Physicians take an oath to “do no harm” when treating patients and often counsel them to adopt healthy habits such as not smoking, not drinking too much, and getting regular exercise. A partly philosophical, partly practical issue is whether pledging to avoid harm is a core value that doctors seek to apply outside of the exam room, to people, and to the planet where we all live.
Of course, those of us who are not doctors face the same issue: we want to avoid causing harm to others. Does that include how we treat the earth and everyone who share its resources? Many of us have installed solar panels, more of us are choosing to drive an EV, and we presume everyone supports basic human rights for all. What about extending these views to the way we invest our money? This is a BIG topic with many angles to consider, but we cover the key points here and try to clear up much of the confusion swirling around the issue.
Why do investors care about environmental, social, and governance (ESG) issues?
It’s no secret that companies use the world’s resources to generate profits. The concept that these companies should have a responsibility not only to their shareholders but also to the planet and society at large is often called “corporate social responsibility.” Most companies now publish what is known as a Corporate Social Responsibility report that details how a business works to be a good steward of the earth’s resources and give back to the communities where it operates.
Many individuals want to incorporate this perspective when investing because it is consistent with their beliefs and values. But for a moment, let’s set aside the question of whether or not businesses have a responsibility to avoid exploiting the earth and other people. From a purely economic standpoint, does it make sense for investors to care about what is known in the corporate and investment world as “Environmental, Social, and Governance” (ESG) or “sustainability” issues?
It’s not hard to find examples to support the economic argument that it does. The consensus is that human-caused climate change is exacerbating certain problems, such as increasingly destructive floods and droughts that are impacting food supplies and increased pollution that is contributing to health problems for a growing number of people. This raises the cost of property insurance, construction, shipping, food, medical care, and so much more. The result can certainly have a negative impact on profits.
Corporate behaviors that fall under the “social” and “governance” components of ESG can also impact corporate profits. Companies should treat their employees well not just because it’s a nice thing to do, but because they have to attract talent and prevent costly turnover. And, good governance practices help firms avoid costly lawsuits and reputation-destroying scandals. Increasingly, customers are placing votes with their dollars. Customers are choosing to purchase certain goods or not shop at specific stores based on their real and perceived political leanings and/or social ideologies.
Basic ESG Definitions
Whether you want to reflect your values through your investing or your focus is on economics, you may firmly believe that ESG issues matter. A growing percentage of people agree. But many investment funds are labeled as either “responsible,” “socially responsible,” “ESG,” “sustainable,” or “green.” These terms are somewhat, but not entirely interchangeable, and that is just the beginning of the confusing terminology. To be honest, many financial advisors are also confused. We aim to clarify things here and first offer brief, broad definitions of what the “E,” “S,” and “G” components of ESG cover.
Environmental issues – The “E” pillar focuses on a company’s use of natural resources and its effects on the environment (greenhouse gas emissions, water and our oceans, biodiversity, and so on), both as a result of direct operations and across their supply chain. Climate change creates financial challenges for many industries, and a company with poor environmental policies and practices can alienate consumers and create financial risk. But it’s not just about risk; “E” also covers opportunities to innovate, help the environment, and increase profits. This generally allows individual investors to skew their investments away from companies emitting the most greenhouse gasses, especially CO2. Oftentimes, investment fund screens retain only those energy companies that are committed to and geared toward a greener future.
Social issues – The “S” pillar covers ways a company interacts with its employees, its other stakeholders (suppliers, customers, etc.), and the communities in which it operates. This may include labor relations and health and safety issues, policies on workplace diversity and pay equity, product safety, and whether the company’s suppliers use forced or child labor. As with the “E” in “ESG”, the Social component presents both risks to a company’s financial health and a way that can set itself apart from its competitors. As far as the individual investor is concerned, the “social” component often gets boiled down to choosing screens for their investment portfolio that filter out companies that participate in things that go against their personal convictions, such as manufacturing cigarettes or “sweatshop” labor.
Governance issues – The “G” pillar examines how a company is managed. Unethical and illegal business practices can result in significant fines, and conflicts of interest can have serious, long-lasting negative impacts on a company’s reputation and destroy shareholder value. Remember Volkswagen’s somewhat recent emissions cheating scandal? What about Elizabeth Holmes’ company Theranos? A board of directors that shirks its duties or inadequate enforcement of workplace policies that lead to costly lawsuits are other examples of governance issues that can affect a company’s value.
