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October 23, 2020

ESG Investing—What does it mean?

When a crisis like COVID-19 hits the world, the natural focus is on providing immediate present relief. If a country is quick to respond, its economic, healthcare, and social systems pivot to ‘react’ mode to take care of students, children, the elderly and the vulnerable. To be able to respond to an external risk factor effectively, an organization needs to have strategies already in place tied to nonfinancial drivers.

These nonfinancial drivers show the societal, human and environmental elements of a business. By bringing in components like culture, better stakeholder relations, and innovation, they find new ways of unlocking business opportunities and identifying new solutions while keeping all stakeholders in mind. These drivers can loosely be defined as ESG:

Environmental factors refer to the company’s stance on environmental issues such as resource depletion, climate change, waste and pollution

Societal factors are related to the company’s treatment regarding people, workers and local communities. Some areas include health and safety, diversity and inclusion.

Governance factors refer to corporate policies and governance, including tax strategy, corruption, structure compensation for leaders.

Investors and other stakeholders want to see resilient, strong companies. It is becoming increasingly clear that companies need to not only face present and immediate risks, but also maintain a strong position in these nonfinancial factors in the long term. On a final note, in the 2020 annual risk report from the World Economic Forum (WEF), the top five risks in terms of likelihood were environmental, and the top four of five risks in terms of impact were both social and environmental in nature

Why ESG investing is here to stay:

ESG can bring new competition

ESG is the next frontier of competition amongst companies. Organizations that recognize the importance of people and the planet along with profits are able to provide a value add to the landscape. They can quickly identify strategic opportunities where competitors are focused on driving down expenses and increasing sales.

According to McKinsey’s report on the topic, “companies that pay attention to environmental, social, and governance concerns do not experience a drag on value creation—in fact, quite the opposite.”

It gives the example of 3M, which has long understood that being proactive about environmental risk can be a source of competitive advantage. The company has saved $2.2 billion since introducing its “pollution prevention pays” (3Ps) program, in 1975. The decision to keep ESG at the center of operations reduced costs by reformulating products, improving manufacturing processes, redesigning equipment, and recycling and reusing waste from production.

ESG companies perform better in the stock market

A study by leading asset manager Amundi, showed that between 2014–2017, its portfolios with high ESG scores outperformed competing investments. Most asset managers and investment companies now have an ESG offering available for interested investors.

This trend bodes well for times of crisis and market downturns (which we happen to be in now). Refinitv analyzed returns of the companies with top 10 ESG scores in the S&P500 compared to the companies with the 10 lowest scores in May 2020. Here’s what they found:

The companies with lower ESG scores dipped considerably into the red during the early months of COVID-19, whereas the companies with the highest ESG scores were able to stabilize their losses quickly.

ESG investors are in it for the long run

There used to be a stark difference between values-based investors and profit-hungry investors, but the lines are blurring fast. ESG investors are values-based investors who, while motivated by positive returns and profits, refuse to sacrifice future growth for the appeal of short-term gains. They understand that true change takes time.

This also gives rise to the ‘activist investor’ trend. A Callan survey of 89 U.S. institutional investors found that 42 percent had included ESG in their investment decision-making processes — almost double the proportion of investors who reported using ESG factors in 2013. A handful of activist investor ‘influencers’ have led the charge on holding companies accountable over their performance on environmental, social and governance (ESG) issues

ESG companies attract the best employees

Numerous studies over many decades show that when employees care about the companies and the work that they are doing, they perform better. When companies stay true to their culture instead of just giving it lip service and invest seriously into empowering employees, the results are obvious.

For example, the London Business School’s Alex Edmans found that the companies that made Fortune’s “100 Best Companies to Work For” list generated 2.3 percent to 3.8 percent higher stock returns per year than their peers over a greater than 25-year horizon.

Employees who are passionate about the organization feel loyal and responsible for the company’s performance. Not only does this improve overall productivity, it creates an intangible advantage for the company that competitors cannot replicate or weaken.

ESG is not just about being a ‘nice’ company

“Green washing” is the name given to the trend of companies who pretend to be more eco-conscious and sustainable than they actually are. Fast fashion retailers, for example, were exposed for using eco-friendly language on their websites and clothing details, without doing much to change harmful environmental practices.

For investors, it’s important to research between companies that are making a real positive impact and companies that are trying to take advantage of the trend.

For example, consider a company that shows a picture of a diverse and inclusive workforce on the company website without actually taking the time to reevaluate hiring practices and fixing a toxic work environment. Sooner or later, the truth will be released publicly and cause incredible damage to the company’s reputation and customer base.

The takeaway

After the COVID-19 crisis has passed, we will likely see the companies that committed to their company culture and innovation emerge as the winners. Whether they did so by providing flexibility and support to their employees, helping their local communities, or keeping the environment and climate change at the forefront of their decision-making process – these companies had a base of resilience and holistic thinking to count on.

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