One of the most common discussions we have with clients, friends and family goes something like this: “I have worked hard all my life and want to continue to ensure the security of my family. I also want to make sure my money is invested in the things I care most about. How do I do that?” In a world flooded with information, it is often difficult to cut through the noise and get to the heart of the matter.
We can help. In this article we explain what Environmental, Social and Governance (ESG) investing is, how it works, how it has performed, and how it relates to Impact Investing. If you would like more information about aligning your investments with your values and using them to make a positive impact in the world, please schedule an introductory meeting.
Table of Contents
- ESG Metrics and Insights
- What are ESG Metrics?
- List of Most Common ESG Metrics
- How is ESG Data Gathered?
- Relationship Between ESG Metrics and Investment Performance
- What ESG Metrics Should I Be Following?
ESG Metrics and Insights
Environmental, Social and Governance (ESG) metrics are becoming an increasingly popular and important way for investors to measure the sustainability and attractiveness of potential investments in large publicly traded companies.
What are ESG Metrics?
ESG metrics are used to assess and understand an organization’s focus on responsibility from a social, environmental and governance perspective.
This could range from the size of a firm’s carbon footprint to the effectiveness of its recycling or pollution mitigation efforts.
This means how a firm manages relationships across the board, from employees and customers to suppliers and the community at large. Factors considered in social criteria include health and safety, fair trade, employment practices, diversity, community involvement, and the nature or value of the goods or services provided.
Evaluating factors like board diversity and independence, executive pay, shareholder rights, business ethics and disclosure practices are all a part of measuring a company’s governance risk.
List of Most Common ESG Metrics
1. Environmental Metrics
Environmental metrics assess a company’s impact on the environment. Investors are increasingly interested in environmental metrics because they provide valuable information about a company’s sustainability and its long-term prospects.
A company that is actively reducing its environmental footprint is more likely to be able to adapt to changing regulations and consumer preferences, as well as mitigate the risks associated with climate change.
Some of the most commonly used environmental metrics in ESG investing include:
- Greenhouse gas emissions
- Air and water pollution
- Energy Efficiency
- Carbon footprint
- Waste generation
- Recycling efforts
2. Social Metrics
Social metrics are used for assessing a company’s relationship with its employees, customers, suppliers, and communities, as well as its involvement in social issues.These metrics are becoming increasingly important for investors, who are seeking to invest in companies that have a positive impact on society.
Companies that prioritize social responsibility are more likely to attract and retain employees, build strong relationships with customers, and avoid reputational risks.
Some of the most commonly used social metrics in ESG investing include:
- Employee turnover
- Employee diversity and inclusion
- Customer satisfaction
- Employee satisfaction
- Community involvement
- Labor standards
3. Governance Metrics
Governance metrics evaluate the quality of a company’s governing structure, which includes its management and board of directors. These metrics take a closer look at a company’s transparency, accountability, and ethical standards.
Governance metrics are important for investors because they provide valuable information about a company’s decision-making processes and its ability to manage risks. Companies with strong governance structures are more likely to make responsible decisions that benefit all stakeholders, including shareholders, employees, customers, and communities.
Some of the most commonly used governance metrics in ESG investing include:
- Political contributions
- Leadership compensation
- Audit committee formation
- Board independence
- Lobbying efforts
- Systemic corruption
How is ESG Data Gathered?
There are three layers in the supply chain of generating ESG rating information: the standard setters, the data providers and the ratings agencies.
There are probably hundreds of non-profit and quasi-governmental standard setting organizations around the world. They provide direction about how and what ESG information should be measured.
Leading organizations include the Global Reporting Initiative (1997), the Carbon Disclosure Project (2000), the Climate Disclosure Standards Board (2007), the International Integrated Reporting Council (2010), and the Sustainability Accounting Standards Board (2010). There has been considerable recent consolidation in this area, with the International Financial Reporting Standards (IRFS) Foundation now serving as the parent organization for the International Accounting Standards Board and the International Sustainability Standards Board.
