Previously, we discussed the origins and nature of Environmental, Social, Governance (ESG), what each of these metrics mean individually and together, and their fiscal and ethical value to investors. Understanding what ESG measures, we can now discuss the practical effects of ESG on return-on-investment and what role it should play, if any, when crafting a portfolio. Does ESG lead to more profitable companies or just more ethical and sustainable ones, and how much weight should ethics and sustainability have when it comes to making decisions about investing?
Informally, ESG is a measure of three big picture factors any business should consider vital to success. In a recent MarshMcLellan study, companies with better ESG scores report 14% higher employee satisfaction, while a separate study done by Cone Communications notes that 88% of consumers will be more loyal to businesses that support social or environmental causes. Because ESG is a major consideration for many advisors, companies with better ESG plans will have an easier time attracting investors, thus raising their price per share and creating an inherent fiscal advantage.
According to a recent KPMG report, 80% of public companies both in the U.S. and worldwide now report on sustainability. Currently, 81% of U.S. public companies are providing ESG disclosures, as compared to 17% of private companies.
ESG Ratings
ESG serves as a social credit score for companies. To help investors understand this metric in a quick and easy way, organizations like Morningstar award companies numerical ratings (in Morningstar’s case, an “ESG Risk Rating”) to determine the risk inherent in each business’s environmental, social, and governance strategies, as determined by current plans and past achievements.
These ratings list factors such as overall investor risk, the highest controversy level raised by the company’s practices, and their primary ESG issues to give investors a snapshot of overall performance. 85% of asset managers consider ESG a high priority and use these ratings to determine whether the business in question is a sound investment due to or despite its ESG bonafides.
This intense scrutiny on ESG means most companies already integrate environmental, social, and governance strategies into their fundamentals. Many companies release a yearly ESG report describing their plans for excelling in these metrics and shoring up any perceived deficiencies to ensure a higher rating in the future. Many investors and asset managers scrutinize these ESG reports just as intently as they do a company’s financials. When doing so, however, it is important to look beyond a company’s own internal plans and self-appraisals to see how they deliver on their promises. An ESG plan that looks great on paper matched with poor performance is often a worse sign than no plan at all.
Is ESG a Good Investment?
With ESG increasingly considered a key performance indicator and companies striving to score strong ratings and publish well-regarded ESG reports, it is safe to say this metric should factor into whether a company is a good investment. At this point, it is simply too central to business discourse to ignore — if only because complete disregard could be a source of poor public relations for companies and their investors. How much of a factor should ESG be when making an investment?
Ultimately, while companies that wish to attract asset managers develop and deliver on solid ESG plans, ESG is not the be-all and end-all of metrics and differs in value to different investors. First and foremost, investors should consider companies that are or promise to be successful in business. The greenest, most ethical company in the world is not a sound investment if it stands no chance of turning a profit.
ESG performance can be a good way to view a company’s leadership to recognize how they manage sustainability and value a healthy society. For many investors, a company’s social credit matters and is an extension of good fundamentals and ethical beliefs. A recent ESG report from McKinsey noted that ESG propositions have a positive impact on equity returns 63% of the time. However, we cannot pinpoint a direct financial connection between ESG and ROI. This may change tomorrow if ESG is ever added to a balance sheet or income statement. Ultimately, we cannot say “only invest in companies with good ESG ratings,” but a good ESG rating could be a sign of a promising investment.
