What is ESG? A QUICK GUIDE

By Daniella Woolf, Danesmead ESG

Historically, investment objectives were primarily financial – the role of investors was to maximise returns and minimise risks – i.e. make as much money as you can. The world has changed. Increasingly, investors and beneficiaries are looking for more from their investments. They don’t simply want to make money, but they also want to do so in a way that considers sustainability, people and the planet, and responsibility.

The financial services industry has adopted the acronym ESG: Environmental, Social, and Governance. This is a framework for evaluating how much a company or investment vehicle prioritises certain societal benefits alongside the normal business objective of maximising profits to shareholders. Other terms sometimes used interchangeably with ESG include Responsible Investment, Sustainable Investment and Socially Responsible Investing.

Environmental

The E in ESG is concerned with the wider environmental impacts of a business.  Historically there has been a focus on climate change and much of the ESG attention has been on metrics such as the carbon emissions of a business.  This often includes whether a business’ operations are aligned with certain frameworks such as the Paris Agreement, which aims to limit global warming to a 1.5 degree C rise in temperature.  Environmental criteria have become more sophisticated in recent years, and now include things like a company’s waste, pollution, deforestation and impact on biodiversity.

Social

Social considerations include the wider social context of a business, such as whether it provides a safe working environment for its employees, if women and minorities are adequately represented in leadership positions, and whether the company advocates social good in the community. 

Governance

Governance is assessed by looking at how a business is run.  Are the accounts transparent and accurate? Is the board acting in the interest of its shareholders?  Governance issues are generally seen as red flags for investors and are often indicative of bigger issues within a company.

ESG Investing

There are two main ESG investing concepts to be aware of:

1.     Financial Materiality – this approach is all about protecting your investments from ESG risks, e.g. to what extent is climate change having an impact on a business.

2.     Double Materiality – this approach looks at the impact companies are having on the real world, e.g. to what extent is the company contributing towards climate change.

Investors have established a range of different approaches and techniques to ESG investing. The main ones include:

-        Screening – negative screening, or exclusions, is where an investor will avoid investing in companies altogether due to ESG risks – this will often relate to certain sectors e.g. tobacco, fossil fuels and weapons. Screening can also be positive – where an investor will only select investments that meet certain positive criteria (e.g. companies that align with the Paris Agreement).

-        Integration – this term is broad and relates to a general consideration of ESG risks and opportunities when selecting investments. For clarity, the identification of an ESG risk may not prohibit an investment going ahead, but would need to be factored into the financial model.

-        Engagement – when an investor seeks to influence change at a company – often relating to improving certain ESG factors, e.g. reducing carbon emissions.

-        Impact – when an investment is made with the intention of generating a positive and measurable social or environmental change, e.g. job creation, education, emissions reductions.

Challenges in ESG Investing

There are several challenges in the ESG investing space at the moment: ESG factors are often very subjective and ESG itself can mean different things to different people resulting in confusion in the market around how sustainable investments really are; the ability to assess a company for ESG risks is limited by availability of data and inconsistent disclosures and transparency; we do not yet have a consistent global framework for classifying how sustainable different investment products are, leading to a risk of greenwashing (where an investor overstates the sustainability of an investment product). Regulation across the globe is being introduced to help out here – improving disclosures and classification of financial products but this will take time to bed in. 

The future of ESG

There may be a time in the future when we do not differentiate between ESG investing and any other kind of investing – where investments are always reviewed through a lens of how they impact the world and how the world impacts them. We are in a transition stage – new language is being developed around how we define and describe ESG investing, transparency is improving, and expectations are evolving quickly as we connect the impact of our financial markets with changes in our global environment throughout society.