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What is ESG investing?
ESG stands for Environmental, Social and Governance. ESG investing is the practice of taking these factors into consideration when making investment decisions. There is a very wide range of ESG-related strategies, from risk avoidance to positive-alpha seeking impact investing. ESG-conscious investors may either seek to avoid supporting companies with poor sustainability records, or may proactively invest in companies that benefit from long-term sustainability trends.
Investors looking to assess a company’s ESG risk would typically examine the company’s performance, plans, commitments and progress in numerous categories, and compare to other companies in the industry, as well as comparing industries and sectors. Investors will often look both at risks in a company’s own operations, as well as in the supply chain utilized by the company. Areas of interest often include the following:
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The impact that a company has on the natural environment, either through its operations, supply chain or products. Environmental factors may include:
- Greenhouse gas (GHG) emissions (e.g., carbon, methane) of operations
- GHG emissions of supply chain
- Resource use (e.g., energy, water)
- Waste production (plastic, other non-recyclables sent to landfill, toxic waste production and disposal)
- Energy sources (coal, fossil fuels, renewables, etc.)
- Land use
- Other high-profile risks (oil spills, mine reclamation, deforestation, water pollution)
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The impact that a company has on stakeholders, both internal (e.g. employees) and external (e.g. customers). Social factors may include:
- Human rights issues
- Modern slavery
- Child labor
- Working conditions
- Employee relations
- Diversity – gender, racial, etc.
- Discrimination policies
- Product quality and safety
- Workplace safety
- Responsible marketing
- Human rights in the supply chain
- Board diversity
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The systems governing the implementation, monitoring and reporting of rules and practices put in place by a company. Governance factors may include:
- Bribery and corruption policies and practices
- Board structure
- Board quality and experience
- Board size
- Board independence (insiders vs independent directors)
- Executive and director pay
- Say on pay
- Whistleblower policy
- ESG disclosure policies
- Shareholder rights
- Balancing of stakeholder interests
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There are several services that rate public companies on their ESG performance and risk profiles. Most of these service providers provide detailed scores to companies on multiple criteria relating to environmental, social and governance issues, as well as a composite ESG score to enable investors to compare companies to others in their industry and the broader investment universe. For example, using a broad set of criteria across multiple ESG factors, MSCI provides ESG ratings on a scale of AAA (ESG Leader) to CCC (ESG Laggard), and provides information to compare companies to their industry peers. Similarly, Sustainalytics ranks companies using a scale of 0-100, with higher scores corresponding to higher risk, and the score being reached through a weighted calculation of industry risk, company risk and management’s performance relating to a broad range of ESG factors. Other ESG ratings providers include SAM (S&P Global), and CSRHub.
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Disclosure requirements for companies vary by region, but for the most part are less formalized and universal compared to financial disclosures.
As investors demand more sustainable accountability from companies, regulators and other third party organizations are developing more stringent disclosure standards and standardized metrics for companies to follow. To date, many regions require only voluntary reporting on most ESG issues, although mandatory reporting is becoming increasingly common.
Organizations that are developing new ESG disclosure standards include:
Sustainability Accounting Standards Board (SASB): The Sustainability Accounting Standards Board (SASB) Foundation is a non-profit organization, established with the mission to establish industry-specific ESG disclosure standards for companies. The standards set by SASB are designed to enable investors to assess the materiality of reported sustainability information, and to compare companies on these metrics on a global basis.
Task Force on Climate-related Financial Disclosures (TCFD): The Task Force on Climate-related Financial Disclosures (TCFD) was established by the Financial Stability Board in 2015, with the goal of developing consistent disclosure standards for companies, to be used on a voluntary basis, in order to enable investors and other stakeholders to assess the companies’ climate-related financial risk.
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There are information service providers that rate investment funds on ESG performance, such as the Morningstar Sustainability Rating, which assesses funds and ETFs based on their holdings’ Sustainalytics ESG scores. Additionally, many regulators are increasing sustainability reporting requirements for fund managers, although the scope and extent of the requirements vary significantly by region. For example, the EU has recently introduced legislation regarding sustainability reporting for fund managers and advisors, including requiring firms to outline how they integrate sustainability risk into their investment processes, how sustainability affects manager compensation, among other factors.
