ESG
Environmental, Social and Governance, or ESG, is a set of criteria to determine the sustainability of a company. These metrics help investors understand whether a company has business practices that don’t harm the environment, the safety working force and have a diverse and reliable governance at the top. Shareholders rights are taken in consideration to make ESG ratings. This type of investing is often called sustainable investing, responsible investing, socially responsible investing etc…
In recent years investors have slowly changed their philosophy and not only look at financial statements in order to decide whether to invest into a company or not but also look at the environmental and social impact that the company has. So, as a result of that many financial companies came up with financial instruments that invest in companies with good ESG ratings, like ETFs exposed to ESG compliant companies.
So let’s break down what makes the ESG rating of company:
First, we take a look at Environmental issues. The use of energy, natural resources, treatment of waste, treatment of animals and pollution are all taken into consideration. Various risks are taken into consideration as well like whether the company uses safe processes and whether it complies with regulation. That’s especially important in order to avoid hefty fines from regulators.
Social criteria look at the company’s relationships. Especially with suppliers, employees and the surrounding community.
If the company uses suppliers that have good values, that respect the environment and employees will give a good outlook on the social part of the ESG rating.
If company has safe working environments, treats employees well and incentivizes them to take part into volunteer activity will also have a good outcome on the ESG rating.
On the governance side, ESG metrics value shareholders rights to have a say in key decisions that the company has to take, transparent accounting methods and managers with no conflict of interest.
Of course, very few companies would have high scores under every single aspect that we’ve mentioned. So, both retail and institutional investors can decide what’s more important for them.
Given the fact that some of these ESG funds performed very well in the last few years, it’s clear that it’s not just a matter of doing the right thing.
London Business School Henri Servaes showed in a presentation how the 100 best companies to work for in America strongly outperformed the S&P 500 between 1984 and 2009. This is not random if you think about it. The best companies to work for attract top talent, they’re able to retain talented professionals and this makes it possible to outperform competitors.
For the companies focused on environmental sustainability, there are a few ways to interpret the good performances compared to the benchmark. Some say that environmental, just like any other policy with a long-term view gives the company an advantage compared to other companies that make year by year strategies or quarter by quarter strategies.
Some others say that environmental friendly policies and processes are intangible assets. So, if the market doesn’t take them into consideration, the company might result as undervalued and with a higher potential.
Others say that the outperformance is just a consequence of the higher influx of capital that ESG compliant companies have compared to their non-compliant competitors.
In the end there are people that see the ESG movement as a hoax and a marketing opportunity for companies. One of these people is Chamath Palihapitiya. One thing that is clear, is that there’s no clear way to track companies’ improvements from and ESG perspective yet. So it’s not clear wether companies are keeping up with their promises.
Lately even a new investment theory came up: companies that are not ESG compliant have better value investing opportunities than ESG compliant companies. Given the fact that they’re denied investing capital have lower P/E Ratios and higher dividends. On the flipside, ESG companies can raise capital at lower rates to reinvest into the business as a result of the higher influx of capital, so it’s not clear yet how it will all play out in the future.
Another plus that companies with a high ESG rating have, is the higher chance to avoid sudden and significant losses. Let’s make a few examples: both Equifax and Facebook didn’t meet ESG requirements because of poor privacy policies and protection. So when the data breach in the case of Equifax, and the Russia Gate in the case of Facebook came, ESG investments weren’t exposed to these companies.
Other similar cases in different sectors were the various oil spills from oil extracting companies and the Volkswagen Dieselgate.
#esg #sustainableinvesting #etf
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