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What Is ESG Investing?

Updated: March 11, 2021, 9:01 p.m.

Author's note: Alyce Lomax co-authored this content.

There are a variety of different investing philosophies within the responsible investing realm. One approach you may have been hearing about more often is ESG investing.

ESG stands for

Environmental, Social, and Governance

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"ESG" stands for environmental, social, and (corporate) governance. ESG investors examine criteria within these three categories to identify companies that perform well using ESG-related metrics. Combining the ESG lens with more traditional stock analysis techniques is known as ESG integration. Anyone can join the swelling ranks of ESG investors by simply learning more about ESG and then using the framework to make future investing decisions.

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ESG investing is gaining traction, and it's no wonder. Research increasingly shows that this investing method can reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks that they own.

The COVID-19 pandemic has only strengthened the case for ESG investing. The resulting market turbulence produced further evidence that the stocks of companies with strong performance on ESG issues are often less volatile. The pandemic also raised public awareness of, and support for, social issues that fall under the ESG purview, such as worker health and safety.

What does ESG stand for?

First, let's demystify the ESG acronym to highlight what ESG investors look for in stocks. As previously noted, ESG stands for environmental, social, and governance. ESG investors consider a company’s record in these three areas, along with its financial performance, when making investment decisions.

E is for environmental

The environmental component encompasses a company's impact on the planet in both positive and negative ways. A company that's an actively good steward for the environment might be more deserving of your dollars than one that is not.

Environmental aspects of a company to research and analyze include:

  • Climate change policies, plans, and disclosures.
  • Greenhouse gas emissions goals and transparency about how the company is meeting those goals.
  • Carbon footprint and carbon intensity (pollution and emissions).
  • Water-related issues and goals, such as usage, conservation, overfishing, and waste disposal.
  • Usage of renewable energy, including wind and solar.
  • Recycling and safe disposal practices.
  • Green products, technologies, and infrastructure.
  • Environmental benefits for employees, such as bicycle commuting rewards programs and environmentally based incentives.
  • Relationship and past history, if any, with the U.S. Environmental Protection Agency (EPA) and other environmental regulatory bodies.

Note how the word "goal" is sprinkled throughout the above bullet points. While goals are nice, concrete numbers and metrics that demonstrate real progress are much better.

For those details, locate sustainability reports prepared using respected sustainability standards, such as those established by the Global Reporting Initiative (GRI) and the United Nations Principles for Responsible Investment (PRI). Corporate websites with sustainability pages can be useful for budding ESG investors, but be wary when they don't contain enough detail to paint a complete picture. For example, we can appreciate companies that demonstrate a commitment to recycling, but that alone would not merit recognition for being environmentally responsible.


Nike (NYSE:NKE), for example, is a company that meets the environmental criteria of ESG. A leader in environmental dedication, Nike has a chief sustainability officer who oversees its many environmental efforts. Its Flyknit and Flyleather products, which use waste materials and synthetic materials and recycled leather fiber, respectively, were developed with environmental sustainability in mind. In 2015, Nike signed on to a coalition of companies called RE100, vowing to use 100% renewable energy across its operations globally by 2025. The company has already reached 100% of that goal in North America.

There's more, but any interested investors should read Nike's latest sustainability report, which applies the GRI framework, the Sustainability Accounting Standards Board (SASB) principles, and the United Nations' Sustainable Development Goals (SDGs). Nike is a great example of what ESG investors should look for in an environmentally responsible company.

S is for social

The social component of ESG consists of people-related elements, like company culture and issues that impact employees, customers, consumers, suppliers, the local community, and society at large.

For information on a company's social performance, ESG investors should look to sustainability reports that use a respected standard like the GRI or PRI framework, which each go beyond environmental issues to include information pertinent to employees, suppliers, and the community.

