ESG investing is undoubtedly one of the fastest-growing trends in finance and alternative data over the past few years.
ESG stands for Environmental, Social, and Governance and is an evolution of socially responsible investing (SRI)—an investment strategy that seeks both financial returns as well as a positive social and environmental impact.
By integrating environmental, social, and governance factors into valuing a company, the goal is to enhance traditional analysis by identifying risks and opportunities that go beyond fundamental metrics.
As several studies have indicated that ESG investing may outperform the overall market, many investors are increasingly looking to incorporate ESG investing and analysis in their research process.
In this guide, we'll discuss exactly what ESG investing is, ESG investing trends, top data providers, and more. In particular, we'll discuss:
- What is ESG Investing?
- What is an ESG Score?
- ESG Reporting Frameworks
- ESG vs. SRI vs. Impact Investing
- ESG Investing Trends
- Does ESG Investing Outperform?
- Top ESG Data Providers
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What is ESG Investing?
ESG stands for environmental, social and corporate governance, which represent three of the main criteria for investors to quantify and evaluate a company's level of sustainability.
Let's look at each of these three criteria in more detail.
Environmental factors that go into a company's ESG score attempt to quantify the impact—positive or negative—that their operations have on the planet. A few of the core sub-factors that go into evaluating a company's environmental impact highlighted by Motley Fool include:
- Carbon footprint
- Water consumption
- Water disposal
- Recycling practices
- Climate change policies
- Use of renewable energy
- Relationship with regulatory bodies such as the EPA (Environmental Protection Act)
Social factors that go into a company's ESG rating are related to how the company addresses issues concerning customers, employees, suppliers, and so on. A few of the sub-factors that go into social ESG scores include:
- Employee compensation, benefits, and turnover
- Employee training
- Employee safety
- Diversity and inclusion in hiring and promotion practices
- Ethical supplier and supply chain sourcing
- Customer ratings and feedback
- Government lobbying efforts
- Consumer protection, such as recalls, lawsuits, and regulatory actions
Finally, factors that go into a company's governance rating include topics such as business ethics, quality of management, and the board's independence. Specifically, a few examples of governance metrics include:
- Ethical business practices and policies
- Executive compensation levels
- Addressing conflicts of interest at the board or executive level
- Shareholder voting rights for nominating board candidates
- Transparency between shareholders and the executive team
- History of legal issues with shareholders
- History with SEC or other regulatory bodies
Now that we've discussed a few of the most common factors that comprise ESG evaluation, let's look at what an ESG score is and how they're calculated.
What is an ESG Score?
A company's ESG score is a numerical value that summarizes how they are performing based on each of the environmental, social, and governance inputs.
ESG scores can be used both internally by management in order to prioritize which areas of the business they need to improve upon. Similarly, ESG scores are used by investors to assess how the market perceives the company's performance in the context of ESG factors.
It's important to note that ESG scores are calculated based on the market's perception of their performance. As the Alva Group writes:
An ESG score is calculated based on how an organisation is seen to be performing – that is, how its behaviour relating to ESG issues is reported. Just as with the building of corporate reputation, there is a gap between reality and perception.
This means that if a company's ESG policies are not public knowledge they may not be reflected in their ESG score yet. This may be a result of improper reporting on the company's part, which may lead to a gap between their ESG score and their true performance.
To solve this, many companies are adopting ESG reporting practices to ensure stakeholders are informed of their internal policies and plans going forward.
ESG Reporting Frameworks
When it comes to ESG reporting, there are several main frameworks that organizations use to measure and assess their initiatives and performance.
In particular, Nordea highlights the following main ESG frameworks:
- GRI (Global Reporting Initiative): GRI was developed in 1997 and is the first and most widely used framework for sustainability reporting.
- SASB (Sustainability Accounting Standards Board): SASB was established in 2018 for 77 industries, which identifies a set of minimal financial sustainability standards and their associated metrics for a given industry. The goal of this standard is to help investors analyze how ESG issues will materially affect financial performance.
- TCFD (Task Force on Climate-Related Financial Disclosure): The FCFD was set up in 2015 and chaired by Michael Bloomberg to develop a set of guidelines for companies and investors in disclosing the financial risks and opportunities related to climate change.
- CDP (Carbon Disclosure Project): CDP is a non-profit that created a disclosure system for companies, investors, cities, and states to main their environmental impacts. The CDP takes this information and provides ESG scores to companies and cities based on their environmental impact.
These are just a few of the most common ESG reporting frameworks, and there will likely be new ones developed as the standards and frameworks continue to mature.
ESG vs. SRI vs. Impact Investing
Value investing has many different sub-categories to be aware of, and in the sustainable investing world the three biggest are ESG, socially responsible investing (SRI), and impact investing.
In this section, we'll break down the differences between each of these investment approaches.
As discussed, ESG investing focuses on quantifying the efforts made by companies and organizations to either benefit society or at least limit their negative societal impact. One organization that is seeking to standardize ESG reporting criteria is the Sustainability Accounting Standards Board (SASB), which as described on their site:
SASB Standards identify the subset of ESG issues most relevant to financial performance in each of 77 industries.
Socially Responsible Investing (SRI)
SRI is an earlier version of ESG that involves avoiding investments in companies that conflict with investor's values, for example, in sectors such as alcohol, tobacco, and gambling.
