The consideration of environmental, social, and governance (ESG) factors is becoming increasingly mainstream in the investments space.
However, ESG has lingered in the background for years, and there is a considerable division between those who have long understood the value of ESG integration and those who have only recently become intrigued.
The Rise of ESG
The term “ESG” first appeared in a 2004 United Nations report called Who Cares Wins. The concept of balancing nonfinancial measures with classic financial analysis quickly resonated with the socially responsible investing (SRI) community. Yet while SRI proponents at the time focused on excluding unpalatable investments—such as those tied to tobacco, weapons, or nations with poor human rights records—the ESG approach relied on deeper company-level analysis and shareholder engagement. At the same time, the related discipline of impact investing forged a parallel path for those more interested in intentionally driving measurable social and environmental change.
For those seeking to use investment leverage to encourage corporate responsibility and accountability while targeting competitive returns, ESG has held much promise. It gained further traction around 2014, when research started validating the ties between sustainable principles and operational and investment performance.
The ESG element to catch large investors’ attention most quickly was governance. A 2018 report published on the Harvard Law School Forum on Corporate Governance and Financial Regulation found that the largest index fund managers in the US “view governance not as a compliance exercise, but as a key component of value creation and risk mitigation.”
The Paris Climate Accord’s passage in 2015 and subsequent research on the dire stakes of climate change bolstered the status of ESG investing as a viable option for environmentally conscientious investors.
The social aspect of ESG received a boost in August 2019, too, when 181 CEOs belonging to the Business Roundtable publicly pledged to hold the interests of all their stakeholders—including their customers, employees, suppliers, and communities—as highly as they hold the interests of their shareholders.
According to the Principles for Responsible Investment (PRI), ESG integration is a manifold process that encompasses:
- Analyzing ESG factors alongside financial performance
- Identifying both ESG and financial drivers
- Gauging the potential impact of material ESG and financial factors on a broad range of stakeholders
- Accounting for ESG factors in investment decisions
From there, applying ESG analysis can assume a variety of forms. With negative screening, investment managers exclude or divest from holdings in certain industries. Money managers may also use a momentum strategy, which focuses on making investments in companies with improving ESG scores, or a tilt strategy, which emphasizes absolute ESG performance, according to the PRI.
As in the traditional investment world, a divide between actively managed and passive camps has emerged in ESG investing. Even so, passive ESG investors seem more willing to take up the shareholder engagement mantle that represents the proactive wing of the investment industry, according to global reputation firm Edelman.
As the push for ESG integration grows, the importance of relevant ESG data mounts. While sources and standards are being validated and refined, global index developer MSCI stresses that the information should be material to the industry being discussed; its transparency, comparability, and reliability is paramount; and objective verification is invaluable.
Movement toward the Mainstream
In early 2020, Larry Fink, the chairman and CEO of the world’s largest asset manager, BlackRock, signed a letter to clients explaining that all of the firm’s portfolios would fully integrate ESG risk assessment into decision-making by the end of 2020.
With such a heavyweight at the table, the transition from ESG integration to MSCI’s target of the “full incorporation of ESG considerations embedded as a core component of standard security selection, portfolio construction, and risk management practices” seems more achievable than ever before.