ESG investing 101

If you’re new to ESG investing, this essay is a good place to start. If you have experience in the industry, you could learn something as well!

Let’s start with the basics. What does ESG stand for? ESG is an acronym for Environmental, Social, and Governance. You may be thinking, ok, that doesn’t make sense – what is environmental, social, and governance investing? And you’d be right to be confused! ESG investing as a term doesn’t really make sense. How do you even invest in environmental, social, and governance?

And to add fuel to the fire, while ESG investing is a common (albeit confusing) term, there are also other terms used interchangeably. Responsible Investing. Sustainable Investing. Stewardship Investing. Even Impact Investing. For the purposes of this essay, we’ll use ESG investing as an umbrella term that captures all the other terms.

But what is it? Think of deploying capital on a spectrum. On one end of the spectrum is traditional investing, where the objective is to maximize risk-adjusted financial returns in line with an investment objective. On the other end of the spectrum is philanthropy, where the objective is to address specific social or environmental issues, without expecting your money back. ESG investing sits at various points between the two ends of this capital deployment spectrum.

Responsible investing, or sustainable investing, is closer to the traditional investing side of the spectrum, and is the most common form of ESG investing. At its core, responsible / sustainable investing is the integration of ESG factors into the investment process, to support the ultimate objective of maximizing risk-adjusted financial returns. The idea is very simple – ESG is a proxy for a good management team. If a company treats its employees well (the S in ESG), adheres to industry rules and regulations about its environmental impact (the E in ESG), and operates ethically and within the law (the G in ESG), then all other things being equal, it should financially outperform its peers that do not do these things. You could argue – and many people do – that integrating ESG considerations into the investment process is just good investing, and is already practiced by the best investors in the world (that is why they have the best returns). ESG considerations are therefore just one part of the more traditional investment process. Hopefully this description of ESG investing, as an input into the investment process, makes more sense. 

Sidebar: There are a variety of practices commonly used under the responsible / sustainable investing banner. The description above explains why you will often hear the phrase ESG integration – the practice of integrating ESG considerations into the investment process. Screening is another practice, where negative screens are the exclusion of certain industries (e.g., tobacco) and positive or thematic screens are the focus on certain industries that have an implicit positive impact (e.g., renewable technologies). But like ESG integration, the objective of this practice is to avoid companies that will result in poor financial returns or focus on companies that will result in outsized financial returns. Stewardship is another common practice, which includes voting on proposals at annual shareholder meetings in line with ESG priorities and engaging with companies to encourage them to address material ESG issues. The table below illustrates common topics within ESG.

Impact investing is closer to the philanthropy side of the capital deployment spectrum. Impact investing is less focused on inputs into the investment process, but rather on objectives. The typical impact investor has the dual objective of addressing a specific social or environmental issue, while still returning capital. Unlike typical ESG issues – which are operational in nature – impact investors focus on outcomes like reducing inequalities or expanding access to products and services for underserved groups. Impact investors will often argue that they do not sacrifice financial return for impact, but in our experience, this is not true. There is inherently a trade off in impact investing. The pool of companies that intentionally aim to address social issues (and measure if they are effective at doing so) is small. And given those companies do not have a singular focus on profit, all things being equal, they will financially underperform their peers that do not prioritize impact to the same degree.

If you are new to this space, you may think the focus is having a positive impact on the world (which is the objective of impact investing), but most of the time, the objective is more on the responsible investing side of things, where having an impact is not the primary goal. This is not to say that responsible investing does not have an impact – if all companies focused on their material ESG issues, the world would be a much better place – but the degree of focus is different, as impact is not the primary objective. This is the crux of the confusion in the space – from the outside, it is marketed as impact investing, when in reality it is responsible investing, and therefore integrating ESG considerations as just one input into an investment process to maximize risk-adjusted financial returns.

Matt Levine from Bloomberg summarizes ESG investing perfectly in his newsletter:

The problem is that “ESG” can be used to refer to several slightly different things:

1. An ESG investor might look at environmental, social and governance factors to evaluate the financial prospects and risks of an investment. If sea levels rise, this coastal-hotels business might be in trouble; if the world gets serious about combatting climate change and so imposes restrictions on carbon emissions, this coal-mining business might not be able to sell its coal. These are financial risks like any other, and should inform investment decisions.

2. A big diversified investor that owns lots of shares of lots of companies will spend most of her time thinking about systematic risks, because she has diversified away idiosyncratic risk. Climate change or social upheaval might be bad for all of her companies, so when she talks to the managers of her companies she will spend less time telling them how to optimize their widget factories and more time asking them about global warming.

3. An investor who wants, not just to make money for herself, but also to make the world better, might try to do that through her investing. (By buying stocks of good companies and avoiding stocks of evil companies, or by buying stocks of evil companies and lobbying them to stop doing evil things, or something else.)

4. An asset manager who wants to make a lot of money might change the name of the XYZ Large-Cap Fund to the XYZ ESG Fund, without making many other changes, because (1) lots of investors want ESG funds, (2) they don’t particularly care about what is in those funds, and (3) you can charge higher fees for ESG funds.

The last point from Matt speaks to what is referred to as greenwashing or impact washing. Given the huge growth of ESG investing in the past few years, it seems like every fund is marketed with an ESG label. In many cases this criticism is fair – when you dig under the covers, these funds don’t practice true ESG integration. But if a fund sincerely practices ESG integration – in support of its objective to maximize risk-adjusted financial returns – then in our opinion greenwashing isn’t a fair criticism. It simply speaks to the broader misconceptions of ESG investing and whether the goal is impact or returns. To put a finer point on it, an ESG fund measured against a benchmark that includes all sectors of the economy, can include oil & gas companies, as long as it is picking those with the best ESG credentials and avoiding those with the worst. Labelling that ESG fund as greenwashing is unfair, in our opinion.

So there you go, ESG Investing 101. If you want to go deeper, explore our other essays – like what ESG investing professionals do day-to-day, what types of companies hire for ESG investing roles, and how to prepare for an ESG investing interview.