ESG may seem like a popular new approach to investing, but it’s an evolution of a concept investors have used for decades to make choices about their portfolios.
“ESG analysis can be incorporated in all types of investment approaches, strategies and asset classes,” said Divya Bendre, an expert on sustainable finance with HSBC’s Infrastructure and Real Estate Group in New York.
ESG stands for environmental, social and governance – the main criteria used to judge possible investments.
The environmental issues include major global concerns like climate change as well as local considerations such as noise pollution or traffic. Social issues often relate to how firms manage their stakeholder relationships. It can also include privacy and equality issues. Governance topics are relatively more standardized in terms of definitions, covering corporate policies, ownership and management structures. It’s applied to concepts such as board independence, diversity and representation.
ESG shouldn’t be seen as static, strict information, but rather as a way to ask smart questions about the company’s management and long-term business strategy.
“When a firm is trying to understand and address the positive and negative externalities of its business model, it can be an indicator of good management and potential outperformance,” said Bendre, who leads the bank’s green bond advisory for the Americas.
While in the 1970s responsible investors would have looked to boycott or exclude companies that were involved with causes they found troublesome, in 2018, ESG analysis is mainly applied through the lens of financial materiality. For the most advanced ESG investors, the positive or negative impact an investment choice has on the real economy is an investment consideration. They are analyzing and considering potential trade-offs in ESG impacts alongside risk and return trade-offs for a more “three-dimensional” approach.
“The legacy socially-responsible investing world, has evolved into the variety of ESG investment approaches we see today,” Bendre said.
This three-dimensional approach positions ESG investing as a strategy for a more thoughtful, comprehensive analysis of a particular firm rather than a focus on exclusionary screens which may negatively impact returns in certain cases.
One area of ESG investing that’s still being worked on is standardizing data and creating metrics that can be trusted across the board, so that everyone judges companies by the same ESG standards.
“There’s quite a lot of work being done currently on standardizing and also lifting the quality and assurance of ESG data,” said Bendre.
Groups like the CFA Institute have begun incorporating ESG readings into its CFA program, and have been publishing blogs and manuals on the topic to educate members and investors as it becomes more mainstream. Europe, which was an early ESG adopter, is taking steps toward legislating guidelines.
Those are positive steps for ESG investors, as policies and regulations will lead to better information they can use to get a clearer picture of where a company may be heading on key strategic issues.
“I don’t see (ESG) going away,” said Bendre. “I see it becoming more and more normalized within investment decision-making.”