Stock photo by Vecteezy

The concept of the "triple bottom line" that emerged in the 1990s eloquently captured the interconnected significance of the "three Ps": people, planet, and profit. This focus has led to the development of corporate social responsibility (CSR) strategies, which form the foundation of ESG investing.

ESG investing has its roots in CSR, but it specifically addresses the sustainability metrics and targets that investors use to evaluate businesses. Over time, the values of the triple bottom line have been increasingly incorporated into ESG investment strategies, where investors select their investments based on a wide range of criteria that support sustainable business practices.

The reason for this growing interest among investors is the strong correlation between higher ESG performance and higher returns, lower risk, and long-term business sustainability.

A study by PwC involving 325 investors found that 79% considered ESG risks as important factors in investment decision-making, while 49% were willing to divest from companies not taking sufficient action on ESG issues.

So are you ready to embrace the potential of ESG investing and profit from companies that prioritize sustainability? Read on to discover how ESG investing can benefit your portfolio.

ESG Investing Defined

It is crucial to understand the three primary criteria that form the basis of ESG performance evaluation: Environmental, Social, and Governance factors. These criteria provide a comprehensive framework to assess a company's sustainable and responsible practices.

Environmental (E)

The "E" in ESG represents how companies manage their environmental impact. This encompasses a company's carbon footprint, which can be categorized into direct (Scope 1) emissions, emissions from the purchase and use of energy (Scope 2), and supply chain emissions (Scope 3).

Furthermore, other environmental factors taken into consideration include waste management, the company's impact on air and water quality, and deforestation. By examining these factors, investors can gauge a company's commitment to reducing its environmental footprint and addressing climate change.

Social (S)

The "S" in ESG focuses on how companies treat their workers and the communities they operate in. The social aspect of ESG can include factors such as employee engagement, inclusivity, gender and diversity, data protection, labor standards, human rights, and community relations.

Companies that prioritize the well-being of their employees and contribute positively to society are more likely to attract talent and maintain a strong brand reputation, ultimately contributing to their long-term success.

Governance (G)

The "G" in ESG encompasses how companies are run, including their internal systems of control, procedures, practices, and how they mitigate and respond to violations. Good governance policies foster transparency, ensure that industry best practices are followed, and encourage an open and ongoing dialogue with regulators.

Governance factors include company leadership, audit committee structure, shareholder rights, lobbying, whistleblower programs, political contributions, and methods for the prevention of bribery and corruption. Strong governance is crucial for a company's long-term success, as it helps minimize the risk of scandals, fines, and damage to the company's reputation.

ESG Performance

ESG investments have demonstrated remarkable resilience during economic downturns, as evidenced by their performance during the 2008 financial crisis and the market turmoil in 2020 and 2021. Companies with strong ESG practices were better equipped to weather these storms, providing investors with more stable returns.

A study by MSCI showed that ESG stocks outperformed traditional ones during the 2008 crisis, experiencing lower declines and faster recoveries. Similarly, during the challenging market conditions of 2020 and 2021, ESG equity funds outperformed their non-ESG counterparts, despite the broad market selloff.

In 2021, 40% of actively managed ESG funds beat their benchmarks, almost as well as conventional funds. However, in 2020, the actively managed ESG funds performed even better; 57% of them beat their benchmarks, while only 43% of conventional funds did so.

The consistent outperformance of ESG investments during recessions indicates the potential benefits of incorporating ESG criteria into investment strategies. Investors seeking to build a resilient portfolio that can withstand market fluctuations should consider the advantages of ESG investing in their decision-making process.

Growing Demand for ESG Investments

The demand for ESG investments has grown significantly in recent years, driven by two key factors: the values and concerns of younger investors, and the desire to reduce regulatory intervention.

Millennials and Gen Z Demand Higher ESG Focus

Millennials are known for being values-driven in their financial and career choices, a trait that extends to their investing habits. They have been instrumental in the growth of sustainable investing, with investors contributing $51.1 billion to sustainable funds in 2020 compared to less than $5 billion five years earlier.

About one-third of millennials often or exclusively use investments that consider ESG factors, compared to 19% of Gen Z, 16% of Gen X, and 2% of baby boomers.

The timing of millennials entering their prime investing years coincided with the proliferation of ESG investment options. In 2019, almost 500 actively managed U.S. funds added ESG criteria to their prospectuses, providing more options and easier access than previous generations had.

With millennials set to inherit approximately $30 trillion over the next few decades, the financial industry and corporate America are expected to continue developing sustainable investing options to cater to this generation's values and wealth.

Reduced Regulatory Intervention Through ESG Adoption

By adopting strong ESG practices, companies can achieve greater strategic freedom and reduce regulatory pressure. Numerous cases across various sectors and geographies show that ESG strength can decrease a company's risk of adverse government action while also garnering government support.