Responsible/ESG investing is a big tent.
While these definitions summarize what “E,” “S,” and “G” cover, there is no universally accepted definition of Sustainable/ESG/Socially Responsible investing. As a result, there are almost as many ways for investors to approach this as there are flavors of ice cream. Unfortunately, this makes apples-to-apples comparisons rather difficult. It also makes it easy for those not in favor of ESG investing to point out one or two particular items to support their point of view.
Investment funds that are often criticized exclude companies or entire sectors that conflict with certain environmental or societal values. Some ban oil & gas stocks and coal-burning power plants, and others may exclude stocks in tobacco companies or casinos (many religiously-affiliated funds will not invest in companies involved in certain activities).
An entirely different approach is to construct a fund using ESG scores assigned to individual companies, usually by third-party providers. These scores cover a wide range of issues (see our definitions above), and most of these funds only hold stocks whose scores are above a certain threshold. Yet another approach is to methodically integrate an analysis of company-level ESG-related risks and opportunities into the fund’s investment decisions.
Some investment funds focus mostly, or solely, on environmental issues (often called “green” funds, but the term has no standard definition in the U.S.). Investment managers such as Dimensional Fund Advisors prioritize a company’s exposure and contributions to greenhouse gas emissions but also consider related concerns such as a company’s toxic waste production and water management. Other funds may focus exclusively on carbon emissions, while others also integrate a company’s exposures to “S” and “G” issues.
Some investors might want to take extreme and hardline views, but how and where does one draw the line? Some people may simply not want funds to hold stocks in tobacco companies… but then the question becomes; does that stance extend to every business that sells any tobacco products? And if someone cares about reducing waste, what about a company eliminating plastic from its packaging but making some products that contain plastic?
This all presents a dilemma for investors because these differences in approaches lead to a wide range of investment experiences. If a fund shuns the energy sector entirely, that fund’s return will likely lag the overall market if oil prices rise strongly. Does that mean ESG investing is a failure? Another fund may favor technology companies, which tend to have low carbon footprints. Should sustainable investing get the credit if tech stocks surge and the fund does well?
ESG investing can make sense if you read the label carefully.
Does investing in “good” ESG stocks deliver better performance than the overall market? That would be difficult to prove one way or the other, given the lack of clear definitions of what ESG covers, inconsistent disclosures about a company’s ESG risks, and the big sector bets that some “green” funds often make. Still, evidence suggests that companies with above-average ESG practices will do at least as well as the overall market over a long period. So, favoring them doesn’t mean accepting a hit to your financial outcomes and could positively affect the planet, people, and communities.
Note that equities are not the only way to pursue sustainable investing. Companies and state and local governments issue green bonds to finance environmentally friendly projects. Green bond funds consider the creditworthiness of these issuers and only hold bonds that meet that fund’s criteria for credit quality.
As investors, it pays to read the fine print to understand a given fund’s approach to ESG. And keep in mind that choices about sustainable investing should fit in with your overall financial plan. The good news is that investors can choose ESG-oriented funds and still maintain the diversification needed to help them achieve their long-term financial goals. If you want to exclude certain sectors from your portfolio, you must be willing to accept the risks (often increased volatility) that doing so entails.
A common question and concern is whether ESG investing makes a difference. If I decide not to buy Exxon in my portfolio because of my environmental concerns, does that even make any difference to Exxon, the industry, and the environment? And how many companies are simply “greenwashing” (making vague or misleading claims to appear more environmentally friendly) to get higher ESG scores and attract investors?
ESG investing might make us feel good, but are we helping companies do good or, at least, act better? Unfortunately, the truth is that the answers to such questions are not obvious, clear, and concrete. As with anything, the power of one person may be small, but the collective power of individuals can be transformative. It may take some time for the collective power of investors to enact real change. How many investors must refuse to invest in a company before said company is negatively impacted; surely there is a tipping point, right? The collective power of innumerable individual choices can change the world. Every time you place your dollars somewhere, a vote counts.
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