Amplifying The ESG Definition

With environmental, social and governance (ESG) principles becoming a more prominent part of the everyday investment lexicon, investors are exploring both the old and the new of what defines ESG. As socially responsible investing (SRI) evolves, advisors and investors need to stay abreast of that shifting landscape.

The standard definition of an ESG equity investment is a company that is not engaged in the production of weapons, pornography, gambling, tobacco or is a significant polluter via fossil fuels. While that old definition rings true today, the environmental, social and governance components of ESG are expanding, potentially to the benefit of investors. For example, the environmental aspect of ESG is expanding well beyond just avoiding traditional energy sector investments.

“Environmental factors include the contribution a company or government makes to climate change through greenhouse gas emissions, along with waste management and energy efficiency,” according to Robeco. “Given renewed efforts to combat global warming, cutting emissions and decarbonizing is become more important.”

There are other elements to the “E” in ESG investors can and should consider.

“ESG is a broad topic, and while fossil fuel-related issues are one of the most common considerations, a variety of other metrics exists across ESG,” said Goldman Sachs Asset Management. “Other environmental metrics of interest include water usage, renewable energy programs and the existence of a specific environmental policy program.”

Another issue to consider in today's evolving SRI landscape is the information companies make available to investors. For example, nearly two-thirds of S&P 500 members tell investors how they are reducing their carbon footprints, but less than 15% highlight their investments in alternative energy sources, notes Goldman.

The social variable in the ESG equation is easily defined, but also shifting.

“Social include human rights, labor standards in the supply chain, any exposure to illegal child labor, and more routine issues such as adherence to workplace health and safety,” according to Robeco. “A social score also rises if a company is well integrated with its local community and therefore has a ‘social license’ to operate with consent.”

Investment managers can apply social and sustainable factors in various ways. Some managers may look to explicitly avoid companies with significant social controversies, such as poor labor records. Another approach is to focus on companies that score highly on a variety of ESG factors, a methodology that some studies suggest does pay off for investors over the long-term.

Data suggest that companies with solid environmental and sustainability records outperform those with dubious sustainability records. There are also sector-driven ESG approaches that can potentially drive returns.

“An intra-sector approach, which seeks to select the best ESG companies within each sector, retains exposure to top ESG companies within inherently challenging ESG sectors,” said Goldman. “An intermediate approach is also possible, whereby a few low-scoring sub-industries, such as coal mining, are eliminated, while the remaining portfolio is constructed using an intra-sector model.”

Governance is one of the ESG factors where institutional investors can engage companies and open dialogue that can result in meaningful change.

“Investment stewardship or corporate governance, is engagement with companies to protect and enhance the value of clients’ assets,” said BlackRock. “Through dialogue and proxy voting, investors engage with business leaders to build a mutual understanding of the material risks facing companies and the expectations of management to mitigate these risks. Hence, identifying and managing relevant ESG risks are an important component of the engagement process and to encouraging sustainable financial performance over the long-term.”

In the fund world, including exchange traded funds (ETFs), products emphasizing governance often focus on issues such as gender, race and sexual diversity in the workplace. However, robust corporate governance encompasses more than those issues. For example, some shareholder rights firms advocate for pay for performance compensation structures, external auditors and increased shareholder rights.

The “G” in ESG is tricky relative to the other components because of its often subjective nature and external influences from firms that specialize in governance ratings. Some of these firms, including Institutional Shareholder Services (ISS) and Governance Metrics International (GMI) are held in high esteem by portfolio managers and credit ratings agencies, but potential conflicts of interest exist in these relationships.

“They also may cross the line from being independent raters to becoming active consultants for the firms they study in ways which lead to questions about their objective credibility,” according to the Securities and Exchange Commission (SEC). “Finally and most importantly, their methods do not work; reliable, accurate governance ratings are not really produced despite all the charts and lists published.”