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ESG investing: meaning and trends

ESG investing has proven to be one of the most durable investment trends over the past decade. Learn why all kinds of investors support ESG funds and investments.
Business
2023-07-12T00:00:00.000Z
en-us
man looking at investment data on laptop

ESG investing has brought about a transformative shift in our approach to investments. Gone are the days when investing was solely focused on financial returns. Today, ESG investing aims to generate returns that not only benefit investors but also contribute to the betterment of society.

👉 What is ESG investing? Why is it becoming so popular? And what are its advantages?

ESG investing - an overview

The term "ESG" encompasses environmental, social, and governance performance, which, along with profitability, reflects the values and impact a company can have on society. It recognises that businesses must strike a balance between these diverse forms of value to ensure their long-term business sustainability.

By integrating ESG factors into investment decisions, investors are taking into account the environmental impact of companies, their social responsibility, and the effectiveness of their governance structures. This comprehensive evaluation of companies enables investors to align their investments with their values and contribute to positive change.

Moreover, ESG investing has broadened the definition of success in the investment world. It acknowledges that financial returns alone are not sufficient indicators of a company's true worth. Instead, ESG investing recognises that companies that excel in environmental stewardship, social responsibility, and strong governance are more likely to deliver sustainable and resilient performance over the long term.

ESG investing has also spurred companies to become more transparent and accountable in their operations. In order to attract ESG-minded investors, companies are increasingly disclosing information about their environmental impact, social initiatives, and governance practices. This level of transparency fosters trust between companies and investors and promotes responsible business practices.

ESG investing has revolutionized the way we approach investments by emphasizing the importance of societal benefits alongside financial returns. It encourages a holistic evaluation of companies, taking into account their environmental, social, and governance performance, to ensure long-term business sustainability and contribute to positive change in the world.

ESG in more detail

ESG investing goes beyond traditional profit-focused approaches by placing equal importance on environmental, social, and governance factors and performance. It acknowledges the material risks and opportunities associated with these factors that businesses encounter.

ESG investing is often referred to by several interchangeable terms, including sustainable investing, impact investing, socially responsible investing, and ethical investing. These terms all reflect a commitment to sustainable development. 

ESG investing prioritizes a long-term perspective over short-term profits that come at the expense of the environment and society. The goal is to ensure that businesses can thrive while preserving the natural resources and human capital they rely on.

The popularity of ESG investments has been driven by increasing consumer demand and regulatory pressures for environmental and social responsibility. Even in the absence of legally required reporting, businesses often choose to voluntarily adopt corporate social responsibility standards and frameworks to measure, report, and communicate their ESG performance.

👉 Well-known frameworks include CDP, the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the Task Force on Climate-related Financial Disclosures (TCFD). Annual corporate social responsibility reporting allows investors to assess and compare the performance of businesses.

ESG investors rely on ESG investment indices such as the Dow Jones Sustainability Index (DJSI), Morgan Stanley Capital International (MSCI), FTSE4Good, and ISS ESG Solutions to analyze ESG rating information. 

Additionally, investors can disclose their own sustainability initiatives by adhering to the Principles for Responsible Investing (PRI), established by the United Nations in 2006. With over 2,000 signatories, these principles are widely recognized as ethical investment guidelines.

👉 To read more about PRI, check out our article.

person sitting in front of computer screens

Mandatory ESG reporting

UK

In April 2022, the UK implemented two mandatory ESG disclosure laws: the Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2022 and the Limited Liability Partnerships (Climate-related Financial Disclosure) Regulations 2022.

These Regulations require specific companies to include climate-related financial disclosures in their strategic report. The companies affected are as follows:

  • UK companies that are required to produce a non-financial information statement, including those with over 500 employees, listed on a UK regulated market, or functioning as banking or insurance companies (Relevant Public Interest Entities).
  • UK registered companies listed on the London Stock Exchange with over 500 employees.
  • UK registered companies not falling into the above categories, but with over 500 employees and a turnover exceeding ÂŁ500m.
  • Large LLPs (Limited Liability Partnerships) without trading or banking activities, with over 500 employees and a turnover exceeding ÂŁ500m.
  • Traded or banking LLPs with over 500 employees.

The impact of this new legislation extends beyond the UK's major companies and financial institutions to include the numerous businesses in their supply chains. This emphasizes the importance of initiating ESG reporting, regardless of direct impact.

EU

Previously, a specific group of large companies (approximately 11,000 entities) in the European Union (EU) were required to disclose ESG information according to the Non-Financial Reporting Directive (NFRD).

However, in 2023, the NFRD was replaced by a new directive called the Corporate Sustainability Reporting Directive (CSRD). The CSRD expands the reach of companies obligated to comply, encompassing around 50,000 companies in the EU. This accounts for approximately 75% of the total turnover of EU companies.