Socially minded investors can also keep up with respected lists and annual rankings, including Fortune's Best Companies to Work For and Forbes' Just 100. Media reports on how companies treat their employees and the companies' lobbying efforts for or against social justice issues are also relevant. Another good way to gauge how a company and its management is received by its workers is to read employee reviews on websites such as

Social aspects of a company to research and analyze include:

  • Employee treatment, pay, benefits, and perks.
  • Employee engagement and staff turnover/churn.
  • Employee training and development.
  • Employee safety policies, including those related to sexual harassment prevention.
  • Diversity and inclusion in hiring and in awarding advancement opportunities and raises.
  • Ethical supply chain sourcing, such as conflict-free minerals and responsibly sourced food and coffee.
  • Mission or higher purpose (or lack thereof).
  • Customer service friendliness and responsiveness.
  • Performance history for consumer protection issues, including lawsuits, recalls, and regulatory penalties.
  • Public stance on social justice issues, as well as lobbying efforts.


Accenture (NYSE:ACN), as an example, has a well-regarded workplace, earning it a spot for 12 years on Fortune's list of Best Companies to Work For. Accenture pays close attention to diversity and inclusion in its workforce. The company plans to improve its workplace gender ratios, with a goal to have 50% female and 50% male employees by the end of 2025. Accenture plans to improve its corporate makeup as well. The company currently has 25% women managing directors and is working to increase that number to 30% by 2025. If you read Accenture's Corporate Citizenship Report, you will find that its efforts satisfy some of the UN's SDGs, and the report also uses the GRI disclosure standard.

G is for corporate governance

The corporate governance component relates to the strength of the board of directors and company oversight, as well as how shareholder-friendly versus management-centric the company is. In less dry terms, a company with good corporate governance and a strong board of directors relates well to different stakeholders, runs its business effectively, and aligns the management team's incentives with the company's success.

Corporate governance issues come to the fore every year during proxy season, when most companies file their proxy statements, which announce annual meetings, define the issues to be voted on, and provide relevant supporting information. These documents routinely cover a variety of corporate governance topics. Shareholders can vote by proxy (without actually attending the annual meeting) on a variety of issues, such as executive compensation ("say-on-pay"), director appointments, and shareholder proposals.

Governance aspects of companies to research and analyze include:

  • Executive compensation, bonuses, and perks, including whether executives receive large bonuses when they leave the company.
  • Compensation tied to metrics that drive long-term business value.
  • Diversity of the board of directors and management team.
  • Potential for conflicts of interest for the board of directors based on the directors' independence and whether they hold other board seats.
  • Proxy access, meaning shareholders' ability to put forth board of director candidates.
  • Whether a company has a classified board of directors, which denotes whether term lengths among board members differ.
  • Whether the company's chairman and CEO roles are separate.
  • Whether board votes are decided based on majority voting (winner receives more than half the votes) or plurality voting (winner receives the most votes).
  • Whether the company issues dual- or multiple-class stock.
  • Transparency of communication with shareholders.
  • The nature and outcome of lawsuits brought by shareholders.
  • Relationship and history with the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies.

Many corporate governance details are found in sustainability reports, but interested investors should also read the annual proxy statements they receive from the companies in which they own shares. To research corporate governance attributes (including interesting tidbits such as CEO pay) before buying a stock, you can access proxy statements on the SEC's website by searching for the filing type DEF 14A.


Intuit (NASDAQ:INTU), as an example, exemplifies strong corporate governance. It has a 40% diverse board and extensively documents its board structure, strategy, and compensation, along with the board's audit, risk, and oversight processes.

Strong management teams and boards have a significant amount of "skin in the game," meaning that they own shares of the company's stock and therefore have a personal incentive to see that the company performs well. Intuit displays this with strong stock ownership guidelines that dictate that its CEO must hold stock worth 10 times his or her annual salary, and non-employee directors must hold the stock equivalent of 10 times their annual cash retainers. Intuit ties its executives' incentive (bonus) compensation to revenue and operating income; bonus pay is also based on the company's annual performance on goals related to treatment of employees, customers, partners, and stockholders.

The history of ESG investing

Over the course of decades, many management teams and investors have adhered to the shareholder value theory, which was popularized in 1970 by Milton Friedman (and is also known as the Friedman Doctrine). Friedman argued that companies' only responsibility is to maximize shareholder value -- in effect, to make money for the folks holding their stock.

