ESG Investing: Critical Questions for Conducting Fundamental Analysis

Market participants can generally consider environmental, social and governance (ESG) issues as risks to a company’s financial performance, and a further means of conducting due diligence when making investment decisions, alongside other critical factors that may affect returns, such as revenues, cash flows, creditworthiness, and operational performance.

As performing ESG analysis may be a daunting task – considering the multitude of known, unknown, and debatable variables that underpin environmental, social, and governance topics – there is more discrete criteria that investors may use to decide whether a particular company is aligned with those values they deem important and whether that firm is effectively mitigating ESG-related risks to protect or bolster its bottom line.

Environmental Risk Analysis

If you are interested in investing in a company that has been historically involved in practices that have adversely impacted nature in some way – whether the air, the land, water, or forests and the wider habitat – you may consider whether these risks, posed by that company, will have an adverse effect on its financial performance. Certainly, you may decide not to invest in the company at all – purely on principle – but if you choose to investigate further, you may ask, for example:

• Does the company produce toxins that are deemed by a regulator, for example the U.S. Environmental Protection Agency (EPA), to be harmful – for instance, is it involved in any way with PCBs, asbestos, or lead-based paint?
• Is it responsible for creating pollutants such as greenhouse gases? Is it a chemical manufacturer, for example, that uses CFCs, or an agricultural company that produces methane, or an energy company that produces carbon dioxide?
• Is it a food manufacturer or a cosmetic or a pharmaceutical company that experiments on, or otherwise mistreats, animals?
• Is it a company that cuts down trees to manufacture wood-based products or supply timber?

If the answer to any of these examples is ‘yes’ you may then want to examine whether any of these risks could hamper that company’s future financial performance.

• Could it face regulatory fines for not complying with federal or local laws?
• Could it face litigation?
• Could its practices damage its reputation, spurring distrust in its management?

Debates

When conducting your fundamental analysis, you may also want to consider different views concerning environmental issues, such as scientific findings that drive those government and corporate policies that are aligned with, for example, climate change or forest management.

For instance, while many federal agencies and scientists may agree on the causes of global warming, others may argue about the lack of a single model that reveals repeatable and reliable evidence for their claims.

Also, while initiatives to protect the world’s forests seem to be on the rise recently, some contend that products manufactured from wood, such as building materials, are not only significant carbon stores but can also substitute other, non-renewable materials, such as concrete or steel, whose production contributes large amounts of carbon emissions into the atmosphere.

As an investor, conducting due diligence can only help better inform your investment decisions, and factoring-in as many variables as you can into your analysis can help you draw a more objective picture of the risk landscape.

If, for instance, one argument seems more plausible to you than another, you may decide whether certain companies are deploying their capital to strategies that will benefit them financially.

Want to Know More?

Learn more about asking conducting fundamental analysis on other ESG factors, as well as conducting further due diligence, in our Traders’ Academy lesson ESG Investing: Strategies for Analysis.

Also, as many investors are likely to find that conducting fundamental analysis on ESG-related issues can be quite a daunting task – especially given the massive amounts of variables that may be considered relevant, many companies and organizations have been working to establish more advanced, technological tools and scoring systems to aid in the effort.

For instance, IBKR’s proprietary Impact Dashboard essentially personalizes responsible investing by enabling investors to select those values they deem important that companies support, as well as the practices they want companies to avoid.

You can see how the tool works via the link to a short video below, but in brief, it supports socially responsible and impact investing by enabling investors to evaluate and invest in companies, whose business principles align with their own personal values.

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