There are many challenges with gathering and using ESG data. Like financial disclosures, the raw ESG data is self-reported by the companies that are being rated. Many important types of information are not consistently reported or even produced by all the companies within an industry. In addition, the importance of a specific measure, such as the amount of pollution generated or energy consumed might be highly meaningful in a manufacturing setting but not nearly so much so for an accounting business.
These once voluntary disclosures are increasingly being mandated by governmental decree, especially in Europe. While this is not yet in place in the U.S., it is being discussed by the SEC. We look forward to the day when ESG data is more widely available and consistently measured.
The final layer is comprised of the over 600 ESG rating agencies that gather and evaluate the company information to form databases and scoring systems. MSCI and Sustainalytics are the most prominent firms in the field and are popular due to their broad coverage. Other leaders include Bloomberg, CDP, FTSE Russell, ISS, and Thompson Reuters.
Critics have noted that the ratings tend to favor larger companies, in highly regulated industries (such as utilities and telecom) and in regions with more disclosure requirements (such as Europe). The ratings firms use different methodologies and data sources in their scoring systems which can lead to very different rankings.
The low correlation between the ratings is often cited as a major issue facing the industry, but not everyone agrees. While some argue for more harmonization and consistency within the field, others appreciate the value of differing perspectives.
Relationship Between ESG Metrics and Investment Performance
There is a lively debate about the benefits of using ESG data and whether it can be expected to add or detract from financial performance. Here we provide some background on both the quantitative and qualitative factors to take into consideration with respect to the investment performance of ESG (and Sustainable) Investing.
A recent meta study found 86 papers published between 2016 and 2020 that measured the relationship between ESG metrics and investment performance. Among these studies, “59% showed similar or better performance relative to conventional investment approaches while only 14% found negative results” (the rest had mixed findings).
The outcomes were increasingly positive for those studies focused on climate change related variables and for those that considered risk (in addition to return). The authors also pointed to hypothetical research (back-testing) that suggested very strong financial benefits from focusing on ESG “improvers” (those firms making the biggest gains in ESG metrics) as opposed to ESG leaders.
Another data source that we look to is the Domini 400 Social Index, originally created in 1990 and rebranded as the MSCI KLD 400 index in 1999. It is one of the oldest and best-known benchmarks for Sustainable Investing (defined here as using both ESG metrics and exclusionary screens).
This index is primarily comprised of large US stocks and is hypothetical in nature because it has no trading costs or management fees. It excludes sin stocks, weapons, GMO’s, and nuclear power, but not fossil fuels. Through March of 2023, it had outpaced its benchmark by about 0.5% per year for the last 10 years, and 1.0% per year for the last five years, but has underperformed by about 0.4% annually since 1999.
As past performance cannot be relied upon as being indicative of future results, we also suggest weighing qualitative considerations. On one hand, narrowing the universe of investment options (by excluding certain companies) would normally be expected to increase concentration risk and reduce portfolio returns. On the other hand, we would expect companies with high ESG ratings to be more attractive to customers, employees, investors and regulatory/legal authorities, and to thus have a lower cost of capital and be more profitable and highly valued.
For many, it is simply common sense to avoid investments in companies that make harmful products, treat people poorly, damage the environment, have numerous lawsuits pending against them and/or are likely to be negatively affected by climate change. Investors clearly have a lot to think about in weighing the pros and cons of Sustainable and ESG Investing.
What ESG Metrics Should I Be Following?
While investors are focusing on the importance of ESG metrics as a whole, there are some standouts that investors should follow in particular. Below, are some top-of-mind considerations when considering an investment’s sustainability and attractiveness:
Carbon Emissions: Climate change is top of mind for investors, which is why a carbon footprint has become a go-to metric for evaluating a company’s impact on the environment. As an investor, it’s imperative to consider an organization’s commitment to reducing carbon emissions. Efforts like recycling, using renewable energy, and reducing travel can all help in combating climate change and minimizing damage to the environment.