Proponents of shareholder value maximization put the pursuit of profit (and shareholder returns) above all other considerations. Pursuing profit isn't inherently problematic -- after all, lack of profits can lead to a host of bad outcomes for companies, including bankruptcy. But many businesses can run into serious issues if management is only concerned with excelling by short-term profit measures to please Wall Street at the expense of all other stakeholders. Companies that chase the approval of shareholders instead of building relationships with stakeholders such as employees make workers more likely to unionize or quit. And, when this toxic focus on short-term gain pervades a company's culture, it's more likely that employees will make poor decisions to engage in dangerous, risky, or even illegal dealings to appease management's demands for immediate profit. Ultimately, obsessing over earnings per share and other short-term metrics is a good way for companies to become vulnerable to lawsuits, investigations, and increased regulations.

Enter socially responsible investing (SRI), which encompasses strategies that prioritize sustainability, responsibility, and positive impact. The precursor to ESG investing, SRI sprung from a niche investment strategy that emerged in the 1960s and 1970s, around the same time as Friedman's shareholder value theory. Some consider the Quakers' historical boycotting of "sinful" companies as the origin of the SRI philosophy, but many other observers point to South Africa's apartheid period as a crucial tipping point when investors began divesting from companies for moral and ethical reasons.

For decades, Friedman's shareholder value theory has been upheld because investors have been enjoying hefty returns, but modern investors are increasingly realizing that shortchanging stakeholders to juice shareholder returns is too high a price for society to pay. A company's stakeholders are not just its shareholders and employees, but they also include its customers, suppliers, distributors, communities, neighbors, and the environment, too. And shareholder value theory, perhaps ironically, ignores the basic fact that shareholders may also have other types of stakes in the companies in which they invest. Shoddy treatment of stakeholders who are also shareholders presents financial risk since those poorly treated stakeholders have the power to damage the company by selling their shares. This collective realization helps to explain why SRI and other ethically focused investing strategies have grown in popularity.

Investment strategies related to ESG

1. Socially responsible investing: SRI generally uses exclusionary screens, or filters, to eliminate from consideration those companies and industries that don't meet an SRI investor's particular value criteria.

For example, many SRI investors screen out tobacco, alcohol, and weapons stocks, leaving most other companies and industries eligible for further analysis. Others take issue with the lobbying done by certain companies and eliminate them from their consideration pools for that reason. SRI investors might also screen out all companies in a particular industry except those considered "best in class." An investor focused on best-in-class stocks in the fossil fuel industry might exclude all companies except those that outperform their peers in the areas such as sustainability, employee treatment, and corporate governance.

2. Shareholder activism: When investors buy large numbers of shares of companies that SRI investors find unpalatable or reprehensible, with the expressed purpose of engaging with those companies to encourage, or demand, improvement, that is shareholder activism. Engagement tactics include filing shareholder proposals, attending annual meetings, and speaking directly with executives. This strategy isn't necessarily about making money or being long-term, buy-and-hold investors. Usually, these shareholders sell their shares after the companies satisfactorily engage with them on reform by addressing the targeted issues or even fully meeting their demands.

Unfortunately, not all shareholder activists are socially responsible. The other type of shareholder activist seeks to influence management for typically short-term profit boosts that can hinder long-term strategic initiatives. Socially responsible or otherwise, activist investors who succeed do so only because of the massive amount of shares that they hold, so becoming an activist investor isn't an option for most individual investors. But it's worth knowing about these deep-pocketed investors, especially the vulturous ones.

3. Impact investing: Impact investors allocate their money to companies that have demonstrably positive environmental and social impacts. Regarding financial returns, impact investors have differing expectations. Some will accept below-market-rate returns, while others expect financial results that are comparable to, or even beat, the market.

An impact investor may choose to focus on supporting a highly impactful sector, such as sustainable agriculture. In such instances, a financial outcome that matches or beats the return of the S&P 500, for example, is not the criteria for success. Rather, impact investors want to observe some type of progress in the sector, using the relevant indicative metrics for analysis.

4. Conscious capitalism: Another buzzword that you've probably heard, conscious capitalism is a business management strategy that seeks to align the priorities of a business with those of its stakeholders for shared success. A "consciously capitalist" company not only seeks to generate profits to benefit shareholders, but it also proactively serves the company's other stakeholders in order to strengthen its business and generate long-term profitability.

