ESG Investing: What It Is and How It Works

“You can’t even comprehend it. Our entire town is gone.” –Resident of Lytton, British Columbia.¹

In June this year, a 120-degree heatwave scorched a village called Lytton in Western Canada and triggered wildfires that virtually destroyed the town. With extreme weather events like these happening right in front of us, it’s no surprise to me that climate change is a focus for many investors.

More investors are analyzing the activities of the companies in which they invest and want to know what their capital is actually funding when they buy securities. My colleagues and I are seeing many clients choosing to invest only in businesses that reflect their values, whether that’s on climate change or other key issues such as social justice. This values-based method for choosing investments is called “impact investing,” and a strategic approach to it is ESG investing.

The Social and Financial Return of Impact Investing

This style of investing aims to create a positive, measurable social and environmental impact in addition to delivering financial returns.

Sustainable investing strategies are one of the fastest-growing areas of the market. In the US alone, assets under management in sustainable investing strategies grew from $12 trillion in 2018 to $17.1 trillion in 2020, a 42 percent jump.² In 2020, there were 392 sustainable investment funds open to US investors, a 30 percent increase from 2019.³ These investment funds pulled in record inflows from US investors of $51.1 billion in 2020.³ In the US, one dollar out of every three under professional management is now invested responsibly.⁴

So, where do responsible investors start? Understanding ESG investing is a great entry point.

What is ESG?

Many investors begin their impact investing with an ESG screening approach. What does ESG stand for?

• The “E” is for the environment, which might consider how a company uses water or whether it is an environmental polluter.
• The “S” is for social, which might look at working conditions along its supply chain, and whether it uses child labor.
• The “G,” which stands for corporate governance, might include executive pay or tax avoidance.

Impact investors will assess a company’s stock according to their activities and behavior in these categories before deciding whether to invest. Different aspects of ESG will matter more to some investors than others. For example, the social element of ESG investing is moving to the forefront of investors’ minds as the COVID-19 crisis highlights social issues such as unequal access to healthcare.⁵ Racial injustice and gender disparity have also gained widespread recognition by the Black Lives Matter, #MeToo, and Time’s Up movements. Meanwhile, climate change remains a key focus for many investors, who will scrutinize a company’s stance on these issues before they back it with their investment dollars in ESG funds.⁶

How ESG Screening Works

Negative screening, or exclusionary ESG investing, removes companies from investment consideration based on controversial business practices or suspect revenue generation. Responsible investors will often exclude companies that negatively affect the planet or people, such as those producing tobacco, alcohol, gambling, nuclear power, and weapons, for example.

Positive screening, or direct investment, takes the individual investor’s social values or environmental aims and seeks to align their portfolio’s holdings with those values in order to help the investor make the kind of impact they desire with their money.

Some ESG funds use a “best-in-class” approach, meaning they pick companies that are performing higher on the ESG scale relative to their peers. With this screening approach, a gambling company might pass the screening process because the company treats its workers well, has a low carbon footprint, and has more women on its board than its competitors. Others might choose not to invest in a gambling company regardless of their ESG performance. Here at Bank of the West, clients can choose which screens they want to apply to their customized portfolio based on how strongly they feel about different ESG factors.

ESG Investing Performance

Performance data continues to reflect good news for ESG investing. In one influential survey of 200 academic studies, 80 percent of the study results showed sustainable business practices can positively influence stock price performance.⁷

Looking at the performance of the largest sustainable indexes also shows that companies with good ESG scores can perform competitively. The Dow Jones Sustainability U.S. Composite Index, for example, would have given its investors an annualized return of 16.31 percent over the five-year period ending July 2, 2021.⁸

Avoiding Company-Specific Risk

A few recent corporate scandals have demonstrated the value of ESG screening in reducing stock-specific risk in investors’ portfolios. German payments processor Wirecard filed for insolvency in 2020 amid a huge accounting scandal and allegations of fraud, but some of its behavior before this point had raised red flags from an ESG perspective. S&P had always excluded the stock from its ESG Index Series because it had never scored highly enough on governance. In fact, Wirecard had scored low on governance issues as far back as 2016, S&P said.⁹

Facebook, too, was the subject of its own ESG scandal in 2018 and saw $40 billion wiped off its stock market value when it was found to have sold unwitting users’ data to Cambridge Analytica without their consent.¹⁰ ESG analyses from providers such as MSCI had flagged up issues with data management, privacy, and corporate governance as early as 2012.¹¹

These cases highlight the need for careful analysis of stocks’ ESG credentials, but the screening process is not infallible: ‘fast fashion’ retailer Boohoo, for example, featured in many ESG portfolios until journalists accused it of using slave labor in its factories. While not a crystal ball, ESG screening can still expose potential problems and areas of risk within an investor’s portfolio prior to their shares being impacted. Luckily, obtaining this information has never been easier: 90 percent of S&P 500 companies are now reporting on sustainability in response to its growing importance to today’s investors.¹²

Becoming Part of the Solution

Through sustainable investing, you can use your money to become part of the solution to major social issues without compromising on performance. Bringing your convictions into the investment mix can help you create a truly personalized portfolio that’s closely aligned to everything you stand for. If you’d like to learn more about purpose-driven investing or Bank of the West’s Impact Solutions, connect with us.