Q2 2023 Commentary: What is ESG?

Pine Haven Investment Counsel, Inc.

Paige Johnson Roth, CFA®

The idea that our financial lives should align with our deeply held beliefs has been around for millennia. The Hebrew Torah offers guidance to believers about the proper ethical view of money lending and investing. The Koran, the Bible, Hindu scriptures, and the texts of almost all faiths address money and finance. Beyond its religious connections, ESG investing is a modern, secular approach that incorporates values-based metrics into investment selections.

ESG takes into consideration environmental (E), social (S), and governance (G) factors alongside financial metrics when making investment decisions. ESG investing has gained popularity in the last decade due to several factors, including the 2008 financial crisis and increased concern over our environment. Current ESG investing has its roots in the South African divestment movement. From this divestment movement, a coalition of investment managers began calling their efforts Socially Responsible Investing. This effort initially focused on avoiding companies that produced tobacco, alcohol, and other “sin” stocks. These negative screens were initially developed and implemented by Methodist Minister John Wesley.

Overall, the focus of ESG is to align investments with sustainability and ethical values, seeking positive social and environmental impact in addition to financial returns. It aims to take a more holistic approach to stock selection by evaluating non-financial risk factors. The belief is that these non-financial risk factors will prove in the long run to have material impact on a company. Of course, investment managers weigh these components and financial factors differently.

The “E” in ESG refers to environmental factors such as resource usage, carbon footprint, and/or climate change policies. Have they reduced the waste they generate? Are they working to reduce their carbon emissions? Use less water? Do they have a plan for addressing climate change and how it might affect their communities, their employees, and their products?

The “S” represents social factors including a company’s impact on their communities, hiring practices, discrimination policies, pay equity efforts and diversity and inclusion efforts. How highly are they rated on corporate review sites? How proactively do they recruit from diverse communities? Have they benchmarked salaries? Where do they locate their facilities? How did they take care of employees during COVID?

The “G” stands for governance, which involves evaluating a company’s leadership, transparency, and ethical practices. What is their board structure? Do they have an independent Chairperson and independent directors? Do they prioritize safety? How does the CEO (and executive team) get incentivized and evaluated?

Investment managers have a variety of metrics they use in approaching stock selection, both financial and ESG related. There are many ways to rank the importance of these metrics and managers do take different approaches. Performance comparisons are inherently difficult for this reason. Most studies of ESG versus traditional investing show that there is no difference in their long-term returns - especially when risk is factored in.

In our current charged social and political climate, ESG investing has become a target of some Republican lawmakers. Several states have enacted rules or laws to prohibit investment managers from using ESG metrics in managing state funds (pension, treasury) or even allowing the managers to have any products that are ESG-related. Their argument is that using factors other than financial metrics is not acting as a fiduciary and not in the best interests of the state or pension fund beneficiaries. Blackrock, a leading investment management firm that has both traditional and ESG strategies, countered by noting that “investors and companies that take a forward-looking position with respect to climate risk and its implications for the energy transition with generate better long-term outcomes.”

Over the years, the ESG movement and other values-based investment approaches have successfully advocated for changes at the corporate level. Many companies have embraced changes that have moved them forward and made them better corporate citizens. Many of these changes have saved companies money, others have improved working conditions, reduced emissions, or tempered CEO salaries.

It is often said that the only constant is change. The shifting landscape of investing has always been connected to broader feelings about economic trends and the world at large. As we learn more about the long-term implications of each of the environmental, social, and governance components, we can continue to tailor our investment portfolios to send a message with our dollars.