In recent years, a growing number of investors have been inspired to consider the impact of their investment choices on both people and planet.
Canada experienced a 48% increase in sustainable investment assets between 2018 and 2020, according to a biennial review published by the Global Sustainable Investment Alliance. Over 60% of the Canadian market is now comprised of sustainable investment assets — the highest proportion in the world, the GSIA review found.
While people are keen to invest in companies and products that can have a positive impact on the world, they need a system to help evaluate their options. That’s where ESG investing comes in.
The meaning of ‘ESG investing’
The ESG in ‘ESG investing’ stands for environmental, social and governance. ESG investing is a strategy that considers a company’s financial performance alongside factors like how sustainably the company operates and treats its employees. Some factors evaluated by ESG criteria include:
More people are concerned with how companies are managed and impact the environment before they start investing. If potential investors don’t feel that a company is operating responsibly or sustainably, they may choose to invest elsewhere.
ESG investing vs. SRI and CSR
If ESG investing sounds familiar, you’re not mistaken. You may have heard of the terms “socially responsible investing” (SRI) or “corporate social responsibility” (CSR). These investing strategies are similar, but there are a few subtle differences.
ESG focuses on three specific, measurable categories of a company’s operation: environmental, social and governance.
SRI is more of a general term used to describe an investment based on ethical guidelines. For example, socially responsible investors may decide that they’re not going to invest in any mutual fund or exchange-traded fund (ETF) that includes companies that produce firearms or alcohol. The ethics that guide SRI may differ between investors; one investor may draw the line at companies that make alcoholic beverages, while another may accept this type of investment but prefer to avoid fossil fuels.
ESG and SRI are similar in the sense that investors attracted to these strategies want their money to make a difference in the world. The difference is that SRI excludes companies based on factors that don’t appeal to investors, whereas ESG only includes companies that score well on specific criteria.
As for corporate social responsibility (CSR), it’s more of a business practice where corporations voluntarily make it their mandate to improve the environment, society, or their local community. Many corporations adopt CSR policies — which may include some ESG criteria — because it can improve their public perception or attract ethically-minded investors.
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How ESG investments are rated
ESG investments are rated or scored by ESG research companies. Each rating company has its own rating system, but most look at issues like corporate governance, resource use, and supply-chain human rights.
For example, Sustainalytics, a Morningstar company, gives companies an ESG score based on a scale from 0 to 100 that measures its exposure to ESG risks and how executives are managing that exposure. Sustainalytics uses five ratings for ESG risk:
- Negligible: 0–10
- Low: 10–20
- Medium: 20–30
- High: 30–40
- Severe: 40+
If you’re considering ESG investing, it’s essential to know a company’s ESG rating — and what criteria are included in that rating — because while some corporations may claim to care about certain ESG principles, the score may say otherwise.
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Pros and cons of ESG investing
While ESG investing might sound appealing, you need to evaluate the potential pros and cons before choosing to integrate these assets into your portfolio.
Pros of ESG investing
- Invest according to your values: Investing in companies that emphasize ESG principles means taking action to support your beliefs.
- Support companies that share your values: Companies that focus on ESG might sacrifice short-term profits to do what’s right for people or the planet. By investing in these companies, you’re showing them that you appreciate this prioritization
- Add portfolio resilience: Although investment performance is never guaranteed, a 2020 report from Morningstar found that ESG index funds generally performed better than conventional index fund through the early stages of the recent economic downturn.
Cons of ESG investing
- Potential for lower or slower growth: Since ESG focused companies have a greater social responsibility, their method of operation may not always prioritize increased profit. This could affect the overall performance of your portfolio.
- Limited choices: Although there are thousands of ESG companies and hundreds of ESG funds that you can invest in, it’s still only a portion of the entire market.
- Not all companies are transparent: Some companies claim they value ESG, but they might be saying that just for marketing purposes. It can be difficult to confirm their policies and actions, even after you’re invested.