The acronym ESG stands for environment, social and governance. Investors are more frequently incorporating non-financial metrics into their analytical approach to identify material risks and growth opportunities. ESG metrics are not typically included in mandatory financial reporting, but are increasingly included in annual and stand-alone sustainability reports.
To help integrate these factors into the investment process, various organizations, such as the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the Task Force on Climate-related Financial Disclosures (TCFD), are attempting to develop standards and definitions of materiality.
Broad trends
What are esg factors? Several major trends are emerging as the demand for ESG investments increases, including climate change and social unrest. The coronavirus epidemic, in particular, has sparked debate about the link between sustainability and the financial system. The CFA Institute is working to establish best practices for integrating ESG investment into financial sector institutions.
A distinction can be made between ESG-focused companies and mainstream companies. The former are primarily non-financial companies that have integrated ESG factors into their business models, while the latter have only recently begun to incorporate sustainability into their business strategies. While there is a growing demand for integrative disclosure, the distinction between these two groups remains difficult to define.
Companies involved
The growing demand for ESG investment opportunities has led to an increase in the number of mainstream companies integrating environmental, social and governance factors into their business strategies. These stakeholder-friendly companies typically implement innovative management and reporting systems that help them attract and retain their (future) customers. This trend is supported by industry analysts such as The Boston ConsultingGroup (BCG), which predicts that the market for sustainable products and services will grow by 6-8% over the next few years.
Companies that incorporate ESG factors into their core business strategies can take many forms, such as B-corporations or fair trade companies. While these initiatives are often created for marketing purposes, they can also provide comprehensive reporting on performance against non-financial metrics.
American Apparel is an example of a company that has integrated ESG factors into its core business model. In 2008, Newsweek recognized it as one of America’s greenest companies. Other examples include Starbucks and IKEA.
ESG investors typically focus on the stage of development of an industry, rather than the development of a company. This means that companies in early stage industries, such as clean energy or ethical fashion, are often more attractive to ESG investors than traditional companies. This preference for emerging industries is not limited to the financial sector; high levels of unemployment and social instability have led ESG investors to seek safe havens for their investments. These safer opportunities are typically located in emerging markets, which are also popular with other investors.
A focus on sustainability
For example, an ESG investor may choose to invest in renewable energy companies first and diversify into other sectors only later. This approach is often used by so-called “patient capital” investors who focus on early-stage industries in the belief that returns on these investments will be greater than those on mature companies.
The financial crisis is another reason why ESG investing has gained momentum in recent years. While most mainstream investment institutions view sustainability as a risk management tool, many ESG investors see it as an opportunity to increase portfolio returns.
