ESG 101: What is
ESG Investing?
Walk along the path with us through the world of environmental, social and governance investing.
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What is ESG?
ESG Investing is a term that is often used synonymously with sustainable investing, socially responsible investing, mission-related investing, or screening. At MSCI ESG Research we define it as the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process.
Under the ESG investing umbrella, MSCI ESG Research has identified three common investor objectives or motivations when considering an ESG strategy: Integration, Values and Impact. In order to achieve these objectives, institutional investors may pursue different approaches such as ESG integration, exclusionary or negative screening, or thematic investing, to name a few. While this is not a comprehensive glossary of all ESG terms in the market, we provide an overview of several commonly used terms and their definitions below.
Glossary of terms:
Common Objectives
- ESG integration: Investing with a systematic and explicit inclusion of ESG risks and opportunities in investment analysis.
- Impact investing: Investing with the intention to generate measurable positive social or environmental benefits alongside a financial return.
- Values-based investing: Investing in alignment with an organization or individual’s moral values and beliefs.
Common Approaches
- Exclusionary or negative screening: Avoiding securities on the basis of an organization or individual’s values, standards and norms, or other ESG considerations.
- Best-in-class selection: Preferring companies with better or improving ESG profiles relative to sector peers.
- Thematic investing: Investing based on trends or structural shifts, such as social, industrial and demographic trends.
- Active ownership: Entering into a dialogue with companies on ESG issues and exercising both ownership rights and voice to effect change.
- Socially responsible investing (SRI): A traditional umbrella term that can be used to describe a values-based approach to investing, with an eye towards reducing exposure to negative externalities. Falls under “values-based investing,” also known as “ethical investing” or “norms-based investing.”
- Faith-based investing: Aligning investments with faith-based values. Faith-based investing often involves avoiding investments in companies whose business activities are viewed as violating the teachings of a given faith. It may also include aims to generate measurable social (or occasionally environmental) impacts. Falls under “values-based investing.”
- Mission-related investing: Aligning investments with organizational values or to further philanthropic goals. Mission-related investments often aim to generate measureable positive social or environmental impacts. Often interchangeable with “impact investing”.
Investors may consider a number of different ESG factors, metrics and data when looking to adopt an ESG investing strategy or apply ESG across a portfolio. These factors typically include industry-specific key issues such as climate change, human capital and labor management, corporate governance, gender diversity, privacy and data security, among others. A mining company and a financial company, for example, may be faced with different key ESG risks and opportunities and therefore evaluated on the key issues specific to their respective industries.
"ESG investing is the consideration
of environmental, social and governance factors alongside financial factors in the investment decision–making process.”
The Evolution of ESG Investing
ESG is growing in significance amongst both institutional and retail investors. The practice of ESG investing began in the 1960s as socially responsible investing, with investors excluding stocks or entire industries from their portfolios based on business activities such as tobacco production or involvement in the South African apartheid regime.
Today, ethical considerations and alignment with values remain common motivations of many ESG investors but the field is rapidly growing and evolving, as many investors look to incorporate ESG factors into the investment process alongside traditional financial analysis.
Explore MSCI ESG Research’s Key Issue Hierarchy below
Why is ESG Investing Growing?
In recent years, institutional investor adoption of ESG and the subsequent growth in ESG assets under management has accelerated.1 While much has contributed to this growth, we focus on three primary drivers of ESG investment.
“This virtuous combination of burgeoning demand and investment rationale will drive the ESG asset pool’s rapid growth…ESG outcomes are likely to become an integral part of investment solutions, and ESG analysis an essential investment tool.” – PwC Report, Asset & Wealth Management Revolution: Embracing
1 US SIF “2016 Report on US Sustainable, Responsible and Impact Investing Trends”
Global sustainability challenges such as flood risk and sea level rise, privacy and data security, demographic shifts, and regulatory pressures, are introducing new risk factors for investors that may not have been seen previously. As companies face rising complexity on a global scale, the modern investor may reevaluate traditional investment approaches.
Over the next two to three decades, the millennial generation could put between $15 trillion and $20 trillion into U.S.-domiciled ESG investments, which would roughly double the size of the U.S. equity market.2 A growing body of studies suggest that millennials - as well as women - are asking more of their investments.
Read more on this topic:
Swipe to Invest: Millennials and ESG, the Perfect Match?
