Understanding the Heart of ESG: Environmental, Social, and Governance Factors Explained
Whether or not you’ve seen this year’s ESG-related headlines, the term can be one that is hard to understand and may be associated with various assumptions. BSW is attempting to cut through the noise and clarify what ESG is and is not. ESG is a framework, applied to an investment strategy, that includes material Environmental, Social, and Governance factors when making investment decisions. Here’s an example: when considering the G (governance) of ESG, there is a belief that it is in the investor’s best interest to ensure a company’s board is comprised of industry experts and that there is sufficient board oversight of executive compensation. If this is not the case, the thought is there may be potential risks when investing in the company. The value proposition of ESG investing is realized by aligning the short-term intentions of investors with the long-term outlook of society while simultaneously mitigating risk and realizing opportunities.
Challenges in the ESG Landscape: Transparency and Greenwashing
To fully understand the ESG landscape, it is important to be aware of the challenges caused by a lack of transparency and greenwashing. As of 2020, there are over $35 trillion in managed assets that claim to have an ESG overlay. This constitutes 30%-to-35% of global managed assets. At first glance, this should be something to celebrate! However, we believe the numbers are deceiving in large part due to a lack of transparency around what qualifies as ESG. For example, large fund companies have an innate advantage (a household name, marketing capabilities etc.) over boutique firms and tend to draw the greatest inflows of capital. However, their ESG funds frequently are composed of the benchmark (e.g., S&P 500) less a small handful of companies. A fund that closely tracks the benchmark and excludes only a handful of obvious names likely gives no significant ESG benefit. Investing in such funds is, in our opinion, more of a superficial, feel-good way of pursuing an ESG strategy where investors fall victim to greenwashing.
Greenwashing, or impact washing, is when fund managers overstate an investment’s positive environmental or societal impact. Why does greenwashing / impact washing occur? The most basic answer, unfortunately, is because it is easy, and it pays. The people who suffer are the ESG players and your everyday investor. Generally speaking, investors gravitate towards simplicity. Knowing this, some fund companies discovered that simply adding an ESG label and forgoing substantial ESG analysis can be sufficient to attract investors to their fund. The broader impact of this is ESG’s reputation takes a hit as being nothing more than a marketing campaign.
BSW’s ESG Knowledge: Navigating Complexity, Providing Clarity
The good news for BSW clients is that we are aware of these challenges and have industry relationships that we believe allow us to better navigate the ESG world. When we choose ESG strategies, we typically evaluate the manager, their process, their commitment to ESG, the team they’ve put in place and their fees. If you want a more detailed refresher on our process, I’d encourage you to revisit a previous BSW blog post Here.
Looking ahead, some ESG themes we foresee impacting investors are: opportunities for impact in the bond world, the global adaptation to a warmer planet and the implications of global climate legislation.
- With fixed income yields at historically attractive entry points, we believe there is a real opportunity to add green, social, or sustainable bonds to your portfolio. Green bonds may fund projects focusing on renewable energy solutions, social bonds tend to focus on positive community impact, and sustainable bonds are generally a mix of green and social.
- 2023 is on track to be the hottest year on record in our planet’s history. We can’t ignore the reality of a warming planet, which comes with risks to the global economy. These risks may have implications for investors and make the case for the materiality of ESG factors. Think about the following risks posed by a hotter planet: increased frequency and severity of wildfires; greater unpredictability for crop and livestock management with implications for food supply and prices; increased demand for power to cool our homes. These examples are a few of many that have the ability to threaten global economic growth. We believe an opportunity for investors lies in allocating funds toward solutions that have the potential to become an essential part of climate risk management.
- Global climate legislation can serve as an indicator of where to direct capital. Paying attention to policies that are put in place, like the Inflation Reduction Act and the European Union’s Green Deal Industrial Plan, can signal where to look for potential investment opportunities.
ESG Beyond Buzzwords: A Fundamental Shift in Investment Paradigm
Despite the varying perceptions, we believe ESG is here to stay. No matter how you spin it, environmental, social, and governance factors can be material to investment decisions. In fact, increasingly more companies are making decisions based on ESG factors. Here are two facts to consider: 1) In 2022, 69% of S&P 500 companies tied executive compensation to ESG goals, an increase from 60% in 2021; 2) Nasdaq reported around 65% of Russell 3000 firms are discussing ESG factors on their quarterly calls. If companies are accounting for ESG factors, shouldn’t we as investors?