The value at stake from state intervention can be significant, with typically one-third of corporate profits at risk. Regulation's impact varies by industry; for pharmaceuticals and healthcare, the profits at stake are about 25 to 30 percent.

In banking, where capital requirements and consumer protection provisions are critical, the value at stake is typically 50 to 60 percent. For the automotive, aerospace and defense, and tech sectors, which often receive government subsidies, the value at stake can reach 60 percent.

Thematic Investing

Thematic investing offers investors an opportunity to align their portfolios with trends shaping the future, including ESG-related themes. This investment approach focuses on long-term and short-term themes that influence which companies excel as economies grow and markets evolve.

Over the last four years, the top themes have captured nearly 25% of US equity market returns on average, a trend that accelerated since the emergence of COVID-19 in 2020. This led to a significant industry shift, with assets managed in US-listed thematic funds growing over 10x from $13 billion in 2016 to $148 billion in 2021.

In recent years, several ESG-focused thematic trends have emerged, such as the rise of electric vehicles (with Tesla being a prime beneficiary, growing its stock 7x since 2018), solar energy, battery energy storage, and EV charging stations (e.g., Enphase Energy, whose revenues have grown 4x and stock has risen 30x over the last five years), and water and wastewater services (e.g., American Water, whose stock more than doubled between 2018 and 2021).

There are two main types of ESG themes:

1. Specific ESG-focused stocks: Companies primarily engaged in sustainability initiatives, such as those mentioned above.

2. Companies unlocking value by deploying ESG initiatives: Traditional businesses transform their operations to adhere to the ESG framework, which creates long-term shareholder value.

For example, tech giant Microsoft plans to generate 100% of electricity for its operations through renewable energy by 2025 and offset all of its carbon emissions since 1975 by 2050. Similarly, consumer electronics retailer Best Buy has committed to building teen tech centers to help young Americans learn about programming and design and has achieved 100% waste diversion for its facilities in California. Both companies have seen their revenues and stocks grow as a result of these ESG initiatives.

Essentially, thematic investing enables investors to profit from ESG-focused trends by investing in companies that prioritize sustainability or traditional businesses that unlock value by adopting ESG practices. By identifying and investing in these themes, investors can build a forward-looking and potentially more resilient portfolio

Conclusion

ESG investing is a rapidly growing trend that enables investors to align their portfolios with sustainable and responsible business practices. As millennials and Gen Z become more influential in the market, their values and concerns are driving demand for ESG investments. Moreover, the adoption of strong ESG practices helps companies reduce regulatory intervention and unlock long-term value.

Thematic investing, focusing on ESG initiatives, offers investors a compelling way to profit from companies dedicated to sustainability or traditional businesses transforming their operations. By embracing ESG investing, investors can build a forward-looking and resilient portfolio, better equipped to weather market fluctuations and contribute to a more sustainable future for all.

Frequently Asked Questions

1. What is ESG investing defined?

ESG investing is an investment approach that considers environmental, social, and governance (ESG) factors when evaluating companies and making investment decisions. It aims to generate long-term financial returns while promoting positive societal and environmental outcomes.

2. What is socially responsible investing in?

Socially responsible investing (SRI) involves selecting investments based on a company's commitment to ethical and sustainable practices, which may include environmental stewardship, social justice, and corporate governance. It seeks to create both financial returns and positive societal impact.

3. What is a socially responsible investing fund?

A socially responsible investing fund is an investment fund that considers ESG criteria in its investment strategy. These funds aim to provide competitive financial returns while promoting positive social and environmental outcomes.

4. What is an ESG investing rule?

An ESG investing rule is a guideline or principle that investors use to evaluate companies based on their performance in environmental, social, and governance factors. These rules help investors identify businesses with strong ESG practices, which may contribute to better long-term performance and risk management.

5. What is responsible investing research?

Responsible investing research involves the analysis of ESG factors to evaluate companies' sustainable and responsible practices. This research can help investors identify companies with strong ESG performance, which may lead to better financial returns and lower risk.

6. How does ESG investing work?

ESG investing involves analyzing and incorporating environmental, social, and governance factors into the investment decision-making process. Investors assess companies' ESG performance, alongside traditional financial metrics, to identify businesses that are well-positioned for long-term success and have a positive impact on society and the environment.

7. What are socially responsible investing advisors?

Socially responsible investing advisors are financial professionals who specialize in helping clients build investment portfolios aligned with their values and ESG considerations. They guide selecting investments based on a company's commitment to ethical and sustainable practices, aiming to generate both financial returns and positive societal impact.

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