ESG Investing
Environmental, social, and governance (ESG) criteria are proving to be an increasingly essential way for investors
to evaluate companies in which they might want to invest. ESG criteria can also help investors avoid companies
that might pose a greater financial risk due to their environmental or other practices. An ESG fund’s target is
to generate long-term competitive financial returns and positive societal impact.
ESG investing is sometimes also known as Sustainable Investing or Socially Responsible Investing (SRI).
The ESG of Investing
ESG funds select companies that score high on all three factors, Environmental, Social and Governance,
relative to their industry peers. These factors usually look at a broad range of behaviours.
Environmental criteria consider how a company performs as a steward of nature. Factors can include a company’s
energy use, managing resources and preventing pollution, and a good treatment of animals. It may also include
any environmental risks a company might face, for example issues related to the disposal of hazardous materials or emissions. One can also find funds
that invest in companies that are aligned to the Paris Climate Agreement.
Social criteria examine how a company manages its relationships with employees, suppliers, customers, and the communities
it operates in. Examples address issues such as, does the company donate a percentage of its profits, do the working conditions show high regard to its employees? It will also
look at how a company works within its community.
Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights. Does the
company avoid conflicts of interest among their board members, does it use political contributions to obtain favourable
treatment, or what is the gender balance across their leadership? Issues with governance are a clear risk to a company, as could be seen for example with the
BP oil spill or the Volkswagen Dieselgate affair, where in each case issues with governance had been raised before the actual disaster happened or had been uncovered.
Positive Versus Negative Screening
Many ESG funds apply both positive and negative screening methods. The first step is often to screen companies based on their environmental, social and
governance factors based on a range of sub-factors. For example, the top 25% or top 50% of all companies in any one sector might be eligible for the fund.
Negative screening filters out companies involved in controversial activities like alcohol, tobacco, nuclear weapons and firearms.
ETF Classifications
There are several providers that provide the ESG ratings for companies, for example Sustainalytics, MSCI, and SAM. While they do not provide exactly the same
scoring for each company, the type of methodologies can be seen as five different classifications.
Classic ESG: Invests in the top percentile of ESG scored companies, i.e. the top 25% or top 50%. These often come with exclusions to companies with
controversial activities. These ETFs are usually called SRI, Sustainable or ESG Leaders.
ESG Light: Seeks a balance between investing in companies that score the highest on ESG and maintaining a similar sector exposure as the original index. Often comes with
additional exclusions and popular with Institutional Investors. These ETFs are often called ESG Select or ESG Enhanced.
Exclusions: Negative screening filters out companies involved in controversial activities like alcohol, tobacco, nuclear weapons, firearms etc.
These may also be used for Religious themes. These ETFs are often named ESG Screened or ESG Exclusions.
Impact Investing: Targeted investments aimed at solving social or environmental problems to use capital to trigger change for social or environmental
purposes. Example ETFs are Green Bond ETFs.
ESG Themed Investing: Exposure to an ESG subsector, like Clean Energy, Gender Equality or the alignment to the Paris Climate Agreement. Individual
companies in the fund may not necessarily score the highest on a general ESG ranking. The name of the ETF should be self-explanatory.