Discover Environmental, Social and Governance (ESG) Investing

In relation to investing, ESG stands for environmental, social and governance, and generally refers to the ways in which investments can be evaluated from an ethical and sustainable perspective.

Environmental

Environmental factors range from energy use and impact on climate change, greenhouse gas emissions, waste, pollution, and natural resource conservation to animal treatment.

Social

Social factors include matters such as a company’s relationships with its stakeholders and includes working conditions, impact on local communities, health and safety and employee relations and diversity.

Governance

This relates to corporate governance and includes the proper use of accurate and transparent accounting methods, fair voting, avoiding conflicts of interest and not engaging in unlawful behavior.

What investors should know about ESG metrics

There is no universal ESG criteria to assess companies, ETFs or other funds around the world. This means the approach used to determine what is a ‘good’ or ‘bad’ ESG rating varies significantly across research bodies and fund managers, ranging from superficial applications of ESG metrics to more comprehensive approaches.

ESG and sustainable investing has been increasing in popularity over the last decade. According to Bloomberg, ESG assets are set to reach over $40 trillion by 2030.There are many potential advantages of ESG investing, as well as some possible challenges.

Advantages of ESG investing

Alignment with investor values and ethics

Adopting an ESG approach helps investors to avoid supporting companies that may be in conflict with their morals or ethics, which could include weapons producers, tobacco producers or companies known to use slave labour, while also actively directing funds toward companies that prioritise sustainability, corporate citizenship and other ethical business practices.

Helps investors identify companies that are damaging the environment

ESG analysis can help determine the environmental impact of a company’s operations, services or products, allowing investors and fund managers to screen out and/or focus on companies that are leading their peers in terms of limiting damage to the environment.

This can give investors the power to avoid supporting polluting companies and those with excessive carbon emissions.

ESG criteria may enhance long-term returns

Some studies have shown companies with more robust ESG practices tend to deliver stronger long-term financial returns and therefore higher returns compared to companies that exhibit poor ESG ratings. According to the Responsible Investment Association Australasia’s (RIAA) 2023 Benchmark Report, the performance of RIAA certified funds consistently stays on par or better than benchmarks over medium and long term periods, with managed growth funds particularly excelling. But as with any investment, past performance is not indicative of future performance.

Incorporating ESG metrics may help mitigate risk

Companies with strong ESG metrics are typically better equipped to navigate environmental, social and governance challenges, reducing the likelihood of reputational damage, regulatory incidents, talent drain and other events which have a negative financial impact and reduces shareholder value. For example, more than US$70 billion was wiped off the value of Facebook (now listed at Meta) in the 11 days after the Cambridge Analytica privacy scandal hit the headlines.

Challenges of ESG investing

Performance challenges

Companies with strong ESG credentials may not deliver outperformance in the short term due to impacts unrelated to ESG factors like general economic and market conditions and sentiment.

Taking an ESG approach reduces the investment universe

By only considering companies that have high ESG ratings, investors have a more limited pool of investments to choose from. For example, typically ESG funds and ESG focused investors do not include coal mining companies due to carbon emissions or some of the world’s largest cosmetics companies due to animal testing exclusions.

Difficulty in selecting and assessing ESG credentials

The vast number of attributes that can be considered ESG factors, the difficulty in measuring many of these factors, and having the capability to locate and access the information required to make these evaluations poses significant barriers for individual investors. It can be very costly and time-consuming to conduct the required research. This is why most ESG investors and many fund managers utilise research houses that have significant expertise in this area and have teams dedicated to periodically evaluating companies.

Greenwashing

Greenwashing is when companies make misleading claims about their business, product or service being more environmentally friendly and/or ethical than in reality. Greenwashing can include vague or unsubstantiated claims, exaggerating benefits or selectively omitting information known as “cherry picking”, and using imagery to imply falsehoods.

For more information about greenwashing in financial services, read Information Sheet 271 from the Australian Securities and Investments Commission (ASIC), which provides more detail around the regulations that fund managers must adhere to with regard to ESG and sustainable funds.