Over the past decade, investment processes have gradually shifted to take into account environmental, social and governance (ESG) factors, as well as the financial considerations that have traditionally driven investment decisions.
Sustainable investing places particular emphasis on these characteristics, for example to capture opportunities such as the energy transition or to prioritise investment in ESG leaders. However, because ESG factors have the potential to affect the long-term financial performance of companies across the economy, many traditional investment processes also consider ESG factors.
Let’s look at E, S and G in turn to understand what falls into each category and why these factors can have a material effect on the value of investments.
E: Environmental factors
The E in ESG is perhaps the most widely understood component. It covers issues relating to the quality and functioning of the natural environment and natural systems – for example, carbon emissions, environmental regulations, water stress and waste.
Environmental factors can affect company performance in many different ways. Shifts in consumer preferences towards companies with better environmental credentials may mean products fall out of favour. Companies that mismanage their waste or fail to conform with environmental regulation may face fines or other consequences.
Companies can also be affected by physical environmental risks – for example, climate events such as floods and fires, which can disrupt supply chains and damage stock or premises. Managers may therefore factor climate preparedness into their investment decisions.
Conversely, companies providing solutions that will support the carbon transition or otherwise contribute positively to our environment may represent investment opportunities.
S: Social factors
Social factors cover a broad array of considerations for companies, from diversity and inclusion to the treatment of workers, customers, suppliers and the wider community.
The impact of social factors may be less intuitive than that of environmental or governance factors, but it is no less important for investors to bear in mind. A company that doesn’t provide a safe and healthy working environment is less likely to have a happy and productive workforce, while a company that cuts corners on product safety, mis-sells products or has poor controls on data privacy risks reputational damage.
Like environmental factors, social factors can affect company performance through shifting consumer preferences, regulatory risks, scandal and more.
G: Governance factors
A company’s corporate governance affects all areas of its operation and is essential to promoting sound decision making. As a result, governance considerations such as board composition, ownership and executive pay have long been part of investment processes.
However, the emphasis was traditionally quite narrow, focusing simply on aligning the interests of a company’s management team with those of shareholders. Governance factors have significantly broadened in recent years to consider the interests of all stakeholders, and to address issues such as diversity of leadership and board independence.
A well-functioning corporate governance system ensures high levels of transparency, accountability, oversight and respect for investors and key stakeholders – factors that are crucial for the long-term health of companies.
Over the years, there have been many high-profile examples of poor corporate governance practices contributing to scandals that have significantly eroded investor value. On the other hand, robust corporate governance can be a strong signal of investment quality.
Bringing it all together: Investing sustainably
As we’ve seen, environmental, social and governance issues can have a material financial impact on company performance. Assessing ESG risks is therefore increasingly important for many investors, either as part of their broader portfolio, or as a way to target specific sustainability objectives.
For investors looking to align their financial goals with their sustainability objectives using an ESG approach, there are several routes that can be taken. Find out more about common approaches to sustainable investing, and how different strategies may fit into your investment portfolio.