👉 If you would like to acquire more knowledge about the CSRD, you can read our article on the topic.

US

At present, there are no compulsory ESG disclosure obligations on the federal level in the United States. However, in May 2022, the US Securities and Exchange Commission (SEC) put forth proposed "amendments to rules and reporting forms to ensure consistent, comparable, and dependable information for investors regarding the integration of environmental, social, and governance (ESG) factors by funds and advisers." 

If the proposal is approved, it will introduce disclosure mandates for funds and advisers that promote themselves as having an ESG emphasis. 

👉 To learn more about the upcoming SEC Climate Disclosure Rules, check out our article.

Why is ESG analysis becoming important to companies?

ESG investing has experienced remarkable growth, soaring by 456% between 2005 and 2020. This surge is aligned with a burgeoning interest among individuals and organizations to leverage their investments for both financial gains and positive societal impact.

Contrary to common belief, achieving substantial profits does not necessitate compromising environmental and social responsibilities. Numerous studies have established a positive correlation between ESG investment performance and financial growth. For instance, a Fidelity study scrutinising global ESG investments from 1970 to 2014 found that half of these investments outperformed the broader market, while only 11% displayed poor performance.

Further research conducted by Morningstar highlights the favorable characteristics of ESG funds. These funds demonstrate lower volatility and deliver positive returns. Over a span of ten years, an impressive 77% of ESG funds remained active compared to just 46% of conventional funds.

The rapid expansion of ESG investing has prompted investors to demand increased transparency and reliable data from the companies they invest in. Accurate ESG ratings heavily rely on voluntarily reported data furnished by these companies. To facilitate this process, companies can adopt corporate social responsibility (CSR) reporting frameworks, which enable the effective delivery of information that is valuable to investors. Contrary to concerns about exposing poor performance, ESG reporting actually grants companies a clearer understanding of their overall business operations.

Implementing ESG improvements doesn't always require expensive or time-consuming initiatives. In fact, they can yield cost savings and enhance operational efficiency. Shifting the organizational mindset towards ethical business practices allows companies to effectively communicate their ethical values to stakeholders.

Consumers place immense value on these ethical considerations, to the extent that they are willing to boycott brands that do not prioritize business sustainability. Additionally, consumers are even willing to pay more for products from companies that prioritize ESG factors.

As the consequences of climate change and social inequalities intensify, investors will increasingly seek out high-quality ESG investments. To seize the opportunities presented by this burgeoning trend in ESG investing, businesses must embrace sustainability reporting and disclosure as an integral part of their operations.
London city financial district

What are the ESG factors?

When it comes to voluntary ESG reporting, businesses have traditionally disclosed their performance based on the issues that are relevant to their operations. Various ESG frameworks suggest that companies report on specific factors such as their greenhouse gas (GHG) emissions.

However, not all factors can be easily categorized into distinct "E" (environmental), "S" (social), or "G" (governance) categories, as they often have interconnected impacts. For example, reducing GHG emissions is crucial for addressing climate change and the environment, but it also has positive effects on community health, which is a social consideration.

In addition, businesses are increasingly expected to report the financial risks and opportunities associated with ESG factors, considering their impact on the company's bottom line. However, quantifying ESG factors in financial terms can be challenging for companies, and verifying the accuracy of these measurements can present further difficulties.

That's why it is essential for businesses to collaborate with organizations that can assist them in quantifying ESG factors accurately. By partnering with such organizations, businesses can receive support in their ESG quantification efforts.

Environmental factors

Examples include:

  • Greenhouse gas emissions
  • Energy efficiency
  • Water consumption
  • Toxic substances and pollution 
  • Biodiversity loss and protection
  • Deforestation 
  • Waste management 
  • Product life cycle analysis
factory releasing pollution

Social factors

‍Examples include:

  • Human rights and child labour
  • Living wages
  • Worker health and safety 
  • Diversity, equity, and inclusion
  • Data protection and privacy
  • Employee and customer satisfaction
  • Community relations
  • Stakeholder engagement
people protesting for the environment

Governance factors

Examples include:

  • Board composition
  • Executive compensation
  • Tax strategy
  • Bribery and corruption
  • Lobbying and political contributions
  • Transparency and public disclosures
  • Codes of conduct
  • Supply chain management
  • Risk and crisis management
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Are there specific metrics to consider?

With so many different factors included in ESG and so many different business models, there are no standard metrics that companies report on. To prepare for ESG reporting, organizations select the ESG performance metrics material to their business industry and model. 

‍However, environmental metrics such as GHG emissions are commonly reported, due to the globally binding Paris Agreement target of limiting global warming to well under 2 degrees Celsius by 2100. 

