What Is ESG Investing & What Are ESG Stocks?

What does ESG stand for?

"ESG" stands for environmental, social, and (corporate) governance.

How to evaluate corporate ESG performance

1. Corporate reporting

Companies committed to ESG initiatives should publish measurable goals, plus the progress against those goals, in periodic sustainability reports.

Some sustainability reports are better than others, however. Look for reporting that follows ESG standards established by the Global Reporting Initiative (GRI) and/or the United Nations Principles for Responsible Investment (PRI).

ESG stocks reduce portfolio risk

In any industry, environmental, social, and governance issues pose serious risks to operations and profits. Below are three examples of negative outcomes that could have been mitigated with proactive ESG policies.

• Electric vehicle (EV) maker Tesla (NASDAQ:TSLA) agreed to pay $1.5 million in 2024, stemming from allegations that it had mishandled hazardous waste in California. If the company implemented better environmental management systems, the issue could have been avoided.
• 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.
• In 2024, the Consumer Financial Protection Bureau (CFPB) charged Toronto-Dominion Bank (NYSE:TD) almost $28 million in penalties for the bank's failure to provide accurate customer information to credit agencies, resulting in possible harm to their credit scores. The CFPB also ordered TD Bank to implement better measures to ensure that such violations didn't happen again.

Companies actively working to address risks like these should see fewer business disruptions and produce more reliable financial results over time, providing less risk for shareholders.

High ESG focus, high returns

There's also growing research that shows ESG stocks generate comparable or superior financial results compared with their non-ESG-focused peers.

Asset management start-up Arabesque found that S&P 500 (SNPINDEX:^GSPC) companies in the top quintile for ESG outperformed those in the bottom quintile by more than 25% between 2014 and 2018. The stock prices of ESG companies were also less volatile.

In The Journal of Applied Corporate Finance, Dan Hanson and Rohan Dhanuka concluded that "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."

ESG as an indicator of strong leadership

Why ESG companies perform better isn't clear. One theory is that a corporate ESG focus requires exemplary leadership. ESG initiatives are long-term programs, and a leadership team's ability to realize long-term outcomes -- while running the core business well -- is a competitive strength.

Risks of ESG investing

• Lack of universal ESG standards. There are no agreed-upon standards for evaluating ESG performance, creating inconsistencies in ESG portfolios and funds. You may be surprised to find some ESG funds hold tobacco stocks, for example.
• No long-term data on the financial performance of ESG companies. Longer-term data could show that ESG companies aren't as resilient as once thought. If that happened, investors who are wholly focused on financial returns would likely shift away from the ESG sector.
• Companies could stop reporting on ESG issues. Companies could stop voluntarily reporting sustainability data. Lowering the priority of ESG attributes could reduce the supply of high-quality, investable ESG companies.