ESG investing is a type of investment that focuses on environmental, social, and governance criteria. This type of investing is becoming increasingly popular as more investors seek to support companies that are making a positive impact on the world. In this blog post, we’ll explore what ESG investing is and how it can be used to create a more sustainable future.

ESG principles were first formally introduced in the United Nations Global Compact in 2000, and have been gaining in popularity ever since, with a growing number of investors using them to guide their investment decisions.

How Is ESG Investing Different from Sustainable Investing?

ESG investing and sustainable investing are both ways to invest in companies that are doing positive things for the environment and society. However, there are some key differences between the two approaches. This post will explore those differences and help you decide which approach is right for you.

ESG investing focuses on a company’s environmental, social, and governance practices. It assesses how well a company is doing in each of these areas and only invests in companies that are doing well in all three. Sustainable investing, on the other hand, takes a broader approach. It looks at a company’s overall sustainability, including its environmental and social impact, business model, and governance practices. Sustainable investing also considers financial factors, such as a company’s debt levels and exposure to climate risk. There are a number of reasons why investors may choose to focus on ESG criteria. For some investors, it’s a way to align their personal values with their investment choices. Others may believe that companies with strong ESG practices will be better positioned to manage risk and withstand financial challenges.

Breaking down the components of ESG

The first component is the environmental one. It normally refers to corporate climate policies, their energy usage and procedures for waste and pollution management. Among those elements, assessments and contingency plans about the company’s environmental risk are included. Some companies offer a wide range of reports on their environmental impact such as carbon footprint reports, and policies on transitioning towards renewable energies, but it might vary from one enterprise to another.

The second consideration is the social aspect, which implies the relationships of the company with its stakeholders. This aspect has long been incorporated into the organisational culture through the development of Corporate Social Responsibility indicators, but under the ESG framework is expanded to other key aspects. It is not only the impact the company has on vulnerable groups of society but also the impact it has on its employees by reaching compromises on issues such as health and safety, supporting LGBTQ+ rights, as well as implementing ethical supply chains.

Finally governance, inferring in the accountability structures. How transparent and accurate is the accounting of the company and in the reporting to shareholders, selecting diverse people to sum up to the scores of the company’s governance.  

Challenges of the E Pillar under the ESG framework

When it comes to the environment, ESG investing is about more than just a company’s impact on the planet. It’s also about how a company treats its employees and the communities it operates. First of all, it’s important to look for companies that have a long-term view of these issues. Secondly, it’s important to consider a company’s entire value chain when assessing its environmental impact. And finally, it’s important to remember that ESG investing is not just about avoiding negative environmental impacts – it’s also about supporting companies that are working to make a positive difference.

The general public is much more likely to be concerned about the future impacts of climate change, whereas companies with ESG ratings have been lagging behind in their consideration of forward-looking metrics. This disconnection needs to be addressed in order for ESG ratings to be more accurate and effective.

There are a few ways that ESG rating companies can improve their E pillar scores. One way is to be more transparent about the carbon intensity of the companies they are rating. Another way is to consider other forward-looking metrics, such as water risk or energy transition risk.

By being more transparent about the carbon intensity of the companies they rate, and by considering other forward-looking metrics, ESG rating companies can start to close the disconnection between how the public perceives the impact of climate change.

However, a recent study shows that beyond just measuring emissions, other factors are driving E scores, including metrics on carbon reduction transition plans, suggesting that the commitment to effectively implementing such plans is critical to greening the financial system. This is significant because it shows that reducing emissions is not only about using the right technology but also about having the right policies and procedures in place to make sure that technology is used effectively. It also suggests that banks and insurance companies that are serious about reducing their emissions should not only invest in clean technology but also should make their operations as green as possible.

Another concern points towards “binary disclosure metrics”, this means that companies have no incentive to act on climate change, but rather to simply formulate a plan. This is not to say that having a plan is unimportant, but it is clearly not enough. In order to effect real change, companies need to be held accountable for taking actionable steps that will lead to a reduction in emissions. In conclusion, companies with risk or emission reduction procedures or transitioning plans will receive the same credit as those ones with actual comprehensive science-based targets or frameworks

There are a number of ways to do this, but one suggestion is to create a climate change scorecard. This would track companies’ progress on specific climate-related goals and objectives and publicly rate them accordingly. This would create a more competitive environment in which companies would be more likely to take meaningful action on climate change in order to improve their score and reputation.

Therefore, the combined opacity of ESG rating methodologies, (non-standardised firm-level disclosures and inconsistencies in the selection and measurement of ESG rating metrics), reduces the ability of users – from central banks to private investors – to assess how externalities from climate change may affect markets, and separately how issuers’ collective actions contribute to such externalities.

Other challenges

ESG investing is not without its challenges, however. Many companies are not yet disclosing enough information to allow investors to make informed decisions, and there is still a lack of standardization around ESG reporting. Some critics argue that ESG investing may sacrifice financial returns in pursuit of social and environmental goals. Additionally, there is a lack of agreement on how to best measure and weigh ESG factors.

Further steps and consensus are needed to strengthen the methodologies and indicators used for measuring ESG ratings if we want it to be a real reference for investors looking into companies pursuing change and positive impact.

Despite these challenges, there is reason to believe that ESG investing is here to stay. As more investors become interested in responsible investing, we are likely to see more companies disclosing ESG information and more products and services being enough information about their ESG practices to allow investors to make informed decisions.
 

Written by Silvia Garces

References

Grant Thornton. What’s Next for ESG Regulation in the Banking Sector? Link.

Investopedia. Environmental, social and governance: ESG criteria. Link.

Mason Hayes & Curran. The Next Steps to Green Banking – Managing ESG Risks in the Banking Industry. Link.

OECD. ESG Investing practices, progress and challenges. Link.

OECD. ESG Investing: Environmental Pillar Scoring and Reporting. Link.

OECD. Financial markets and climate transition opportunities: Challenges and Policy implications. Link.