Investing in companies that focus on their impact on the environment, in support of social issues, and on corporate governance (ESG) seems to be the focus of a newer generation of investors. This newer generation seems to care more about how companies are participating in socioeconomic and environmental progress, than maximizing personal financial success.
There are many factors that can impact returns on ESG investments, contributing to this apparent decline. But rather, could these factors indicate a cyclical nature to ESG investing? This post will explore the criteria for ESG rating, the factors that contribute to its profitability, the recent trends in ESG investing, and if we ought to invest in ESG companies.
What are the ESG Ratings Criteria?
Companies are rated by ESG firms, such as CDP and ISS-ESG, which assess the environmental, social, and corporate governance practices of the organization. Investment rating service, Morningstar®, has also added ESG ratings to its company and fund evaluations. The three categories of ESG are used to determine if a company is being responsible and making progress towards improved corporate practices.
The details of these three criteria in ESG ratings are:
• Environment: This new generation of investors are concerned with the long-term effects on the local and global environment. How a company is impacting and investing in the health of the planet is important to these heirs of the earth.
They not only highly value the natural word, but want to repair and preserve it for future generations. Under this guidance, companies can no longer afford to carelessly dump pollutants into the earth. They will need to demonstrate environmental responsibility.
• Social: Social ratings include the impact of the company on current social issues, including diversity, equity, and inclusion (DEI) policies, and its role in supporting social issues. Corporate policies on, and action towards, improved diversity, equity and inclusion are important factors for minority investors.
• Governance: Governance ratings pertain to how leadership manages company resources, including its employees and its efficacy in driving positive change. For example, corporate tax percentages, wage gap discrimination, public policies on maternity leave and leadership relatability influence public perception of corporations.
According to Forbes, within these criteria, there are differences in how ESG rating firms rate companies. However, there are a few common tools used across the board, reports Forbes, such as “annual reports, corporate sustainability measures, resource/employee/financial management, board structure and compensation and even controversial weapons screenings.”
These tools are used to help to determine where a company’s money is going and how the company is being managed. This rating system helps to promote corporate transparency and provides investors with greater insight into their investments.
Factors to Consider in ESG Investing
ESG ratings help investors incorporate a wider range of metrics when choosing where to invest their money. There are both internal and external factors thatcan influence an investor’s deci- sion to add a company to their portfolio. Financial profitability is not the only factor in play.
Additional factors affecting investment decision-making include:
• Demographics: There is a new generation of investors who are impacting ESG investing. According to Nasdaq.com, this new generation comprises women, millennials, Gen. Z’ers, and those “underrepresented” cultural minorities. Their priorities differ from previous generations, desiring their money to support companies that align with their beliefs on ESG progress, rather than those promising high ROI.
• Economic Stability: Changes in the stability of the economy impacts investors’ priorities. An article in the Harvard Business Review states that investments in highly rated ESG funds performed more poorly compared to lower-rated funds. This can influence investors in a weaker economy to focus on ROI rather than on ESG ratings. Pressures from rising interest rates, slow post-COVID economic recovery, and global economic challenges, such as the Russia/Ukraine war, may reduce investor confidence, prioritizing higher ROI’s over high ESG rates.
• Public Perception: There is pressure to conform to a changing culture and resistance can negatively impact a company’s public perception. Companies that adapt to cultural paradigms, such as renewable energy and inclusion, who promote themselves on social media, and work to be culturally relevant to a younger generation of investors can improve their public perception.
Investors are influenced by many factors, not just the financial data. The trend in the American workforce, where the majority of employees are choosing to sacrifice salary for more meaningful work, seems to carry over into investing. It is more important for Millennial and Gen. Z investors to invest in companies that align with their values rather than their pockets. They want to make a difference and feel purposeful rather than propagate corporate greed and make a profit.
Is ESG Investing Profitable?
Profitability can be relative. Financially speaking, a fourth grader selling candy bars on the school bus can make a profit. However, buying and selling luxury real estate properties can also make a profit. However, the latter has higher profit potential than the former. When it comes to investing, investors tend to put their money into companies with higher returns on their investment (ROI).
ESG Investing is Typically Less Profitable
As mentioned above, highly-rated ESG companies tend to be less profitable than lower-rated companies. Looking at Investors. com rating of the top 100 ESG companies as of August 2023, of the companies with the greatest return on equity (ROE), only three of the top twenty companies have a “top ten” ESG rating. The average ROE of top ten ESG companies is 38.3% compared to the rest averaging about 50.5% ROE.
ESG Investments May Come at a Premium
Furthermore, the Forbes article mentioned above says ESG investors “may be paying
a slight premium to invest in funds that are targeting ESG criteria.” This can reduce their ROI and is something to consider when investing. Investors focusing on financial profitability may choose to ignore ESG ratings if they want higher returns.
ESG Can Be Less Stable
Additionally, the current global economic headwinds and geo-political unrest may be forcing investors to change their focus, placing financial profitability over ESG. Depending on the investor, High ESG ratings may not be enough to compensate for lower returns.
Investing in ESG-conscious companies help strengthen the importance of ESG policies. If companies with low ESG ratings are losing investors to those with high ESG ratings, they may be inclined to change their corporate policies.
Is ESG Investing Facing Extinction?
It may depend on who you ask. It would seem ESG investing is declining. However, some statistics reveal an increase in ESG investing, despite the lower profitability of highly rated ESG companies. It seems social awareness on corporate responsibility keeps ESG investing relevant, despite lower profitability.
This new generation of investors is leading the way to reforming the corporate and investor mindset. Their outspoken beliefs on socio-ethical and environmental issues are transforming the culture and persuading political positions. In a recent high-profile example, climate protesters attempted to storm Shell’s annual shareholders meeting over its climate strategy, and CEO, Wael Sawan, had to be whisked away by security.
Lack of Regulation
However, one problem with ESG investing is undermining investor confidence in ESG ratings. These ratings can be misleading due to poor ESG regulations and inadequate ratings, calling for a reformation of the current rating system. The Harvard Business Review (HBR) reports that “companies in the ESG portfolios had worse compliance records for both labor and environmental rules.”
HBR also found that “companies added to ESG portfolios did not subsequently improve compliance with labor or environmental regulations.” A broken ratings system destroys investor confidence in ESG ratings and hurts companies with actual ESG-positive policies.
Is ESG Investing Cyclical?
What seems to be a more relevant question is, “Is ESG investing cyclical?” Its lower profitability, cultural pressure, investor demographic, and the economic and political environment all contribute to the fluctuation of ESG investing. It almost seems like ESG investing is a luxury, like cars, rather than a staple, like milk.
So, is ESG investing dead? Maybe not. Rather, it may be going through a trough in the cycle. However, to keep ESG ratings account- able and investing progressing, there must be action from both investors and corporations.
For the investor, research and profit sacrifice can help support ESG investing. Additionally, growth in ESG investing can drive corporate reform and strengthen the market for it. If more money is being invested in ESG-conscious companies, this may set the example for others to strengthen their ESG policies.
For the corporation, a re-aligning of the company mission to meet their customers’ needs while also implementing ESG-conscious policies may be needed. This updated corporate mission must begin with the company’s leadership if the rest of the company is to adopt an ESG-conscious mission.
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