What is ESG? The Ultimate Guide

If you live anywhere in the world, you can invest. Luckily, these days, in addition to sweeping opportunities pretty much wherever you live, you can also be choosy about the types of investments you select. 

Companies as a whole have listened to investors — they’ve done more to embrace environmental, social and governance (ESG) standards across the board. 

Here’s our quick overview of ESG and why it benefits the greater good in many ways. 

What is Environmental, Social and Governance (ESG)?

ESG is an acronym for environmental, social and governance. The practice of ESG investing began in the 1960s and became known as socially responsible investing. ESG investors exclude stocks or entire industries from their portfolios based on business activities such as tobacco production or involvement in an unjust regime.

You can invest in companies that prove they fit the ESG criteria you’re looking for. Some investors ease into the framework by merging the ESG approach with more traditional stock analysis, an approach called “ESG integration.”

What are ESG Principles?

Let’s get right down to it. ESG stands for environment, social and governance, but what do those individual principles actually mean?

Environmental Factors

As you might expect, environmental factors take into consideration a company’s impact on the environment. Companies have major potential to create threats for ecosystems, water, air and human health. The ways companies can improve their environmental presence include:

• Using energy efficiently

• Using renewable energies that contributes less to climate change

• Managing waste responsibly

• Avoiding deforestation 

• Keeping animal welfare issues top of mind

• Disclosing information on all environmental policies

Social Factors

Social factors consider how businesses treat and value people. How do companies do as they impact people and society? Factors can include:

• Diversity and inclusion policies to combat discrimination

• Safe working conditions

• Fair wages and human rights protection

• Good relationships with local communities 

• Disclosing information on all social policy factors

Governance Factors

Governance factors take corporate policies and how companies are governed into consideration so stakeholder interests are met and companies’ long-term strategies are completely transparent. This can involve the following factors:

• Tax strategy

• Corporate risk management

• Executive compensation

• Lobbying

• Corruption and bribery

• Protecting shareholder interests

• Disclosing information on all governance factors

Why is ESG Important?

ESG is important because it looks beyond just profits. The ESG framework takes the interconnected nature of humanity into account.

But the benefits go beyond your conscience. There are a slew of financial advantages ESG can bring. High ESG companies place a premium on the following. They:

• Attract investors. Socially-conscious investors and environmental investment funds continue to grow. Each is more likely to fund firms with solid ESG ratings.

• Experience improved performance. 

• Boast solid financial indicators. Companies with high ESG may experience lower cost of capital and less volatility.

• Adapt and evolve. Companies experience fewer instances of bribery, corruption and fraud. These companies are also prepped to evolve with or even invent technology and environmental regulations.

• Bring positive brand recognition. Companies with ESG values are taking others into account. These companies can have higher employee retention rates and positive brand recognition with customers and the general public.

How ESG Began

ESG began in the 1960s but it didn’t take the world by storm right away. 

Former UN Secretary General Kofi Annan wrote to over 50 CEOs of major financial institutions and invited them to participate in a joint initiative under the UN Global Compact, the International Finance Corporation and the Swiss government.

Then, a few things happened in the early 2000s: 

• The joint initiative ultimately produced a report entitled “Who Cares Wins,” published in 2004, which covered how environmental, social and governance factors in capital markets contribute to a win-win for companies and individuals. It also discussed sustainable markets and better outcomes for societies. 

• UNEP/Fi also produced something called the “Freshfield Report,” which showed that ESG issues for companies can benefit everyone — companies, individuals and society. 

• The next published piece turned into the Principles for Responsible Investment (PRI) in 2006 and the launch of the Sustainable Stock Exchange Initiative (SSEI) in 2007.

What is an ESG Strategy?

Consciously developing an ESG strategy can turn into a lifelong pursuit. However, it’s important to know what’s important to you before you can choose a general ESG strategy. Before you get started, think carefully about the following questions: 

• What companies align with your beliefs and objectives?

• How do companies engage their stakeholders?

• How will you choose the right manager?

• How will you actively manage and monitor your performance and impact?

• What’s the best way to review and fine-tune a long-term strategy?

• Do you want to get help from a financial advisor or other financial professional to hone in on the right type of companies are important to you?

How Can Companies Pursue ESG?

A company can pursue ESG by completely changing its approach to everything it does. The ESG framework needs to be the backbone of decision-making from how the management interacts with employees to how the company acts as a steward of the natural environment. 

The process must embed ESG concerns into strategy until it’s just “business as usual” and can include: 

• Energy usage, waste, pollution or natural resource conservation. It can also look at the environmental risks a company faces. 

• Social criteria revolves around relationships. A company must reexamine suppliers, distribution of profits and regard for employee health and safety. Every stakeholder should be considered. The company must pursue the best possible outcome for each. 

• Investors want to know a company operates with integrity. Accuracy and transparency are important, but it is also imperative companies avoid conflicts of interest.

How can individuals pursue ESG?

Individuals can pursue an ESG investing strategy based on SRI ETFs/portfolios. Here’s how to do ESG investing in just three steps: 

Step 1: Check ESG ratings: Check ESG ratings by each company to help you pick the best ESG funds.

Step 2: Consider active investing: You can choose active management, where fund managers handpick the contents of a portfolio company by company. The catch to choosing this option is that these types of funds tend to have higher fees — high fees can hurt returns. Fees can be especially high for international funds where more expensive research may be necessary. 

Step 3: Consider passive investing: You can also choose passive management, where you choose an index fund or go with a robo advisor option. 

What fund do you pick?

Choosing a fund can be complicated. To keep it simple, hone in on what you want for yourself before moving forward. Perhaps there are industries you want to avoid or technologies you think it’s important to support. Approach your investment with this outcome as your anchor. 

With that in mind, review a couple of the most common thought processes for sifting through ESG companies. There are pros and cons to each, but one is bound to lead you to the right investment fund.

• Exclusionary screening: This approach is what it sounds like. The fund excludes companies that don’t meet criteria. If the criteria is an investment in renewable energy, a company must do that or be excluded. If the criteria is no alcohol sales, a company may not be associated with any alcohol outlet. Exclusion is an easy way to screen, but it can eliminate companies that you approve of overall for a single criteria. It doesn’t allow for gray area.

• Best-in-class: This approach takes the composite ESG rating into account. It goes beyond the one-and-done approach of exclusion and weighs all three criteria equally. The major problem with this screening is ESG criteria is not yet standardized. How can funds be held to true standard if the standard is relative?

• ESG integration: Funds have been historically judged by financial indicators. Examining a fund with an ESG integration approach means you should weigh financial performance alongside ESG integration. This will give you a holistic view of the fund. However, you’ll still deal with the lack of standardization of both ESG criteria and stock data.

• Active ownership or corporate engagement: Take a look at how whoever is at the top interacts with the company on ESG issues. Do shareholders show up to meetings and make their voice heard? An active voice can be powerful, but you may or may not have the time and energy to become personally invested in your investments.

• Impact investing: This approach is what it sounds like. Choose a specific and measurable ESG goal like affordable housing or solar energy. Then narrow in on a fund that accomplishes this goal. You may have to set aside other criteria, but this targeted approach focuses on that singular impact.

Choose ESG Funds for Your Portfolio 

When you want to uphold specific ideals, one of the best ways to do it is to research the right funds for your specific needs and interests. Your best bet is to find the right ESG funds early on so you can rest easy knowing that your portfolio accomplishes exactly what you want it to in the world.