What Is ESG Investing?
Environmental, social and corporate governance (ESG) investing focuses on companies that support environmental protection, social justice, and ethical management practices. Like all investors, ESG investors value returns. However, they do not prioritize profits above supporting companies that fit into their ethical frameworks.
Ethical investing is a growing force in capital markets, and ESG funds account for around 10% of worldwide fund assets, according to Reuters. More than $649 billion poured into ESG funds in 2021, a sharp increase over previous years. Below are three of the most important trends in this area.
- Environmental, social, and governance (ESG) investing seeks to support companies and projects that provide a social benefit, not just profit.
- ESG investors are a growing force in capital markets, pouring over $649 billion into ESG funds in 2021.
- Climate change is a major concern for environmentalists, but also offers potential profits for renewable energy investors.
- Executive compensation is another major concern, and many funds seek companies that pay a fair salary.
- It is also important to treat employees fairly, and ESG funds seek out companies with equitable pay and hiring practices.
Environmental, Social, and Governance (ESG) Criteria, Explained
Understanding ESG Investing
Different ESG investors follow different trends in ethical investing. For example, some ESG investors are environmentally focused and prefer to put their money into alternative energy and green companies. Others champion social justice and seek out companies that promote diversity, economic equality, and other human rights issues.
Then there are ESG investors who focus on companies' management practices, looking for businesses that employ practices such as restricting management pay to reasonable levels and providing work/life balance to employees.
With the coming transfer of wealth to the Millennial generation, many of these new potential investors will be looking to put their money to work. This is a generation of people who are very socially conscious and advocates of ESG causes. Most if not all of these emerging investors will want to invest in things that they believe in and support, and learning about ESG investing can help you better understand what these investors are looking for.
The U.S. Labor Department, reversing Trump administration decision, issued a final rule Tuesday that should give investors greater access to ESG investments in their 401(K) retirement plans.
The rule rescinds one that went into effect in late 2020. That rule had barred retirement plan fiduciaries from considering the potential financial benefits of ESG investments and portfolios in selecting plan investment options.
Retirement plan sponsors, the Labor Department said, had complained that rule had a "chilling effect" on placing ESG investments on 401(K) menus. With the new regulation in place, plan fiduciaries will have wider latitude to consider ESG impacts in building those menus.
Consideration of ESG attributes has increased substantially in the past decade. A recent Harvard Law School study found that 79% of North American investors said they now consider or apply ESG metrics to their investment approach. In addition, a study earlier this year by global asset management firm Schroders found that 87% of defined-contribution retirement plan participants want to invest in line with their values.
However, most 401(K) plan participants do not have access to ESG options. Industry estimates vary, but only about 5-15% of 401(K) plans include ESG funds. The rule issued Tuesday will make it considerably easier for plan sponsors to increase that proportion.
US SIF: The Forum for Sustainable and Responsible Investment, a leading advocate for ESG investing, applauded the Labor Department's decision.
"In reality, the rule is catching up to where the marketplace has been for years," US SIF stated. "The final rule helps to address the gap between the growth of sustainable investment overall and the much more limited growth of sustainable investment options in retirement plans."
Here are three trends to consider.
Well over 90% of climate scientists believe that climate change is real and that human activity is responsible for it. Several roadblocks, both political and practical, have kept many developed countries from moving full steam ahead in tackling climate change. However, progress is being made, and climate change represents an opportunity for ESG investors to profit while also supporting a cause they believe in.
Solutions such as cap and trade legislation are constantly passed around like a political football in the United States. If cap and trade legislation passes, it could have a devastating effect on the nonrenewable energy sectors, such as oil and coal. However, the demise of coal and oil would create a void to be filled by renewable energy sources, such as wind, solar and nuclear energy. ESG investors who are optimistic about climate change legislation should research potential alternative energy investments.
Climate change represents an existential threat to human society, with many nations pledging to become carbon neutral by 2050. Reaching these goals will require substantial investments in alternative energies and other green technologies.
According to some politicians and activists, women in the U.S. still earn, on average, only 78% of what men earn for doing the same jobs, though there are some questions surrounding the methodology used to come up with this statistic.
Regardless of its accuracy, companies that actively improve gender equality represent a buying opportunity for ESG investors. Those who believe the gender wage gap is a pressing problem have growing opportunities to invest in companies that prioritize being on the forefront of this issue.
To get the latest analysis and advice on green investing, check out The Green Investor podcast powered by Investopedia.
For those who were affected by the Great Recession of 2007-2009, insult was added to injury when news stories emerged about the exorbitant salaries paid to chief executive officers (CEOs) who had largely contributed to the downturn. In some cases, executives were paid millions to go away quietly after they had run their companies into the ground.
Executive compensation is a major concern for many ESG investors. For investors who fall into this camp, opportunities abound as many large corporations are dialing back their executive compensation to more reasonable levels. The CEOs of several large companies have voluntarily reduced their annual compensation, though it should be noted that these executives were already very wealthy before making this decision.
For ESG investors who feel that runaway executive compensation undermines the economy, it might be time to seek out and invest in companies that are proactive on this issue.
How Did ESG Investing Start?
Although ethical concerns have always existed in investing, the institutional practice likely dates back to the 1950s and 60s, when union pension funds began to seek investments that would accomplish both social goods and reliable returns. At the same time, there was increasing pressure to divest from the apartheid regime in South Africa, creating demand for more ethically-minded fund management.
What Is the Difference Between ESG and Impact Investing?
Impact investing places a high priority on achieving social good, regardless of whether or not the investment returns a measurable profit. This is distinct from ESG investing, which seeks out socially beneficial investments but nonetheless seeks to earn profitable returns.
How Big Is the ESG Investing Market?
ESG funds account for about 10% of worldwide fund assets, according to Reuters. In the first eleven months of 2021, about $649 billion poured into ESG-focused funds. This was a sharp increase over previous years.
The Bottom Line
Sustainable investing is a growing force in capital markets, as more funds seek investments with favorable social outcomes as well as opportunities for profit. Companies that implement strong environmental practices and fair wages aren't just helping society—they may also be making themselves more attractive to investors.