ESG investing focuses on environmental, social, and governance principles. It has grown in popularity over the years.
Sometimes referred to as sustainable investing, impact investing, or socially responsible investing, ESG investing is a way for investors to look past profits and consider the role companies play in the world’s greater good. Here’s what you should know about it.
The ESG metrics
There are three main metrics used to grade companies based on ESG standards. Looking at a business through the ESG lens reveals things about it that you won’t see looking through financial statements — which is the point.
The environmental portion of ESG focuses on how a company’s operations impact the environment, especially regarding climate change. There are many businesses whose operations add to climate change due to high pollution and energy use, for example. That’s something you want to be aware of — not only the company’s role in climate change, but also how climate change can affect businesses and the broader industries in the future.
The social aspect focuses on how a company interacts with people, including its employees, customers, and society as a whole. This can deal with issues like diversity and inclusion, employee safety, human rights, data protection, how a company reinvests back into the local community, and much more. As an investor, whether you’re focused on ESG metrics or not, you should be aware of where companies stand on these issues because they prove to be costly in the future. Mistreating employees results in less top talent, data breaches mean more money spent on cybersecurity and PR, and so forth.
Governance focuses on how companies are run. As an investor, you want to be aware of this because you’re also a part owner. When scoring companies on their governance, institutions may factor in transparency, accuracy of financial reporting, compliance, and independence of the board of directors. If a company has shady business practices, you want to know. Some of the most noticeable business bankruptcies of all time have come as a shock to investors because they just weren’t aware of what was happening behind the scenes.
There are many funds put together with an emphasis on ESG metrics, so it’s become easier to make investments that align with your sustainability standards. Some funds include all three components for criteria, while others may choose to focus on just one or two. You can find funds that focus on specific themes — like clean energy, cybersecurity, and climate change commitments — as well as broader funds that focus on high ESG standards in general.
There are no universal ratings in ESG standards, so ESG funds don’t always grade ESG metrics on the same scale. You’ll find that some give a different weight to each of the three ESG practices, and others may focus more heavily on a subtopic within one of the categories. If you’re passionate about a particular issue, be sure to read the fund’s objective and how the companies were chosen.
Don’t forget the fundamentals
If you’re going to focus on sustainable investing — which is a good thing — remember to use ESG insights along with traditional investment wisdom and rules of thumb. You don’t want to get to a point where ESG standards are all you use to make investment decisions. At the end of the day, you’re investing to make money. There are ways to do so sustainably, ethically, and aligned with your passions, but you never want to lose sight of the purpose of investing. You still need to consider your financial goals, risk tolerance, and other such factors.