The focus on creating value for stakeholders puts conscious capitalism in the same philosophical category as ESG, but it's better understood as a philosophy that is implemented by company executives. Investors can use the tenets of conscious capitalism as a way to evaluate the management of companies of interest.

How ESG investing is unique

ESG criteria is primarily applied to publicly traded companies for investing purposes. ESG-focused investors actively buy shares of companies because of their impressive environmental, social, and corporate governance rather than actively excluding certain industries or companies from their portfolios because they are deficient in certain ways. The ESG approach offers the most investment flexibility and makes good use of research into the details of comprehensive corporate initiatives and management teams' patterns.

ESG investing emphasizes financial materiality

ESG investors sometimes choose to focus only on companies' material financial issues, which vary by industry. Data security, for example, is of utmost importance to internet companies and retailers but less material for infrastructure companies.

Charitable giving by companies doesn't typically impact operations beyond good PR and brand enhancement, and so it is generally not considered by ESG investors as a financially material aspect. But a company's role in driving climate change is a financially material issue since global warming substantially impacts the company and all of its stakeholders.

The SASB designed a Materiality Map that defines which issues are "reasonably likely to impact the financial condition or operating performance of a company and therefore are most important to investors." ESG investors can use this Materiality Map to navigate which issues are financially material for which sectors.

But just because an issue isn't financially material to a company doesn't mean it doesn't ever matter to ESG investors. There are occasions when ESG investors buy or sell stock on the grounds that it's the right thing to do regardless of the financial materiality or impact of the issue at hand.

ESG investing can be exclusionary, too

Throughout the investment industry, ESG criteria are applied in different ways since there are no official ESG standards as yet. ESG investors' novel ways of using both inclusionary criteria and the financial materiality clause can yield interesting results in terms of what qualifies as an ESG investment. Distasteful industries that nonetheless rank well for ESG may make ESG-minded investors feel uncomfortable.

For example, a defense company that specializes in missile production but scores high on environmental sustainability, employee diversity and treatment, and corporate governance may technically merit inclusion in an ESG fund even though its stock would be a "no-fly zone" for a traditional SRI investor.

Some ESG investors do screen out entire industries, excluding certain companies no matter how high they rank for ESG.

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How ESG investing can reduce portfolio risk

Beyond its ability to help identify attractive long-term investment opportunities, the ESG approach to capital allocation reduces portfolio risk. Stakeholder issues related to the environment, social justice, and corporate governance all pose serious risks to companies' operations and profits, regardless of industry. To explain how an ESG-focused approach to investing can help mitigate business risk, below are a few examples of negative outcomes that could have been mitigated or completely avoided with greater corporate emphasis on ESG.

  • Major electricity and natural gas provider PG&E (NYSE:PCG) declared bankruptcy in 2019 as a result of the climate change-induced wildfires that have been ravaging California. This outcome, while extreme, is likely to become more common if companies don't adequately prepare for the financial risks related to climate change. While no company on its own can wholly stop climate change, major power producers like PG&E could reduce their environmental risks by actively working to not contribute to global warming.
  • Tyson Foods (NYSE: TSN) was sued in 2020 for wrongful death after employees with COVID-19 symptoms were allegedly ordered to continue reporting for work. The lawsuit also claims that the company did not provide face coverings or personal protective equipment and did not enforce social distancing practices. Not surprisingly, the company has faced public backlash as a direct result.
  • Banking institution Wells Fargo (NYSE: WFC) was compelled to fire 5,000 employees after the Consumer Financial Protection Bureau uncovered a fake account scheme within the bank in 2016. Employees, motivated to reach sales targets, were opening fake accounts, making transfers into those accounts, and assessing bank fees -- all without customer authorization. This failure in business ethics led to the forced resignation of CEO John Stumpf and the loss of accreditation from the Better Business Bureau.

ESG investing reduces environmental risks

Environmental risks are not limited to regulatory and reputational risks. Environmental challenges increase in conjunction with global warming, which is on track to devastate entire economies if it's not soon mitigated or reversed. Climate change can cause resource scarcity, natural disasters that are more frequent and of greater magnitude, and increased global poverty, as well as political unrest, instability, and even war -- all of which pose significant risks to companies' profitability. Environmentally responsible companies are not immune to these risks, but they are likely to fare better.