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Most major index providers have developed numerous ESG investment benchmarks, and continue to release new indexes. Available benchmarks cover a broad range of geographies, assets classes and ESG topics. Index providers with ESG indexes include S&P (S&P 500 ESG Index, S&P Global 1200 ESG Index, S&P Europe 350 ESG Index, S&P Japan 500 ESG Index, etc.), MSCI (MSCI ESG Leaders Indexes, MSCI ESG Focus Indexes, MSCI ESG Universal Indexes, etc.), and FTSE Russell (FTSE Developed ESG Index, FTSE Emerging ESG Index, FTSE All-share ESG Index, Russell 1000 ESG Index, etc.), among others.
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Green bonds, also known as climate bonds, are securities issued specifically for financing environmental and climate-related projects. The bonds may be issued by government-sanctioned organizations, and typically enjoy tax incentives. Green bond issuance exceeded $250 billion in 2019, increasing more than 45% year-over-year.
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The Paris Agreement is a multi-nation pact developed by parties to the United Nations Framework Convention on Climate Change (UNFCCC) to combat climate change. The agreement’s main goal is to limit the global temperature increase in this century to below 2 degrees Celsius above pre-industrial levels, and to work toward limiting the increase to 1.5 degrees. The Paris Agreement was drafted in December 2015, and went into effect as of November 2016. Currently, there are 189 countries that are party to the agreement, and 195 signatory countries. Many companies set their climate-related targets to be in line with the goals of the Paris Agreement.
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GRI Sustainability Reporting Standards are the most commonly accepted global standards for sustainability reporting by companies. GRI standards were developed to enable consistent reporting across companies and industries, providing clearer communication to stakeholders regarding sustainability matters. GRI standards are available for reporting across a wide range of ESG-related topics, ranging from anti-corruption practices to biodiversity and emissions.
In 2015, the GRI established the Global Sustainability Standards Board (GSSB) as an independent operating entity. The GSSB now has sole responsibility for the development of GRI sustainability standards.
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Many companies, funds and regulators claim their ESG goals align with one or more “UN SGDs.” These efforts refer to the 17 categories of sustainable Development Goals (SDGs) adopted by world leaders at the United Nations Sustainable Development Summit in September 2015, with the aim to protect the planet and improve quality of life globally. The UN SDGs set targets to achieve a broad range of aspirational goals, including ending poverty and hunger, improving education, and protecting the environment.
The UN SDGs are divided into 17 categories: No Poverty, Zero Hunger, Good Health and Well-being, Quality Education, Gender Equality, Clean Water and Sanitation, Affordable and Clean Energy, Decent Work and Economic Growth, Industry, Innovation, & Infrastructure, Reduced Inequalities, Sustainable Cities and Communities, Responsible Consumption and Production, Climate Action, Life Below Water, Life on Land, Peace, Justice & Strong Institutions, and Partnerships for the Goals.
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The Principles for Responsible Investment (PRI) were established by a group of investor signatories in 2006, supported by the United Nations, to aid investors in integrating ESG factors into the investment process. To achieve this goal, the PRI group established 6 voluntary and aspirational principles for investors to follow (source: PRI Association https://www.unpri.org/ ):
- Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
- Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
- Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
- Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
- Principle 6: We will each report on our activities and progress towards implementing the Principles.
The PRI currently has over 2,300 signatories, representing nearly $90 trillion in AUM.
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The EU Action Plan on Financing Sustainable Growth is a set of strategies, including legislative and non-legislative actions and proposals, set by the European Commission to channel investment flows toward the sustainability goals established in the Paris Agreement and other similar initiatives, such as the 2030 goals established under the UN SDG framework (the UN 2030 Agenda for Sustainable Development). The European Commission estimates that meeting current targets (within the EU) will require annual investments of approximately 180 billion Euro. The actions included in the plan cover a broad range of topics, such as establishing a sustainability taxonomy, creating standards for green financial products, encouraging asset managers to consider ESG issues in the investment framework, and strengthening sustainability disclosures.