Environmental, Social, and Governance (ESG)

Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.

How Environmental, Social, and Governance (ESG) Criteria Work

To assess a company based on environmental, social, and governance (ESG) criteria, investors look at a broad range of behaviors.

Environmental criteria may include a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals. The criteria can also be used in evaluating any environmental risks a company might face and how the company is managing those risks. For example, are there issues related to its ownership of contaminated land, its disposal of hazardous waste, its management of toxic emissions, or its compliance with government environmental regulations?

Social criteria look at the company’s business relationships. Does it work with suppliers that hold the same values as it claims to hold? Does the company donate a percentage of its profits to the local community or encourage employees to perform volunteer work there? Do the company’s working conditions show high regard for its employees’ health and safety? Are other stakeholders’ interests taken into account?

With regard to governance, investors may want to know that a company uses accurate and transparent accounting methods and that stockholders are given an opportunity to vote on important issues. They may also want assurances that companies avoid conflicts of interest in their choice of board members, don’t use political contributions to obtain unduly favourable treatment and, of course, don’t engage in illegal practices.

No single company may pass every test in every category, of course, so investors need to decide what’s most important to them. On a practical level, investment firms that follow ESG criteria must also set priorities.

What are the Pros and Cons of ESG Investing?

For socially conscious investors, the pros are obvious – you have the ability to invest in companies you can feel good about, that align with values that are important to you, and that have the potential to grow and deliver returns to your portfolio. Oftentimes, companies that have high ESG scores are also ones the forefront of innovation, which generally speaking could be attractive companies to own.

The cons of ESG investing generally revolve around limited options and the lack of diversification. Many ESG-focused mutual funds and ETFs, for example, focus exclusively on domestic large-cap stocks. In that case, the investor may be left with little or no exposure to small-cap, mid-cap, and non-US companies. Another downside is that some ESG mutual funds, ETFs, and do-it-yourself investors develop strategies that simply exclude select industries such as oil and tobacco, which may ultimately allow non-ESG friendly companies into the portfolio. On the opposite end of the spectrum, a strategy may focus on a singular industry, like solar power, which arguably increases risk via lack of diversification. 

Is ESG Investing Right for You?

For most investors, this is a relatively easy question to answer once you understand what ESG investing is. If it is of paramount importance that you only invest in companies that meet certain environment, social, and governance criteria, then it makes sense to explore options within the ESG space.

At the end of the day, however, socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized will reflect the beliefs or values of any one particular investor. That’s why it is important to find an advisor or manager who you can have thorough and candid conversations with, to understand your needs and passions.

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