ESG investing reduces social risks

Research shows that treating employees well -- and keeping them engaged with their work -- improves business operations. According to Gallup, companies that excel at engaging their employees achieve per-share earnings growth more than four times higher than the growth rates of rivals. Compared with the companies in the bottom quartile for employee engagement, those in the top quartile enjoy higher employee productivity, better retention, fewer accidents, and 21% higher profitability.

Beyond contending with bad press and lawsuits that result from disregard for worker safety, companies with employees who are unhappy, unhealthy, or stressed are more likely to underperform. Unhappy employees won't be eager brand ambassadors willing to provide excellent customer service or dream up innovative new ideas for the company. They're also more likely to quit their jobs, leading to high rates of employee turnover that force the company to spend more money on hiring, training, and onboarding new employees.

ESG investing reduces governance risks

While the diversity of a company might sound like a social component, it also is directly related to governance. Companies with high levels of gender, racial, and other forms of diversity across workforces, management teams, and boardrooms gain unique and valuable intellectual capital and varied perspectives. Research shows that teams composed of the exact same types of people both make worse decisions and fare worse financially. In 2018, McKinsey examined data from 366 public companies in the U.S., Canada, Latin America, and the U.K. to find that companies in the top quartile for gender, racial, or ethnic diversity are more likely to generate above-median financial returns. The McKinsey researchers also discovered that the converse is true, concluding that "diversity is probably a competitive differentiator that shifts market share toward more diverse companies over time."

Did you know?

Research increasingly shows that ESG investing can reduce portfolio risk and generate competitive investment returns.

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High ESG focus, high returns

Portfolio risk reduction is important, but many more people are realizing that strong performances on ESG criteria can be viewed as indicators of companies with exemplary management teams. After all, concern about companies' ESG impacts aligns perfectly with long-term thinking, and the ability of a company to envision long-term outcomes is a competitive strength. Strategizing and planning for decades in the future is necessary although not the norm for the business world, where too many CEOs chase only short-term, quarterly profits. Thinking about how a business impacts various stakeholders requires a level of holistic, creative thinking, which by itself is a distinctive competitive advantage.

Plenty of data back up the notion that ESG-focused companies are also well-run and capable of producing financial results that are comparable or superior to their non-ESG-focused peers. The asset management start-up Arabesque found that S&P 500 companies in the top quintile for ESG outperformed those in the bottom quintile by more than 25% between 2014 and 2018. The ESG-focused companies' stock prices were also less volatile.

Consider this conclusion from The Journal of Applied Corporate Finance by Dan Hanson and Rohan Dhanuka:

In recent years a wide literature of academics and practitioners has been developed which supports the proposition that high ESG characteristics are associated with lower costs of capital and higher quality profitability including high [return on invested capital]. Several meta studies illustrate the "do well by doing good" premise that corporate responsibility as proxied for by ESG is consistent with stronger firm performance. As we observe across these multiple studies, there seems to be clear evidence that companies with high non-financial indicators of quality seem to perform significantly better on market and accounting-based metrics.

Integrating ESG into business operations allows executives to better manage complexity, too. Just think of how difficult it is to change the operations of a massive legacy business to become meaningfully more sustainable -- yet plenty of executive management teams are doing it. As one encouraging sign, 86% of S&P 500 companies now publish detailed sustainability reports outlining their efforts, up from just 20% in 2011.

Former PepsiCo (NASDAQ:PEP) CEO Indra Nooyi sagely envisioned that healthy food offerings would become more popular and unhealthy snacks and drinks, which contribute to public health risks, would fall out of favor. Acting on that vision, she began dedicating research and development spending to develop healthier treats to appeal to consumers.

An ESG investing focus can help make the world a better place for generations to come.

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ESG investing growth is stunning

Ethical investing has come a long way since its origins as a small investing niche, known at first only as social responsible investing. ESG investing and other related investment approaches are increasingly gaining traction with both financial institutions and everyday investors, all of whom are seeking to do good with their investing dollars while doing well for themselves. The growing ranks of ESG investors are a validating sign.