2 Bank of America Corporation 2016 Environmental, Social & Governance Report
3 Accenture. The “Greater” Wealth Transfer – Capitalizing on the Intergenerational Shift in Wealth, 2012
4 US Trusts’ Insights on Wealth and Worth 2014
5 FactSet’s HNWIs’ Vision for the Wealth Management Industry in the Information Age
6 Source: Morgan Stanley Institute for Sustainable Investing. Sustainable Signals: The Individual Investor Perspective (February 2015)
With better data from companies combined with better ESG research and analytics capabilities, we are seeing more systematic, quantitative, objective and financially relevant approaches to ESG key issues. Better data and analytics have paved the way for numerous studies that explore ESG investing (see: Does ESG add value?).
MSCI ESG Research provides research and ratings on over 13,000 equity and fixed income issuers linked to over 590,000 equity and fixed income securities on a ‘AAA’ to ‘CCC’ scale according to their exposure to industry specific ESG risks and their ability to manage those risks relative to peers. MSCI ESG Ratings is designed to help investors identify ESG risks and opportunities within their portfolio.
Read more on this topic:
MSCI ESG Research is a leading provider of ESG ratings and analysis globally with more than 185 analysts worldwide:
"We’re in the middle of a $30 trillion intergenerational wealth transfer from baby boomers to their children. And those kids - not really millennials only, but people from 25 to 40 years old - simply think about their investment decisions differently.”
LEADING INSTITUTIONAL INVESTORS ARE INCORPORATING ESG FACTORS INTO THE INVESTMENT PROCESS
Since its founding in 2006, the United Nations Principles for Responsible Investing (PRI) has attracted support from more than 1,800 signatories representing over USD $68 trillion in assets under management as of April 2017. Signatories commit to six voluntary principles, the first of which is the incorporation of ESG issues into investment analysis and decision-making.
Source: UN PRI as of April 2017; https://www.unpri.org/about
Has ESG historically compromised financial returns?
A common debate with ESG investing revolves around the idea that incorporating ESG factors into the investment process will hurt performance. However, some studies suggest that companies with robust ESG practices displayed a lower cost of capital, lower volatility, and fewer instances of bribery, corruption and fraud over certain time periods. Conversely, studies have shown that companies that performed poorly on ESG have had a higher cost of capital, higher volatility due to controversies and other incidences such as spills, labor strikes and fraud, and accounting and other governance irregularities.7
It may come as no surprise then that numerous academic and investor studies (see below) in recent years have found historically lower risk and even outperformance over the medium to long term for portfolios that integrated key ESG factors alongside rigorous financial analysis.
In a recent study, MSCI researchers focused on understanding how ESG characteristics have led to financially significant effects. The study examined how ESG information embedded within stocks is transmitted to the equity market. Borrowing from central banks, we created three “transmission channels” within a standard discounted cash flow (DCF) model. We call these the cash-flow channel, the idiosyncratic risk channel and the valuation channel. The former two channels are transmitted through corporations’ idiosyncratic risk profiles, whereas the latter transmission channel is linked to companies’ systematic risk profiles. Our research showed that ESG had an effect on valuation and performance of many of the companies in the study.
We identified three major channels from ESG to financial value. Companies with higher ESG ratings were associated with:
7 Sources: Chava, 2011; 20+ studies, both academic and industry; Lansilahti, 2012; Credit Suisse; Deutsche Bank; MSCI ESG Research, et al.; Huang, 2010; Bhagat and Bolton, 2008; Cremers et al., 2005; Deutsche Bank, 2012; ISS, 2011; et al.
Cash-flow channel: High ESG-rated companies studied were more competitive and generated abnormal returns, often leading to higher profitability and dividend payments.
Idiosyncratic risk channel: High ESG-rated companies were better statistically at managing company-specific business and operational risks and therefore had a lower probability of suffering incidents that impacted their share price. Consequently, their stock prices display lower idiosyncratic tail risks.
Valuation channel: High ESG-rated companies tended to have lower exposure to systematic risk factors. Therefore, their expected cost of capital was lower, leading to higher valuations in a DCF model framework.7
7 Note that these studies use back tested, simulated and historical data for illustration purposes only. Results may differ materially depending upon a number of factors, and are not indicative of future results.
Does ESG add value?
Read the studies:
- MSCI 2018, ‘Foundations of ESG Investing – Part 1: How ESG Affects Equity Valuation, Risk and Performance’
- AQR 2017, ‘Assessing Risk Through Environmental Social and Governance Exposures’
- Nordea 2017, ‘Cracking the ESG Code’
- JP Morgan 2016, ‘A Quantitative Perspective of how ESG can Enhance your Portfolio’
- Barclays 2016, ‘The positive impact of ESG investing on bond performance’
- Credit Suisse 2015, ‘Finding Alpha in ESG’
- MSCI 2015, 'Can ESG Add Alpha'
- Harvard Business School 2015, ‘Corporate Sustainability: First Evidence on Materiality’
- Journal of Sustainable Finance and Investment 2015, ‘ESG and financial performance: aggregated evidence from more than 2000 empirical studies’
- Journal of Business Ethics 2015, ‘The Opportunity Cost of Negative Screening in Socially Responsible Investing’
- Deutsche Bank 2013, ‘The Socially Responsible Quant’
Disclaimer: These reports may contain analysis of historical data, which may include hypothetical, backtested or simulated performance results. There are frequently material differences between backtested or simulated performance results and actual results subsequently achieved by any investment strategy. None of the information or analysis herein is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision or asset allocation and should not be relied on as such.
