The Role of ESG Criteria in Investment Decisions: A Beginner’s Guide

Introduction

One of the largest emerging trends in finance has been the implementation of ESG frameworks. Now, ESG might sound like alphabet soup, but stick with me, and you’ll see it’s more like a secret sauce for making your money work not just for you, but for the planet and society too. ESG stands for Environmental, Social, and Governance, and it’s like the moral compass of the financial world. Think of it as your investment’s way of saying, “I’m not just here to make you rich; I’m here to make a difference.” Large financial institutions have already adopted features of socially responsible investing, and with ESG becoming such a huge part of the finance world, it’s important you learn about it too!

Socially Responsible Investing

So, you know how investing is all about making that green, but have you ever thought about making a positive impact while at it? That’s where socially responsible investing (SRI) comes in. It’s like the superhero of investing, where you not only aim for solid returns but also consider the social and environmental footprint of your investments. It’s not just about dollars and cents; it’s about investing in companies that do good for the planet and society. Think of it as putting your money where your values are. Whether it’s supporting companies with stellar environmental practices or those championing social justice, socially responsible investing lets you build a portfolio that aligns with your beliefs. So, why not make your money work for positive change? It’s not just a smart move financially; it’s a feel-good strategy that makes your wallet and the world a better place. Essentially, SRI is just considering the impact of your investment portfolio on the world.

Letter by Letter

Next, let’s make sure we understand what ESG encompasses. The first part of learning more about ESG is learning more about how it is implemented and what its components do in a business. Of course, if you want to take into consideration ESG factors when investing, you need to understand how they affect the business!

E, Environment

Let’s start with E, standing for environment. The environmental aspect of the ESG framework is probably the most intuitive of the bunch but nevertheless a key aspect of the framework. This includes all aspects of the business that have an impact on the environment. For example, a company’s climate policy or mission to reduce carbon emissions all fall under this category.

S, Social

Next let’s talk about S, for Social. The social aspect of the ESG framework includes a company’s impact on its community, how it gives back, and its overarching ethics. This also includes diversity and efforts to fight against racial discrimination. Do they donate to their communities? Or on the other hand, do they take unethical advantage of their consumers? Socially responsible investors (SRIs) invest in companies that treat their staff well, and follow generally ethical practices, pushing more companies to have a positive impact on their communities.

G, Governance

Finally let’s review G, for governance. Governance is really just a fancy way to talk about corporate hierarchy and overall control of the company. Companies that follow ethical governance practices are accountable to their shareholders, select diverse and qualified leadership, and follow transparent accounting practices.

Keeping this in mind, socially responsible investors can research companies and determine whether a company’s ESG standards follow one’s investment principles. Keeping an eye on these factors is growing even more important as companies that don’t adhere to their ESG standards are prone to facing backlash and institutional investors, such as BlackRock, heavily weight ESG in their analyses.

How you can use ESG factors to your advantage

One well-known example of a blowup correlated to ESG criteria is the Volkswagen emissions scandal. If you aren’t already familiar with the event, Volkswagen’s emissions scandal revolved around the car manufacturer installing software in their vehicles to manipulate emissions tests, exposing a serious breach of trust in the automotive industry, and leading to hefty fines and legal repercussions. This ultimately resulted in the company losing nearly half of its market capitalization.

This could have been avoided by investors had they been careful to invest in companies that are transparent with their strategies and have histories of honesty and integrity. Volkswagen had a history of tampering with tests dating back to 1973 creating a culture of deception and trickery. This should show why institutional investors are quick to adopt ESG frameworks. Being extremely risk averse, they use ESG factors to ensure their investments don’t blow up in their face.

As an individual, you likely don’t have the resources to be an activist investor and make meaningful changes in a company’s structure, however, it is still important to be aware of a company’s overall policy and how they treat not only their own staff and customers, but also the public. It’s easy to discount the negative impacts of a company on the environment but ensuring that a company is committed to not only its investors, but its community is an easy way to make sure your investment fails for the wrong reasons.

So, you may be questioning how one is supposed to understand the operations of a company and be able to make an informed decision about its ESG standards. This is warranted as without being a large institutional investor or stakeholder it can be hard to know what a company’s management is truly thinking and their true values. Despite this, one can typically get a good idea of a company’s ESG positioning based on its commitment to its community. This isn’t just its investors in the social aspect of ESG but also its commitment to the environment or to governance transparency. Doing this is important as a company’s commitment to ethical practices is often a good reflection of its true values and a good way to gauge its future reputation.

Conclusion

In summary, ESG is an important framework that should be factored into all your investments. A company failing to follow basic ESG standards should be flagged due to its risk of being involved in future scandals. Whether it be an obvious red flag like dumping sewage in the ocean or something more minor like a history of slight exaggeration in accounting, it’s important to consider all ESG criteria violations. To be a socially responsible investor, you should thoroughly research all investments,