Impact investing is another form of investing that prioritizes investor's values with the use of their capital. Impact investment funds typically try to quantify their positive societal impact as opposed to simply avoiding vice investments.
Fidelity describes the difference between these three investment trends as follows:
It's important to note that impact investing refers to private funds, while SRI and ESG investing involve publicly traded assets. For investors who seek transparency about the specific ways their capital is being applied to a particular cause, impact investing might be a more attractive vehicle than ESG or SRI.
ESG Investing Trends
Although ESG investing is still relatively new and was first discussed at a 2006 UN conference, there are several major trends to be aware of. Specifically, the data provider Refinitiv highlights the following ESG trends:
- COVID-19 highlighted the importance of ESG
As the market witnessed several major changes in investment trends from the pandemic such as stay-at-home stocks, another major shift was towards ESG investing as 2020 saw record inflows into ESG funds.
2. Social will move to the forefront
Again the pandemic highlighted the importance and impact of corporate social practices. One trend that will likely continue is the social aspect of ESG to be increasingly important criteria for investors, for example, putting employees first, equitable wages, and so on.
3. Transparency in ESG data and reporting
Another major trend is that transparency surrounding ESG data and reporting is a key element of investing in the sector.
This transparency includes answering questions such as:
- Which metrics and measurements will ESG investors use?
- How will organizations establish transparency and new corporate practices that support their ESG initiatives?
The key here is that there is a trend towards clarifying which performance indicators will be at the forefront of ESG investing during this decade.
4. The emergence of new technologies and ESG concepts
Another major trend is the rise of new technology to handle the rising importance of ESG data.
Similar to other types of alternative data in finance, ESG data can be overwhelming in its size and unstructured nature. To deal with this big data, new technologies such as AI and machine learning are being applied to the field.
In short, these new technologies will help investors make data-driven decisions and build investment strategies to reflect their ESG initiatives.
5. The sustainability bond market will continue to grow
2o20 saw massive increases in investments into green bonds, and that trend is predicted to continue rising in 2021 and beyond.
A similar trend in the bond market are 'greeniums' that incentivize bond issuers to put ESG at the forefront of their financing strategies.
Does ESG Investing Outperform?
There's a lot of debate about whether ESG investing outperforms the overall market. In this section, we'll look at a few arguments on both sides of the spectrum.
In an article on Institutional Investor, the author states that ESG funds have been outperforming the market during the COVID-19 pandemic.
In particular, their analysis included 26 ESG exchange-traded funds and mutual funds with at least $250M in assets under management. During the year from March 5th, 2020 to March 5th, 2021, 19 of the funds grew between 27.3% and 55%, which outpaced the S&P 500's gain of 27.1%.
Of course, this is just a one-year period and doesn't necessarily tell us whether ESG funds outperform over the long run.
As the head of global sustainable finance at Morgan Stanley stated in an interview:
I think that more and more research, whether it’s from the Morgan Stanley Institute for Sustainable Investing, from S&P, from Oxford or Harvard or others are showing that sustainable investing can in fact, perform and deliver stronger risk-adjusted returns.
On the other side of the argument, a study by Scientific Beta presented in CFODive states that ESG funds show no signs of outperformance when adjusted for risk.
As the authors state:
Claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed. Our findings do not question that ESG strategies can offer substantial value to investors, instead, they suggest that investors who look for value-added through outperformance are looking in the wrong place.
The article goes on to state that the SEC stated recently that some investment advisors and companies may be misleading investors about their ESG initiatives and investing.
As the SEC stated in their review, they uncovered:
...some instances of potentially misleading statements regarding ESG investing processes and representations regarding the adherence to global ESG frameworks.
Without strict guidelines on ESG reporting frameworks, it's likely that these misleading claims will continue.
In our opinion, it's still too early to tell whether ESG funds truly outperform. That said, there's little doubt that the ESG investing trend will continue over the next decade and that new reporting requirements will provide further transparency into the performance of ESG investment funds.
Top ESG Data Providers
Since ESG falls into the alternative data category, you'll need to find the right data provider to invest in the industry. Let's look at a few of the top ESG data providers that are bringing transparency to the field.
As a leading financial data provider, Bloomberg of course has gotten involved in ESG data. Their dataset provides ESG metrics and disclosure scores for more than 11500 companies in 80+ countries. They also launched their own proprietary ESG scores, starting with the Oil & Gas sector.
Sustainalytics is another leading ESG data provider that includes research, ratings, and data for over 12000 companies. They feature more than 220 ESG indicators and 450 fields for investors to make data-driven ESG investing decisions.
Morgan Stanley Capital International (MSCI) is another investment research firm that provides ESG ratings for funds and stocks, ESG indexes, and ESG analytics. They currently rate over 8500 companies and focus on serving institutional clients.
ExtractAlpha is another alternative data provider that offers ESG data to investors. In particular, they include data for CFPB Complaints, CPSC Recalls, DOL Visa Applications, EPA Enforcements, and more.
Summary: ESG Investing
ESG investing has grown rapidly over the past year and this trend is likely to continue over the coming years.
While there are still issues with a lack of reporting requirements and transparency, it's also likely that new frameworks and standards and introduced over the next decade.
While the jury is still out over whether ESG investing outperforms the overall market, the pandemic has shown us that investor's appetite for this investment trend is growing rapidly.
To meet this new demand, many alternative data providers and proprietary ESG scores are being developed to help investors make more informed and data-driven decisions.