects such as plastic recycling
  • Social loans are used for social impact projects such as employability training
  • Sustainability loans see funds committed to a combination of green and social impact projects. The ESG performance of the company is key. Sustainability Linked Loans are evaluated on the impact that ESG issues have had on a company’s economic value rather than the use of the funds. An improvement in the borrower’s ESG performance will translate to a decrease in the interest rate.

The Future of ESG Investing

The financial services industry created a series of ESG-focused ETFs (exchange-traded funds) in response to the growing demand for ESG investments. 2020 recorded a year-on-year increase of 30% of the number of open-ended and ETFs created with ESG-focus. This is set to grow.

ESG metrics are not currently required in publicly traded companies’ financial reports but many have chosen to display them in a separately issued document. Many regulators are pushing for a standardised framework, through which ESG disclosures can and are required to be reported. One risk of ESG investing is ‘greenwashing’. This involves misrepresenting an investment product’s ESG characteristics. ESG branding is usually markets as ‘green’, ‘low-carbon’ and ‘sustainable’ but, as pointed out by SEC chair Gary Gensler, there is no standardised meaning of these terms.

Critics of ESG investing often rely on neoclassical economist Milton Friedman’s argument that evaluating a stock should focus on the company’s financial value and bottom-line profits alone. By considering ‘non-essential expenses’ such as socially responsible corporate expenditures, there is detraction from profitable investments and financial markets operate less efficiently. However, by conducting ESG research, it could be argued that investors are able to avoid companies whose practices could signal a risk factor. Two examples are BP’s 2010 oil spill and Volkwagen’s emissions scandal – both of which rocked the companies’ stock prices and resulted in billions of dollars of associated losses. These companies are unlikely to have been made it onto an ESG-focussed ETF. For ESG investing-cynics, perhaps ESG could be considered as another level of due diligence. Interestingly, over the three years to the end of 2020, 75% of ESG funds ranked in the top half of their fund category for performance.

Investopedia records that 67% of Generation X prioritise ESG performance when it comes to their investments. Similarly, Morgan Stanley Bank found that nearly 90% of millennial investors were interested in pursuing investments that more closely reflected the values they hold. It is likely therefore that ESG’s popularity will grow.

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