ESG: Environmental, Social and Governance. SI: Sustainable Investing. SRI: Socially Responsible Investing. The list could go on, but what do they all mean? Is ESG the same as sustainable investing? Why is there such controversy surrounding the practice? And what should you know about it?
ESG VS. SRI
First, we need to understand the difference between ESG and SRI. The ESG acronym originated in a Principles for Responsible Investing report from The United Nations in 2004. The report, titled "Who Cares Wins," advocates for integrating environmental, social and governance metrics in investment research. It states: “Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate.” The authors — a group of 20 large asset managers, banks and insurers — believed that the additional information provided by ESG metrics could only help in investment analysis.
Fast-forward nearly 20 years, and investors have integrated ESG metrics into their processes for trillions of dollars’ worth of investments, but an understanding of what the practice means still lags. Put simply, ESG is merely a set of metrics that measures the environmental, social and governance risk of a security. Easily said, much harder to implement. Currently, a host of different data providers are attempting to produce meaningful, material information that investors can reliably use.
The problem is that many of these data providers use different algorithms with little transparency. This results in very different ratings of the same security. This “black box” approach has prompted much of the current criticism of ESG, while the Securities and Exchange Commission attempts to create some standardization within the financial services industry.
Now, what is sustainable investing? I define it as true growth investing — investing in where the economy is going, instead of where it has been. Sustainable investing embraces positive change by identifying companies that are making a positive impact on our planet. ESG investing is focused on mitigating risks, while sustainable investing focuses on investing in the economy of tomorrow.
POLITICIZING ESG
ESG has become a political beach ball, bounced around by lawmakers, investment practitioners and the public without a real understanding of what it means. The lack of ESG understanding is leading to an increase in anti-ESG legislation. Not only is it dangerous to instill uninformed policies, it is also costing taxpayers billions of dollars.
But at its core, ESG is a means of measuring risks on a company, and not the company’s impact on the world. A Bloomberg article detailed this in 2021: “There’s virtually no connection between MSCI’s ‘better world’ marketing and its methodology. That’s because the ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”
This is probably why ESG is so misunderstood. In fact, here’s what happens with many ESG portfolios on the market: The investment manager chooses a traditional index and then layers ESG risk metrics over that index. This usually results in a reduction of the index’s exposure to industries such as fossil fuels or other legacy industries that are judged to have higher ESG risk. It creates what I call a “less bad” portfolio. Large asset managers who sell these “less bad” portfolios also have a habit of equating ESG with sustainable investing. What the ESG layering process doesn’t do, however, is intentionally add companies that are solutions providers. This is the key to the distinction between ESG and sustainable investing.
INVESTING IN OUR FUTURE
In my experience, investors who are interested in sustainable investing are looking to invest in companies providing solutions to our biggest challenges: climate change, resource scarcity, resilience, and equity and inequality. They want to know that a portfolio is constructed from the ground up with these challenges and opportunities in mind. Because there are most certainly opportunities in what I call the new economy — a cleaner, healthier, more sustainable, resilient and inclusive economy.
Don’t let yourself get swept up in the politics. Instead, talk to an adviser who can help you invest your legacy for generations to come. And remember, that’s what sustainable investing is truly focused on — the future. All of the major auto manufacturers are transitioning their fleets to electric vehicles. Clean energy has passed fossil fuels as the majority of new electric generation coming online. And biotechnology advances are moving forward, saving lives and contributing to the improvement of human health and well-being. The smart money is investing in the new, cleaner, healthier, more sustainable and resilient economy
The media and political backlash against ESG investing should not deter any investor from investing sustainably but instead awaken an opportunity to look deeper into the companies and industries you’re investing in. Let the political pundits use ESG as their political pawn, but know that when you craft a portfolio built for the next economy, it can withstand a whole lot of hot air.