What is ESG Investing and why should you care?

ESG investing has boomed throughout 2020 and 2021, with European sustainable funds facing an 84% quarter-on-quarter rise in inflows (the cash coming in) in the 3 months to December. With predictions that ESG investing will grow exponentially following the impact of COVID-19, it is crucial that individuals interested in commercial affairs understand what ESG investing is and its advantages and disadvantages.

What is ESG investing?

ESG stands for environmental, social, and governance; ESG investing encompasses considerations regarding ESG criteria alongside traditional financial considerations. Socially conscious investors utilize this criteria to screen potential investments, determining the future financial performance of potential investments in companies.

Environmental concerns regard the company’s performance as a steward of nature, whilst social concerns consider how the company manages relationships with stakeholders (such as employees, suppliers, customers, and the communities it operates within). Governance looks at the leadership of the company, for example the shareholder rights, internal controls, audits (inspections of the financial information of the company), and executive pay.

Advantages of ESG investing

ESG investing, with its ‘sustainable’ branding, has multiple advantages for investors, companies, and consumers.

Whilst multinational corporations such as Facebook and Boohoo have suffered colossal share price declines from mismanagement of ESG concerns, other companies such as Nike and Google have boosted growth through offering green investments and publicly backing social justice movements. This is an example of how ESG investment benefits the consumer, investor and company; as the company offers more socially beneficial initiatives, consumers increase engagement with the company. Following this, the company will become more attractive to investors. Thus, the share prices will grow, as more investors invest in the company. With this, the company grows more, being able to offer more socially beneficial initiatives, and the cycle continues. So, ESG investing, due to its attractiveness to consumers, can bolster economic and business growth.

Alongside this, there is a consensus that investors holding an attachment to their investments usually will hold onto them throughout turbulent times in the markets (as stated by Lessard). Thus, the emotional and moral connection that investors usually hold to ESG investments may improve their willingness to invest longterm, leading to potentially stronger and more profitable investments. This also may have a knock-on effect on the market, decreasing market turbulence and strengthening sustainable emerging markets such as green energy.

Finally, the clearest benefit of ESG investing is its impact on society and the environment. The attractiveness of ESG investing comes from its focus on beneficial practices; whilst investing is focused on making money, it is more appealing to make money sustainably. With society becoming more enamoured with the potential of initiatives regarding green energy and less impressed by traditional businesses lacking diversity and environmental concern, ESG investing offers an opportunity to grow investments whilst caring for each other. Ethically killing two birds with one stone is clearly beneficial.

Disadvantages of ESG investing

Whilst ESG investing seems like a fantastic approach on its face, it delivers potential disadvantages which may lessen its effectiveness or popularity with traditional investors.

Firstly, there are differing definitions of what the criteria should involve, for example with ‘socially responsible’ holding different meanings to different people. With this lack of global consensus on what constitutes an ESG fund, investors may be discouraged by this lack of certainty. It also may lead to confusion for laypeople investing in their free time. Whether or not an oil company with strong diversity counts as an ESG investment is debatable, and leads to issues for individuals who may not be interested in figuring this out.

Following on from this, the requirements for managers to research into ESG criterion of businesses and consider potential investments is costly compared to traditional investing considerations. This is magnified by the issues considered above regarding the meaning of the ESG criteria. This may push more investors away, as the goal of investing is to make money and this quite clearly goes against that in the shorter term.

Furthermore, ESG investing limits the potential investing environment, further reducing potential profit. ESG investing involves either impact funds (where the manager actively invests in businesses considered socially beneficial) or exclusionary funds (where the manager will avoid companies whose business activities are considered to have a negative impact on society). By limiting the potential range of businesses to invest in, the investor may lose out. For example, if oil prices jump, the investor who did not invest in oil due to ESG criteria will not benefit from the growth.

Investors may believe that they can do more good by maximising their returns and using this excess return to give to charitable initiatives, thus defeating one of the core benefits of ESG investing: its social good. Thus, many traditional investors may avoid the potential uncertainty and loss of profit provided by ESG investing to focus on more traditional, ‘reliable’ investments. This weakens the potential of ESG investing.

What the future holds

Whilst the potential disadvantages of ESG investing may seem unappealing, it still has great growth projections for the future. companies investing in, for example, alternatives to fossil fuels, are seen as being potential energy leaders in the following years, whilst those ignoring the sustainability trend may struggle to compete in the future.

With ESG-focused ETFs (exchange traded funds: a type of investment fund often tracking an underlying index, or segment of the financial market) gaining $15.7bn of new assets globally in January, the practice is becoming more popular. The two US equity funds with the strongest returns in 2020 both focused on clean energy, potentially highlighting the popularity of more sustainable investments with investors.

COVID-19 being the 21st Century’s first sustainability crisis may have led to this growth; with people feeling the effects of climate change and social injustice more throughout the pandemic, investors may be wanting to invest in the companies who are meeting the consumer’s moral interests.

Alongside this, with the EU’s new Sustainable Finance Disclosure Regulations coming into effect in March 2021, more clarity will be brought to ESG investing, dispelling concerns regarding uncertainty.

Thus, ESG investing is a practice which will be valuable to watch, with potentially impressive impacts both on the economy and society in the following months and years.