With over 1,000 ESG indices globally, we’ve come a long way from the first ESG index in the 90s. In the US, the first half of 2021 alone saw almost $39b being funneled into sustainability-related funds. 2020 figures were even more impressive, standing at $51b in capital inflows — over two times larger than in 2019 and over ten times larger than 2018. This makes the growth of the ESG market almost exponential!
Sustainability-focused Capital Flows & Assets Under Management (AUM) for US Funds: 2009 – H1 2021
The world of ESG-related conscious investing is clearly huge. But although ESG criteria are neatly packed into three distinct components, each of them house their own array of focus areas. Although there isn’t one exhaustive list of those focus areas, looking at big-name examples of each ESG criteria allows us to better understand what they could look like. And so, in the second part of our conscious investing deep dive series, we now move into breaking down the A, B, Cs (or rather E, S, Gs) of the criteria. What exactly are the types of focus areas that come under each of those three letters?
Environmental — it’s all about the EVs
When it comes to the ‘E’ of ESG, its focus areas range from climate change, preservation of natural resources, green tech, and limiting pollution. Essentially, the ‘E’ is concerned with how a company utilizes natural resources and the effect of its operations on the overall environment — basically, a company’s efforts to hold itself accountable for its actions. In the past, companies that were concerned with the ‘E’ might have done so out of a voluntary sense of social responsibility. However, nowadays, with stricter carbon emission laws, ignoring the ‘E’ component can lead to regulatory or legal risk. More than that, with companies like BlackRock (BLK) legitimizing climate change by viewing it as a measurable investment risk to shareholders, the push for ‘E’ is also coming from the private sector.
A hot environmental-heavy ESG market that’s been on the rise is the electronic vehicles (EVs) segment. With cars being one of the major contributors to carbon emissions and still reliant on fossil fuels for energy, EVs come in as an ESG-ready disruptor to the transportation market. Pure electric cars produce almost no carbon emissions when driving and, in the US, the number of registered EVs has grown by a significant 266% between 2016 – 2020. With countries like the UK targeting to ban the sale of all petrol and diesel cars by 2040, EVs have become an environmentally friendly alternative.
EV stocks aren’t just climate-friendly though, they’re also an ESG-favorite among investors. The BetaShares Climate Change ETF (ERTH), for instance, tracks up to 100 top ESG companies. The fund’s portfolio value currently has 14% of it allocated towards EV stocks. Whereas BlackRock’s (BLK) iShares ESG Aware ETF (ESGU) holds stock from EV-maker Tesla (TSLA) in its top ten largest holdings. Similarly, Facedrive (FD), a Canada-based ridesharing company, allows users to pick electric and hybrid-powered vehicles, and then a portion of the ride’s price is set aside to plant trees and offset the ride’s carbon emissions.
Individual stocks like Facedrive and ESG-focused ETFs provide investors with a balanced exposure to the ‘E’ component. While EVs form just one of the component’s focus areas, it gives a snippet into what investors should be looking for in a company with an environmental focus.
Social — familiarity breeds contempt
The ‘S’ in ESG considers a company’s relationship to its customers and employees. The ‘social’ component includes emphasizing fair labor practices when developing products, distancing the company from any politically controversial views, and engaging in CSR initiatives such as helping underserved communities or a firm-wide charity drive.
When it comes to the ‘S’, it’s hard to establish an across-the-board set of indicators since social issues are constantly changing. A company’s initiative to decarbonize is easy to measure due to data points like carbon emission quotas. But a company that performs well on the ‘S’ scale varies between consumers: to some, it might be a company that adopts fair wages for its employees, to others it might be a business halting the sale of socially harmful products. Although ‘S’ measures are less standardized they are still visible. For example, Uber’s (UBER) low pricing model in London led to it being legally required to provide all of its drivers with a minimum wage, paid vacation, and a pension plan.
A recent ‘S’ trend across companies has also been the growth of diversity and inclusion practices. Seeing the same faces over and over again can be exhausting and that isn’t just a sign to start mixing up your social circles but something that companies have caught onto as well. In an increasingly globalized world, where consumers (and investors) are incredibly diverse, having companies that reflect that is important to ESG investors. Some investors focus on companies that prioritize policies such as equal pay or racial and gender-sensitivity training. Much like how the MSCI ESG Ratings system functions, companies like Refinitiv also release annual rankings of the top 100 diversity-focused companies globally.
Conscious investors might think ‘S’ factors are related to beefing up a company’s brand, but they filter into returns as well. The S&P’s analysis of over 2,000 stocks found that almost 90% of them were concerned with social issues and had average to above-average returns. This is because a company’s strategy to deal with the ‘S’ ultimately affects its profits — businesses with exposure to controversy, unfair labor practices, and discriminatory hiring will face lower returns as unpopularity grows with customers and conscious investors.
Governance — how many pockets do you have?
The ‘G’ in ESG is all about systems. Governance criteria relate to ensuring that the oversight of a company is well-handled and that the necessary checks and balances are built-in in case things go wrong. Good governance looks a lot like a well-oiled machine running smoothly — you won’t notice it while it’s running, but it’s there in the background ensuring things are progressing as required. Questions such as whether a firm has a suitable sexual harassment prevention and reporting policy or if regular inspections of the working conditions in its manufacturing factories take place are all examples of ‘G’.
Governance policies also ensure that shareholders are there to keep tabs as companies aren’t always the goody-two-shoes they sometimes posit themselves out to be. Last year, for instance, Procter & Gamble (PG) was pushed by its shareholders to reduce deforestation as a result of its paper products. 67% of shareholders voted to mandate P&G to issue a report outlining how much its supply-chain impacts the destruction of forest habitats.
In the context of ESG, issues like these bring up the question of whether firms should be concerned with only profits or also extend their goals beyond the scope of the business?
Different terms are used to describe this dilemma but they describe the same thing. Stakeholder capitalism and one-pocket thinking, for example, advocate that a business has the social responsibility to increase the well-being of all stakeholders in the company (e.g. customers, employees, local communities) and that it doesn’t have to be distinct to making a profit.
Two-pocket thinking and shareholder capitalism, on the other hand, push the idea that a company’s main purpose is to maximize value for only one stakeholder: the shareholder and that profit-making should be seen as distinct to making an impact (two different pockets: one for philanthropy and one for making returns).
While things aren’t quite as binary as they might seem in these distinctions, most companies are still grappling with this aspect of governance: shareholders or stakeholders? As a conscious investor, it becomes important to uncover which governance strategy is guiding the companies you’re targeting.
why it matters
Having an idea of each component in the ESG framework provides us with a better understanding of how the criteria for conscious investing aren’t rigid. While the examples mentioned here are synonymous with conscious investing, they’re also not exhaustive — however, having a rough idea of what each ESG component has to offer allows conscious investors to dig deeper into issues that align with them.