Sustainable investing is popular, but it’s also different from traditional investing. And it inspires a lot of questions. So before you explore your first sustainable investment (what the investment industry tends to call “ESG”), here are answers to several common questions about what ESG is and how it works.
As advocates of financial information, it can be frustrating to us to see people’s natural inclination to align their money with their values reduced to another three-letter acronym. Within the investment industry, however, ESG is an easy shorthand that distinguishes traditional investment strategies from more sustainability-focused strategies.
Broadly, “ESG” stands for a set of non-financial data that can impact a company’s reputation, costs, and cash flow. These data sets come in three categories: environmental, social, and governance.
E stands for environmental data. E data tries to capture both a company’s impact on its surrounding environment (such as carbon emissions, net-zero pledges, resource management, and pollution) as well as the risks that environmental challenges may impose on the company’s future success (such as resource costs, regulatory actions, and lawsuits).
For example: In many environments, renewable energy technologies are becoming cheaper than traditional fossil fuels. Companies that don’t utilize renewable energy may then produce higher carbon emissions while also spending more than they need to on energy.
S stands for social data. Social factors capture a company’s relationships with its employees, customers, suppliers, and communities. It includes aspects such as labor standards, human rights, diversity and inclusion, community engagement, and product safety.
For example: In the short-term, companies can amp up their bottom line by paying employees sub-standard wages or deemphasizing product safety. But these companies are far more likely to experience labor actions, employee turnover, lawsuits, regulation, and negative media coverage, any of which can threaten its long-term sustainability.
G stands for governance data. Governance may not be the first thing you think of as a sustainable investor, but it’s an essential look into what drives a company’s policies and business decisions. Governance factors include board composition, executive compensation, shareholder rights, transparency, ethics, and risk management.
For example: Data shows that climate change is linked with a higher number of natural disasters, like forest fires and damaging storms. Insurance company leadership teams that aren’t strategizing around this data are failing to anticipate and manage a serious threat to their survival.
The idea of investing with a set of values in mind is not new. “Socially responsible” mutual funds have existed since the 1960s, using sustainable values like protecting the environment or treating workers fairly. Even earlier, faith-based investors sought to avoid “sin stocks” – that is, industries they find objectionable, such as alcohol and tobacco, pornography, and gambling.
These initial sustainable investments all had important limitations. It was easy to avoid companies if you didn’t like their product or industry, but it was hard to peer into companies and evaluate how sustainable their business operations were. The data just wasn’t available.
And yet, socially responsible funds persisted. Even though the “profit at any cost” type of investment analyst often scoffed at the idea, investors themselves often asked – even demanded – a chance to invest their values. So sustainable funds continued to occupy a small corner of the investment landscape for decades.
And then, the Internet came along. The Web raised awareness about big concerns like climate change, and it gave people a space to report on, share, and react to business practices that violated the values of average people. Now equipped with information they had previously lacked, investors discovered it was possible to have influence over company actions. The investment industry responded by developing sustainable strategies, using a new type of data labelled ESG.
ESG investing is beneficial in that it allows investors to align their investments with their values. It relies on newly emerging data about a company’s environmental impact, its commitment to the wellbeing of its employees and community, and the ability of its management to focus more on long-term viability than on short-term profiteering. As such, ESG investing prioritizes long-term thinking and risk management, and presents opportunities to invest in innovation.
The cons of ESG vary a lot depending on what you are looking for. But most of the issues with ESG investments can be summarized by the fact that ESG data – which analysts rely on to make their judgments – is a relatively recent phenomenon. Because it’s still fairly new, regulators and the investment industry haven’t reached a consensus on what ESG data should measure and how it should be used. That opens the door for challenges such as subjectivity, lack of standardization, data gaps, and even greenwashing. That can make evaluating ESG investment options frustrating and time-consuming.
But there is an important payoff to navigating these challenges: thousands of historical studies have shown that ESG investing performs as well as, or better than, traditional investing approaches. Over the long term, ESG data measures the things that make a company sustainable – that is to say, more resilient during market downturns, more open to new opportunities, and less subject to damaging non-financial risks like boycotts, strikes, and lawsuits.
The #1 challenge of sustainable investing is a frustrating lack of consistency among the terms and concepts you will encounter. ESG investing is variably called sustainable investing, responsible investing, ethical investing, impact investing, socially responsible investing, and several other labels. The ESG data sets are all slightly different, and ESG ratings tend to focus on different aspects of sustainability.
For the most part, this alphabet soup reflects honest differences of opinion among ESG professionals. But it creates a comfortable environment for the #2 challenge of ESG, greenwashing. Greenwashing happens when a company, or a fund, bills itself as being “green” or “socially conscious” without backing its words up with actions.
