ESG investing, sometimes referred to as socially responsible or sustainable investing, has grown in popularity over the years. ESG stands for environmental, social, and corporate governance, and it's used to help investors examine companies through a different lens.
Traditionally, what mattered most was a company's financial performance, but ESG investing looks beyond that. That's not to say ESG investors ignore financial performance altogether, but it's not the only factor used in making investing decisions.
The ESG metrics
The environmental aspect of ESG focuses on a company's environmental impact with an emphasis on its role in climate change -- not only with its current operations, but also its commitment to operating more "green" in the future. This metric is especially useful when examining companies with high energy use or pollution.
If you're looking at a company as a potential investment, you should also want to know how it interacts with society. That's where the social aspect of ESG comes into play. It focuses on how a company treats its employees and customers, as well as its involvement in local communities. Issues can include worker conditions, diversity and inclusion, data privacy, and philanthropy.
Corporate governance examines how a company is run. As an investor, you should want your companies to be honest in their reporting, transparent, compliant, and generally run with integrity. There have been many instances in which a company is seemingly thriving from the outside, but on the inside it's pure chaos, leaving investors unknowingly on a sinking ship. ESG helps to hopefully avoid these instances.
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Using ESG metrics to find risks
One important thing to note about ESG metrics is that investors should primarily use them to gauge the risks of a company's business. For example, an energy company that profits off fossil fuels would be susceptible to growing regulations around climate change; a company that deals with sensitive data could face costly consequences from a data breach; and a company misleading investors with inaccurate financial reporting could do irreversible damage to its reputation.
You may not personally care about a certain aspect of ESG, but if it affects a company's long-term success, you should at least be aware of it.
ESG ratings
Unfortunately, no universal ESG rating system is used across all stocks and funds, and you'll find that some systems give a different weight to each of the three different aspects of ESG investing. Some may prioritize one metric over the others, while others focus solely on specific metrics. This is why when you're looking to invest in an ESG fund, it's important to read the fund's objective and how the companies were picked to ensure it aligns with the particular issue you care about.
The MSCI ESG score is one of the most popular ESG grading systems, and uses the following ratings (from worst to best):
- CCC
- B
- BB
- BBB
- A
- AA
- AAA
Companies that fall in the CCC/B range are considered to be more exposed to ESG risks, those in the BB to A range are average, and those in the AA/AAA range are considered ESG leaders (a title less than a quarter of companies receive).
Kill two birds with one stone
Focusing on sustainable investing is a good thing and should be encouraged. However, it's also important to use ESG insights as a supplement to traditional investment wisdom, not as the sole deciding factor. You don't want to be making ill-advised investments in companies strictly because they're performing well on the ESG scale -- that goes against the purpose of investing, which is to make money.
Luckily, many great companies perform well on the ESG scale, allowing you to kill two birds with one stone. Investing ethically and in ways that align with your values while also making money is a win-win.