ESG in Emerging Markets
Investing in emerging markets can carry a high degree of risk, not least from the threat of environmental, social and political instability. Research suggests that "tail risk" - the risk of unlikely events causing catastrophic damage - may be reduced in an emerging markets portfolio that has limited its exposure to these ESG risks. 8,9
Emerging market asset managers keen to utilize ESG analysis have historically faced significant information problems; however, with the introduction of stewardship codes in the Asia Pacific region and an emphasis on reporting and disclosure globally, this is changing.
MSCI ESG Ratings are used in the construction of many of MSCI's 900 ESG Indexes.
The MSCI ESG Leaders Indexes are designed to represent the performance of companies that have high Environmental, Social and Governance (ESG) performance. The MSCI ESG Leaders Indexes aim to target sector weights that reflect the relative sector weights of the underlying indexes to limit the systematic risk introduced by the ESG selection process.
The MSCI Socially Responsible Investing (SRI Indexes) are designed to exclude companies that are inconsistent with specific values-based criteria focused on products with high negative social or environmental impact and to target companies with high Environmental, Social and Governance (ESG) ratings relative to their sector peers, to ensure the inclusion of the best-in-class companies from an ESG perspective. Further, these Indexes aim to target sector weights that reflect the relative sector weights of the underlying MSCI Global Investable Market Indexes to limit the systematic risk introduced by the ESG selection process.
Emerging Markets Case Study: Performance of Sample MSCI ESG Indexes
Explore MSCI ESG Index performance
Disclaimer: Date as of October 31, 2017. Index returns are for illustrative purposes only. Index performance returns do not reflect any fees, costs or expenses. Indexes are unmanaged and one cannot invest in an index. Past performance does not guarantee future results. Index returns do not represent any actual portfolio performance.
8 “Sustainable Investing: Sustainable Value Creation in Emerging Markets,” UBS, January 2017.
9 “Responsible Investing Reloaded: Sustainability Criteria Matter,” Risklab, April 2011.
Three common ESG investor objectives
ESG can mean different things to different people. However, we see the objectives of investors converging around three main categories.
I believe that incorporating ESG may improve my investment results.
Growing research suggests that ESG factors have contributed to long-term financial performance. ESG factors can be used to identify better-managed companies or to flag companies with business models that are likely to face headwinds or tailwinds driven by rapidly evolving regulatory, environmental, demographic or technological trends. Institutional investors are increasingly looking to ESG factors as a way to manage these risks and to achieve long-term sustainable financial performance.10
Read more:
Facebook case study
Equifax Case Study
Volkswagen Case Study
10 Khan, Serafeim and Yoon (2015). “Corporate Sustainability: First Evidence on Materiality,” Harvard Business School Working Paper No. 15-073. Friede, Busch and Bassen (2015), “ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies.” Journal of Sustainable Finance & Investment. Richard Hitchens, Sandra McCullagh and Chris Parks (2014) “Finding Alpha in ESG.” Credit Suisse ESG-α Series, 19 June 2015. Northern Trust (2014, “Doing Good and Doing Well – How Quality Can Enhance Your ESG Strategy.”
My investments should reflect my values.
Some investors consider ESG issues a means for aligning investments with their ethical, religious or political beliefs. They have typically used ESG research to screen for controversial activities such as tobacco, weapons, alcohol, gambling or fossil fuels, and to help exclude such activities from their investment universe. Unlike the ESG integration goals described above, where ESG factors are considered on the basis of their potential economic impact, values-based goals are intentionally aligned to match an investor’s beliefs.
Read more:
Investor Responses to Gun Violence
Fossil Fuel Divestment: A Practical Introduction
I want my investments to make a difference in the world.
A third group of investors focuses on the impact of their investments on the world around them. These investors may seek to direct their capital toward companies that provide solutions to environmental or social challenges and, through formal frameworks such as the UN Sustainable Development Goals (SDGs), monitor the extent to which their investments are generating positive social or environmental impacts alongside their financial returns.
Read more:
Toward Sustainable Impact in Public Markets
The UN Sustainable Development Goals and Sustainable Impact: A Practical Guide for Investors
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