Sustainable Investing: ESG Scores
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ESG is an acronym for Environmental, Social, and Governance, and the ESG score measures how well a company’s actions and culture perform in these three key areas. Obviously, the environmental factor pertains to how the company negatively or positively affects the climate and natural world. The social score is based on the company’s public relations and treatment of employees, and the government score is based on the company leadership, the rights of shareholders, and other ways in which the company is run. The ESG score has become a popular metric used by investors that want to place their money into companies that are more socially or environmentally conscious.
Many investors looks for companies fulfilling specific criteria within the factors of ESG. For example, Trillium Asset Management is a firm with nearly $5B under management who is completely focused on positive impact investing. In their analysis, they look for companies that publish reports on how their operations are affecting the environment and companies that are making an effort to lower their carbon footprint each year. In the past sustainable investing required investors to lose out on gains because of their limited options in which companies they can invest into, but as time goes on, more sustainable and innovative companies are going public, and many companies are changing their policies to lessen their effect on the environment.
The two main strategies that investors use to create a sustainable portfolio are negative screening and ESG integration. Negative screening is cutting out certain problematic sectors like oil, natural gas, or cigarettes from a portfolio of investments. On the other hand, ESG integration is a strategy that allocates more of a portfolio’s asset to companies with a good ESG score than to those with worse ESG scores. Although ESG investing is becoming more prominent, it still seems to come with some loss in returns from not investing in certain companies. In a 2019 Paper, Rocco Ciciretti, Ambrogio Dalo, and Lammertjan Dam found that companies with lower ESG scores seem to have higher returns than companies with higher ESG scores. They suggested that either investors that want a socially conscious portfolio will pay a higher premium on ESG and accept lower returns, or because lower ESG score companies (Oil for example) carry more risk, they have higher returns. Their mathematical result was that decreasing ESG by one standard deviation brings about a 1.5% increase in annual expected return.
Although higher ESG companies seem to bring lower expected returns than less sustainable companies, most investors still like a portfolio that is aligned with their values. Personally, I do not invest in any oil, gas, or tobacco companies, and I try to focus a good portion of my portfolio on electric vehicles and other companies innovating against the climate crisis. Returns are not the only driving factor in investing because an investor is also helping the company they choose to invest in, and as the climate crisis worsens, it is important to support those companies choosing to fight it, or at least those companies not making it any worse.