But even for GHG emissions, there are variable methods for measurement. GHG emissions data may be measured in “absolute” or “emissions intensity” terms. 

👉 Absolute emissions measurement reports the total greenhouse gas emissions over a period of time. Emissions intensity shows how much GHG emissions were produced per unit of profit.

While absolute emissions targets are helpful for assessing performance according to a national carbon budget and achieving net zero, emissions intensity targets allow growing businesses to reduce emissions relative to their growth. 

Assessing ESG performance starts with choosing a baseline year for comparison, establishing key metrics to measure performance, and KPIs to assess improvements.

ESG labeling regulations

Many jurisdictions are in the process of introducing ESG fund labelling regulations. Such regulations aim to make the assessment and comparison of ESG funds more transparent and to limit the risk of greenwashing.

UK

The FCA is currently in the final stages of developing the UK Sustainable Disclosure Regulation (UK SDR), and the finalized regulations are expected to be published later this year. The primary change brought about by the UK SDR is the implementation of a label-based rating system. This system categorizes financial products based on their level of sustainability, allowing investors to differentiate between them based on their sustainability credentials.

  • Sustainable focus - Assets with this label primarily emphasize environmental or social sustainability. These funds are required to maintain a high level of sustainability by investing at least 70% in sustainable assets.
  • Sustainable improvers - Assets with this classification aim to have a positive impact on the environment or sustainability in the future. Asset managers are expected to demonstrate measurable improvements in the funds' environmental, social, and governance (ESG) performance.
  • Sustainable impact -Assets labeled as such focus on investments that address real-world problems and contribute measurably to environmental or social sustainability outcomes. While there is no minimum sustainable investment requirement for this classification, financial products must have a specific sustainable objective as their intended outcome.

👉 To learn more about the UK’s sustainability disclosure requirements take a look at our article.

EU

The Sustainable Finance Disclosure Regulation (SFDR) is a regulatory framework implemented in the European Union (EU) that enforces compulsory disclosure requirements regarding environmental, social, and governance (ESG) factors for EU financial market participants. These regulations were introduced in 2021 with the objective of ensuring transparency for investors regarding the environmental and social characteristics of financial products.

The SFDR has implemented varying levels of disclosure, categorizing funds into three distinct groups based on their level of sustainability:

  • Article 6 funds - These funds do not incorporate sustainability into their investment processes.
  • Article 8 funds - These funds promote sustainable investment, although it is not their primary objective.
  • Article 9 funds - These funds prioritize sustainable investment as their main objective.

👉 To learn more, read our article on the Sustainable Finance Disclosure regulations.

US

The U.S. Securities and Exchange Commission (SEC) has announced proposed amendments to the 'Investment Company Act,' a regulatory framework governing funds. These proposed changes aim to strengthen the fund labeling regulations by categorising funds into three tiers:

  • ESG-integrated funds, where ESG qualities are a routine selection factor, but only as one factor among many. Where this is the case, the fund needs to disclose its methodologies and data sources used in their ESG evaluation.
  • ESG-focused funds, where ESG qualities are a “significant” or “main” consideration. In this case funds will need to disclose greenhouse gas emissions and outline their methodology for selecting fund assets. They will also need to display the information in a standardized table for easy comparison. 
  • Impact-focused funds, where specific ESG outcomes are the primary focus of the funds. They’ll need to disclose how they measure qualitative and quantitative progress towards those ESG goals - this includes relevant emissions data for any environmental goals.

Another aspect of the proposed amendments will mean that any fund that includes a specific type of investment in its name (for example ESG) will need to allocate at least 80% of the fund accordingly. 

👉 To find out more about the proposed ESG fund labeling rules please read our article on the topic.

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‍What are the main trends in ESG?

In light of the COVID-19 pandemic, the significance of business resilience amidst global disruptions has become paramount. Much like the pandemic, climate change is anticipated to exacerbate social inequalities and present difficulties in adapting to transformative circumstances.. 

As a result, we’ve seen a steady increase in sustainable investment net inflows over the years. 2021 saw the largest amount of sustainable investments totalling $649 billion, according to Bloomberg. This was more than twice the amount invested in 2020. 

Sustainable investments now make up more than a third of the total global managed assets, and this amount grows each year.  In fact, it’s estimated that ESG assets could reach $50 trillion by 2025.

Tackling global warming ‍

The 2015 Paris Agreement made climate change a key focus for global ambition. Net zero GHG emissions targets cover 70% of global GDP combined from national and regional commitment levels. 

Public opinion also seems to favor climate change action. Yale’s climate opinion polls from 2021 show that 72% of people in the US think that CO2 should be regulated and 70% feel that corporations should do more to address global warming. 