Fortunately, greenwashing can be fairly easy to spot when you do a little research. But that raises the #3 challenge of ESG investing: at this point in time, you have to do a lot of your own digging. There are tools and screeners to help you find ESG investment funds, and ratings to help you evaluate them. But because of challenge #1, you have to dig a little deeper to find something that’s right for you.
It’s our belief that the effort is worthwhile, because it strikes us as appropriate and sensible to want your investments to align with your values. But there’s a financial benefit too. Studies show ESG strategies tend to outperform over longer time periods. If you’re investing for retirement or another long-term goal, that advantage could prove highly valuable over time.
A sensible ESG investing strategy is as individual as you are. But for most everyday investors (and quite a few smaller foundations and nonprofits as well!), there are three important components you’ll need to consider.
Your financial needs. An ESG strategy shouldn’t replace the financial strategy you’re using to enhance your own sustainability. Traditional personal finance advice about building a diverse portfolio suited to both your goals and risk tolerance still applies.
Your fighting style. How do you like to advocate for your values? Do you prefer to steer clear of people and organizations you distrust? Do you go out of your way to find better options? Maybe you prefer to confront people or groups you think aren’t acting right? Each of these approaches has its corollary in the ESG world, although the names they use are technical. In order, they would be called exclusionary strategies, ESG integration strategies, and engagement strategies.
Your investment options. There are literally hundreds of mutual funds and exchange-traded funds (ETFs) that use some sort of sustainable strategy. But each of the fund management firms that sponsor these funds have their own take on ESG, and unfortunately some ESG funds are more legitimate and substantive than others.
If you want to better understand your fighting style, take our fighting style quiz or read our blog post.
Our Fund Company Profiles are a quick and easy way to review the major ESG fund providers and identify which ones fit best with what you are looking for.
There are many personal finance resources available to create a personalized financial plan, and of course you can always discuss this with a financial advisor.
ESG is an emerging field, and ESG data is in high demand. The good news about this situation is that there are a lot of bright minds and rigorous competition involved in creating new and better ESG data. The challenge is that different definitions and concepts have proliferated, and at the moment, there are no agreed upon standards.
For example, several independent rating agencies assign ESG scores to companies, including MSCI ESG Research, Sustainalytics, and Institutional Shareholder Services (ISS). But each agency has its own approach to evaluating ESG factors, and their scores may not agree.
That doesn’t mean that ESG scores are useless. ESG data has baked into it a lot of quality insight regarding the materiality of different ESG factors for different industries. For example, environmental factors might carry more weight for a shipping company, while social factors might be more significant for a consumer goods company. We typically find that examining ESG scores can be interesting and illuminating to investors.
It does suggest, though, that any specific ESG score should not be viewed as a “good” or “bad” judgment. You’ll get better insight by considering multiple sources and understanding the underlying criteria being used.
The corporate world is often seen as being at odds with environmental and social concerns, but that’s not entirely true. Companies are run by people, and plenty of corporate leaders are highly focused on making money in ways that are ethical and responsible.
But to be fair, companies are also pressured every day by cost, competition, and the demands of shareholders. There is always a certain amount of temptation to cut corners, or worse. When the only measuring stick is stock price, the temptation to sacrifice ethics, safety, or long-term viability in pursuit of short-term profits can be extreme. And this is a key reason that ethical companies benefit from ESG data.
ESG helps companies communicate about sustainability initiatives in a grounded, data-driven way. It gives a company space to explain long-term strategies that don’t necessarily drive short-term profits. It also helps a company respond clearly to its stakeholders – that is, shareholders, customers, employees, and the community – when they have concerns about aspects of corporate practices.
Finally, most experienced ESG investors will tell you that ESG data is a powerful risk management tool. It can help company leadership anticipate risks and avoid missteps. Companies with good governance tend to do a better job of avoiding lawsuits, restrictive regulations, and business-destroying media exposes.
One of the challenges of being an ESG investor is the inconsistency in ESG definitions and terms. For the most part, this exists because ESG data is relatively new and rapidly evolving, and a consensus hasn’t had time to form. But the inconsistency makes it fairly easy for people opposed to ESG to poke holes in it.
Why would people be opposed to ESG? There are lots of companies and even whole industries that don’t fare well by ESG measurements, and they don’t like responding to questions from ESG analysts or criticism from the media. Some economic traditionalists believe that ESG is a “distraction” from the core financial functions of a business. Some leading figures think ESG goes too far; others not far enough. And then there are politicians, who cannot resist turning honest debates into political footballs.
Anti-ESG efforts accelerated in 2023, as several conservative states introduced legislation to limit ESG options in state investment funds. Conservative politicians also started calling sustainable investing “woke.” These efforts have had a chilling effect on the public conversation around ESG investing.
But importantly, they have not cooled either the demand for ESG options or the practice of ESG analysis. The majority of companies already see ESG data as a legitimate and practical input into business decisions. Meanwhile, investors continue to demand the opportunity to invest in alignment with their values.