Energy Efficiency: Investors are increasingly focused on companies’ environmental impact, and energy efficiency is a key indicator of a company’s commitment to sustainability. Energy-efficient companies can reduce costs, enhance reputation, and mitigate risks associated with climate change and energy volatility.
Health and Safety Standards (For Workers and Products): Investors recognize that a company’s employees and consumers are critical stakeholders, and their health and safety is essential to a company’s long-term success. Companies that prioritize health and safety can improve employee morale, reduce absenteeism and turnover, and enhance brand reputation.
Diversity and Inclusion (At All Levels): Investors understand that a diverse and inclusive workforce at all levels can bring a range of perspectives and skills that can enhance a company’s performance and innovation. Companies that prioritize diversity and inclusion can improve talent retention and attraction, and reduce legal and reputational risks associated with discrimination.
Data Protection and Privacy: In today’s digital age, data breaches and privacy violations can have severe financial, legal, and reputational consequences for companies. Investors recognize that companies that prioritize data protection and privacy can mitigate these risks and build trust with customers and stakeholders.
Organizational Ethics: Investors understand that companies that prioritize ethical business practices and transparent corporate governance can enhance their long-term value creation potential. Companies that prioritize business ethics can reduce legal and reputational risks, and enhance stakeholder trust and loyalty. It’s worth examining a company’s code of conduct to garner a comprehensive insight into how the organization aims to handle business both internally and externally.
How Is ESG Performance Rated?
There is currently no universal assessment framework for assessing companies based on their ESG practices. However, MSCI and Sustainalytics are two of the most prominent independent ESG risk rating firms, and each employs distinct standards to derive their ratings.
Sustainalytics employs a scoring system ranging from 0 to 100, where lower numbers indicate reduced exposure to ESG risks specific to the industry. MSCI uses a rating system from AAA to CCC, with AAA and AA ratings assigned to industry “leaders” with fewer risks, while A, BBB, and BBB companies are “average,” and CCC or B-rated companies are referred to as “laggards.”
Again, MSCI and Sustainalytics are just two of the biggest ESG metric rating agencies. Other major players include the likes of Bloomberg, CDP, FTSE Russell, ISS, and Thompson Reuters. Regardless of the agency, it’s imperative you understand the scoring system that’s evaluating the ESG investments you’re considering.
MSCI and Sustainalytics were early leaders in the field of generating ESG ratings. Their focus is on the risk to investors. Other organizations such as As You Sow, Your Stake, and Ethos provide valuable screening tools for investors who are more concerned about the risk to people and planet.
What ESG Investments Should I Consider?
Determining the appropriate ESG investments for you will depend on various factors, such as your long-term goals, the ESG metrics most important to you, the level of control you desire, and your overall tolerance for risk.
Like conventional investments, ESG alternatives come in multiple structures such as individual stocks, mutual funds, and exchange-traded funds (ETFs), and should be looked at as part of a well-balanced, diversified investment portfolio.
Beyond ESG Investing: Making a Return and An Impact
We believe the greatest impact can be realized by putting new money to work directly into the causes that you care about. We call this Impact Investing. It goes beyond what is available in the public stock market and typically involves funding specific projects with measurable impact. Common examples include affordable housing, renewable energy, organic farms and land conservation.
It could also involve backing new ventures in education, healthcare, or beneficial infrastructure needed by a community. It might further address gender or racial inequality by investing in woman- or minority-led small businesses, particularly in under-served areas. These are all examples of impact investments. Usually these investments target market-rate returns, although some investors may place a greater emphasis on impact than on return.
If you are interested in aligning your portfolio with both your values and your long-term goals, Colorado Capital Management can help. Schedule a complimentary meeting with an advisor.