‍With such a strong consensus among policy leaders and public opinion to reduce global GHG emissions, investors increasingly expect businesses to measure, report, and establish reduction targets for their corporate emissions. 

The investment community no longer sees companies as mere contributors to the problem of climate change. It is also now acknowledged that business assets are vulnerable to climate risks too. 

These risks include “transition risks” related to regulations, consumer demand, litigation, and shifting technologies. They also include “physical risks” related to climate change such as water scarcity, extreme temperatures, sea level rises, and other complex impacts. 

Direct climate change impacts have totalled $2.565 trillion in damages since 1980, according to the NOAA. Without significantly reducing CO2 emissions, these impacts are expected to increase in intensity and frequency. That’s why climate change has become a “hot” trend within ESG investing. 

As climate risks grow, passive investment could become a relic of the past.

wind turbines

Considering mental health

The global pandemic has cast a spotlight on the profound mental health challenges stemming from grief, isolation, and uncertainty. Disruptions to schedules, disparities in healthcare accessibility, and inconsistent safety measures have left individuals in a state of confusion and frustration. And even though the pandemic may have receded, its lingering impacts continue to be felt.

Compounding this issue is the growing cost of living crisis, which is creating financial difficulties for people across the globe and pushing more and more families below the poverty line. This is resulting in an increase in health issues such as anxiety and depression. 

These mental health issues take their toll on the workforce and reduce the morale of team members beyond those directly impacted. Overall, this can affect the profits and reputation of businesses. 

Work-life balance, flexible work schedules, and opportunities for career advancement can all help employees engage more meaningfully at work. Mental health is an important ESG consideration for investors, because it correlates with stronger productivity and financial returns.

two people talking to one another

Focus on social inequality

The Covid-19 pandemic also severely impacted and exacerbated social inequalities, many of which are still being felt today. For example, parents had to find childcare or sacrifice work when their children could not attend school, and  this often disproportionately affected women who tend to be the primary caregivers. As a result the gender disparity in the labor market has widened. 

Another impact of the pandemic was a widening of the world’s wealthiest and poorest individuals. Across supply chains, people lacking economic safety nets had to risk their lives to continue producing the world’s commodities. In contrast, global wealth soared during this time, creating a greater divide. 

And this divide has only gotten bigger with the cost of living crisis. As a result, employees, frustrated by the level of social inequality, have taken efforts to form unions, go on strike, and demand stronger health and safety protections, living wages, and equal pay across gender and race. 

Social inequality not only wears down on the performance of a company, it threatens organizations with reputational damage that can last for years. Nike spent over a decade recovering from campaigns and lawsuits highlighting its sweatshop labour practices in the 1990s. 

Companies that prioritize greater equality within supply chains and their own workforce can maintain strong relationships with their diverse stakeholders. The benefits of lower turnover, greater brand loyalty, and increased productivity are all vital for positive financial performance.

woman working from home

Moving to a sustainable society

Many people, especially millennials and Gen-Z consumers, are opting for vegan or organic food, second-hand fashion or sustainable brand clothing, eco-conscious travel destinations, and products with low waste or plastic-free packaging options. 

  • Consumers are also consciously choosing biodegradable or reusable products and packaging to live zero-waste or low-waste lifestyles. They are more likely to compost and save water or electricity when possible. 
  • The global plant-based protein industry is now valued at $12.2 billion. Mainstream fast food restaurants are beginning to offer plant-based menu options to respond to this growing trend. Alternative meat start-ups like Impossible Burger have successfully tapped into the demand for meatless options. 
  • ‍Second-hand apparel is rapidly expanding and is expected to grow three times faster than the market for new clothing. Online shopping and reselling, as well as cheaper price points have made second-hand clothing convenient to buy and sell. People can upload and sell directly from their closets on apps like Depop, Poshmark, Vinted, and Etsy.
  • Resellers specializing in brand name clothing like ThredUp, Vestiaire Collective, and the RealReal have also created a high-end equivalent of the second-hand clothing marketplace.
  • Traditional retail clothing sellers like Patagonia, Levi’s, and Eileen Fisher have also started to buy back their inventory to resell their own used inventory at a lower cost. This way, brand-loyal shoppers can support the companies at lower price points.
‍Sustainable lifestyle choices are likely to grow in importance as more people respond to global shifts by changing their personal habits. Companies that offer relevant low-waste, ethical opportunities for consumers are likely to reap financial rewards.
recycling plastic

What about Greenly?

At Greenly we can help you to assess your company’s carbon footprint, and then give you the tools you need to cut down on emissions. Why not request a free demo with one of our experts - no obligation or commitment required. 

If reading this article has inspired you to consider your company’s own carbon footprint, Greenly can help. Learn more about Greenly’s carbon management platform here.

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