According to US SIF's 2018 Report on Sustainable, Responsible, and Impact Investing Trends, the value of the U.S. assets under management that have SRI- or ESG-related mandates has jumped 38% since 2016 to $12 trillion. These assets represent 26% of the total assets under management ($1 of every $4) in the U.S. For comparison, when US SIF first measured the value of ESG-focused assets under management in 1995, it was $639 billion. This segment of the investing market has increased 18-fold and produced a compound annual growth rate of 13.6%.

There are a variety of reasons why ESG-focused investing is becoming more mainstream. A frequently cited reason is that millennials -- people born between 1981 and 1996 -- consistently show a tendency to crave social responsibility, whether it's via the products they purchase, the organizations they work for, or their investment portfolios.

This activist attitude is reshaping many aspects of how business works in our society, including companies' increasing willingness to implement ESG best practices and take public stands on issues that were once considered too controversial. Why? Millennials are a massive generation, comprising more than 80 million individuals in the U.S. alone. In 2020, millennials represented an estimated $2.5 trillion in U.S. spending power, according to YPulse.

Baby boomers -- another huge demographic -- are poised to pass their money down to the younger generations, including millennials, with an unprecedented $30 trillion expected to come under new stewardship over the course of the next several decades.

Big financial institutions haven't failed to notice that younger generations care the most about ESG. Morgan Stanley's Institute for Sustainable Investing has conducted many studies and surveys related to the link between millennials and sustainable investing. Its 2017 survey of active individual investors revealed that (emphasis original) "86% of Millennials are interested in sustainable investing, or investing in companies or funds that aim to generate market-rate financial returns, while pursuing positive social and/or environmental impact. Millennials are twice as likely as the overall investor population to invest in companies targeting social or environmental goals. And 90% of them say they want sustainable investing as an option within their 401(k) plans." Bank of America Merrill Lynch predicted that, in the next 20 to 30 years, millennials could allocate between $15 trillion and $20 trillion to ESG investments in the U.S.

Risks of ESG investing

Every investing strategy has its risks, and ESG is no different. Let's go through a few potential pitfalls of prioritizing ESG criteria and how you can avoid them.

One of the major ongoing risks is the lack of widely agreed-upon standards in the fledgling ESG investing industry. While this opens the playing field for many interesting approaches to doing good while generating a solid investment performance, it also increases the possibility that some investment firms will use the veneer of being ESG-focused to acquire new clients without employing disciplined ESG investment strategies.

While there's potential for added benefit with the collection of better data on ESG performance, that data could also show that individual ESG investors aren't rock stars over the long term as we'd hoped. Headlines from new ESG research may proclaim that "ESG doesn't work" -- which may be true for some investors. Perhaps counterintuitively, surveys of millennials consistently show that they accept lower performance in order to invest in highly sustainable companies. So, even if millennials’ investments underperform, they're sleeping better at night.

Younger people are working for investment firms to perform research and analysis, and it's reasonable to assume that many will hone in on ESG. While companies with strong ESG track records largely performed well in the coronavirus-prompted crash in March 2020, ESG-focused companies are not immune from the effects of a more extended economic downturn -- especially if younger investors bail on their ESG investment theses under financial pressure.

Another risk of ESG investing is that companies can at any time abandon their stakeholder-centric actions and stop voluntarily reporting sustainability data. Any broad market deprioritization of ESG attributes would have the effect of reducing the supply of high-quality ESG companies for investors.

Is ESG investing right for you?

If you're not a self-directed investor, then it's important to do your homework on the methods that your money manager uses and whether they screen out certain industries. Otherwise, you may be invested in companies and industries that you don't want in your portfolio.

When justifying ESG investing from a purely financial perspective, it's important to remember that ESG is a stakeholder-centric approach. If you believe that considering the priorities of all stakeholders is a reliable way to generate above-market returns, then you could even treat ESG investing as a fiduciary responsibility.

ESG investing isn't all that mysterious, but it is something to get and remain excited about. If you're attracted to the more traditional SRI and want your portfolio to outperform the broader market, then ESG investing could be the strategy for you.

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