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ESG 101: what is ESG?
Walk along the path with us through the world of environmental, social and governance investing.

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  • What is ESG?
  • The evolution of ESG investing
  • Why ESG is growing?
  • ESG & Performance
  • Investors approach to ESG
  • Additional resources
  • ESG Glossary

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Intro - What is ESG?

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.

ESG terms overview

Integration
Values
Impact

Integration

Objective:

Investing with a systematic and explicit inclusion of ESG risks and opportunities with the intention to enhance long-term risk-adjusted returns.

Common approaches:

Bottom-up ESG integration

Investing with a systematic and explicit inclusion of ESG risks and opportunities in investment analysis.

Top-down ESG integration

Investing with a systematic and explicit inclusion of ESG factors in portfolio construction.

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.

Values

Objective:

Investing in alignment with an organization or individual's moral values and beliefs.

Common approaches:

Best-in-class selection:

Preferring companies with better or improving ESG profiles relative to sector peers.

Exclusionary or negative screening:

Avoiding securities on the basis of an organization or individual's values, standards and norms, or other ESG considerations.

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. 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.

Impact

Objective:

Investing with the intention to support positive social or environmental benefits alongside a financial return.

Common approaches:

Impact investing:

Investing with the intention to generate measurable positive social or environmental benefits.

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.

Mission-related investing:

Aligning investments with organizational values or to further philanthropic goals. Mission-related investments often aim to generate measurable positive social or environmental impacts. Often interchangeable with "impact investing."

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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.

Quote 1

"ESG investing is the consideration
of environmental, social and governance factors alongside financial factors in the investment decision–making process.”

Remy Briand, Managing Director of MSCI ESG Research

Intro 2

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

Interactive Assets

Climate change

Natural resources

Pollution & waste

Environmental opportunities

Human capital

Product liability

Stakeholder opposition

Social opportunities

Corporate governance

Corporate behaviour

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Why is ESG Investing Growing?

Why is ESG Investing Growing?

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

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 195 analysts worldwide:
 

Quote 2

"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.”

Dave Nadig, CEO of ETF.com

LEADING INSTITUTIONAL INVESTORS ARE INCORPORATING ESG FACTORS INTO THE INVESTMENT PROCESS

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

Has ESG historically compromised financial returns? NEW

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 were more competitive and generated abnormal returns, often leading to higher profitability and dividend payments, especially when compared to low ESG-rated companies.

 
Gross profitability of ESG quintiles


01 = worst ESG quintile and 05 = best ESG quintile

Idiosyncratic risk channel: High ESG-rated companies experienced a lower frequency of idiosyncratic risk incidents such as major drawdowns. Conversely, companies with low ESG ratings were more likely to experience major incidents.

 
Large drawdown frequency of top vs. bottom ESG quintile

 

Valuation channel: High ESG-rated companies have shown lower systematic risk exposure, evidenced by less volatile earnings and less systematic volatility. Compared to low ESG-rated companies, they also experienced lower betas and lower costs of capital.

 
Systematic volatility of ESG quintiles

 

01 = worst ESG quintile and 05 = best ESG quintile

Does ESG add value?

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ESG in Emerging Markets

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Three common ESG investor objectives

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: 
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  

Additional Resources

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Legislation

MSCI ESG Research LLC. is a Registered Investment Adviser under the Investment Adviser Act of 1940. The most recent SEC Form ADV filing, including Form ADV Part 2A, is available on the U.S. SEC’s website at www.adviserinfo.sec.gov.

MIFID2/MIFIR notice: MSCI ESG Research LLC does not distribute or act as an intermediary for financial instruments or structured deposits, nor does it deal on its own account, provide execution services for others or manage client accounts. No MSCI ESG Research product or service supports, promotes or is intended to support or promote any such activity. MSCI ESG Research is an independent provider of ESG data, reports and ratings based on published methodologies and available to clients on a subscription basis.  We do not provide custom or one-off ratings or recommendations of securities or other financial instruments upon request.

ESG ADV 2A
ESG ADV 2B (brochure supplement)

Regulation