Consumers and companies have noticed the rising popularity of ESG investing in recent years. This is a fast-growing space that has the investing world excited about its future earning potential. To understand this latest trend, we will dive into what exactly ESG investing is, how it works, some pros and cons, and how to get started in ESG investing.

What is ESG Investing?

ESG investing stands for environmental, social, and governance. ESG investing is a strategy that focuses on a company’s dedication to environmental sustainability, social responsibility, and ethical governance compared to its competitors. It then gives them a score measured by independent, third-party research organisations. Let’s break down each of the three criteria in more detail.

Environmental

Sustainable practises and better environmental protection are more important now than ever in the face of global warming. ESG uses several factors to measure a company’s impact on the environment, including overall energy consumption (including green energy), carbon emissions and air pollution, water pollution, use of toxic chemicals and hazardous materials, waste management, depletion of natural resources, and deforestation.

Social

In the digital age, people care about the level of social responsibility shown by companies. Consumers want to know that a company treats not only their business partners well but their employees too, as well as having general human decency. Social criteria measured by ESG include equal employment and diversity as well as anti-discrimination policies at all levels of the company; fair labour practises such as a living wage and decent health care; subsequently aligned company policies; privacy and data security; and human rights.

Governance

Governance refers to how a company is run; leadership from the top will trickle down and steer the company in a certain direction, and with ESG, it’s hoped that leadership will support environmental and social initiatives. Governance mainly deals with ethical business practises, financial transparency, political contributions, rules surrounding corruption, executive pay, and the diversity of the management.

How does ESG Investing Work?

ESG investing offers investors the opportunity to align their money with their values. ESG looks at the net positive impact that a company brings to the world. By searching out companies with a high ESG score, investors can feel good about supporting sustainable, socially responsible companies. With the rising popularity of ESG investing, especially among young investors, more brokerage firms and mutual fund companies are offering exchange-traded funds (ETFs) that focus on ESG investment opportunities.

How ESG Investing is Measured?

Independent ESG research firms look at all the criteria to assess individual company ESG scores. Not every research firm uses the same metrics, and often they rely on multiple criteria to evaluate each component E, S, and G individually. Typically, a 100-point scoring system is used, the higher the number, the better the company’s overall ESG performance. Companies are also split up by industry so investors can choose an industry and compare companies’ ESG ratings.

Some of the most well-known ESG research companies and tools include S&P Dow Jones Indices (JDSI), Global Reporting Initiative (GRI), JUST Capital, MSCI and The Task Force on Climate-Related Disclosures (TCFD). ESG rankings can be different depending on the metrics a research firm chooses to assess. Some common things to review include annual reports, resource management, financial reports, corporate sustainability measures, employee compensation plans, and board structure. This gives a general overview of how a company is positively impacting its environment, communities, workers, and customers.

Pros and Cons of ESG Investing

Now that we have established what exactly ESG investing is, let’s discuss the positive and negative sides of ESG investing. First, the pros. ESG investors could see improved financial returns with responsible investment. This is because the company’s ethical business practises and lack of harm to the environment and society make it a safer investment. Companies that cause environmental harm or court scandals with multiple lawsuits often see their stocks plummet as their reputation takes a hit. ESG investors want to rest assured that the companies they choose to invest in have no risky business dealings or ethical concerns they need to worry about. With ESG investing gaining more traction and proving to be a financial success, it could be that this sector will see even more investment gains in the future.

ESG investing is not a golden goose, though; there are still some drawbacks that investors should be aware of. First, ESG investing can limit the types of stocks to invest in and therefore narrow a portfolio’s potential gains. With the threat of a recession looming, investors might have to decide if they are willing to take a slight financial loss to stand by their ethical values. There is also a lack of universal standards when it comes to ESG investing, which can sometimes lead to reporting issues. Since the concept of ESG investing gained prominence relatively quickly, it outpaced regulations and tracking standards. This might lead to inconsistencies and errors in reporting ESG scores. In time, hopefully a solution will present itself.

How to get Started in ESG Investing?

If you are interested in ESG investing but are not sure where to start, not to worry, it is relatively simple. There are three important factors: knowing your own values, doing your research, and choosing your investments. The first step is to identify your values. Once you understand what’s important to you, you can define the areas you want to focus your investments on and what items you are unwilling to compromise on.

Then you can move on to step two: doing your research. You can accomplish this step on your own or with assistance from a financial or robotic advisor. You must look at companies you want to invest in and research their environmental, social, and governance policies to see if they align with your values or not.

Finally, you could choose your investments. You can choose to either invest in individual ESG stocks, an ESG fund, or a combination of both. ESG funds could do a good job of diversifying a portfolio while adhering to ESG standards, while picking individual stocks allows investors to focus on a specific environmental or social issue. Combining both could be a good way to round out a portfolio.

Final Takeaways

With its rising popularity in the investing world, it is good to define what ESG investing is and how it works. Developing a full understanding is key before making any financial decisions. ESG investing is an ethical way to invest based on a company’s commitment to improving environmental, social, and governance policies. Ratings allow investors to determine if a company aligns with their personal values. While there are pros and cons to ESG investing, the financial track record of these types of investments will show if its popularity will continue to increase.

The information presented in this article is for informational purposes only and does not constitute investment advice or suggesting investment. The information contained in this article may not be complete or current and is subject to change without notice. It is recommended that independent advice be sought from a qualified financial adviser before making any investment decision. Past performance of financial instruments is not a guarantee of future results. The value of investments can both rise and fall and may not be guaranteed. Investments in ESG products are subject to risks associated with all investments. Readers should carefully consider the specific risks associated with ESG investments before making an investment.