What actually is ESG investing?
Good returns and a clear conscience: ESG investors try to combine these two aspects by preferentially investing in assets that take into account factors such as environmental, social and good corporate governance. But what exactly is ESG investing? And what do investors need to consider?
These ESG factors make the difference
The origins of ESG investing date back to the 1930s. Even then, some investors began to incorporate ethical considerations into their investment decisions by excluding certain industries or companies that were considered unethical or hazardous to health. The first investment instrument to describe itself as “responsible” was the US Pioneer Fund, launched in 1928. Even then, the investment concept consistently excluded companies from the gambling, tobacco and alcohol sectors.
In the following decades, public discussion about the environmental consequences of uncontrolled economic growth picked up considerable steam, and environmental aspects began to become more of an investor focus in the 1990s. The adoption of a total of 17 goals for sustainable development (Sustainable Development Goals, SDGs) by the UN General Assembly on September 25, 2015 marked a breakthrough in international support for sustainable development goals.
Today, institutional and private investors take ESG factors into account to ensure that their investments have positive social and environmental effects in addition to return opportunities. In this context, it is important to clearly differentiate between “genuine” ESG investment forms and synonymously used terms, which often only have an advertising character. These include, for example, “ethical investment,” “socially responsible investing,” “green investment,” “sustainable investing,” or “impact investing.”.
These suggest that the financial sector should not only act in a profit-oriented manner, but should also contribute to achieving long-term social and environmental goals. However, ESG investing goes far beyond that: It formulates specific goals and objective criteria for selecting investments that are suitable for achieving social and sustainability goals.
These are the main components of ESG:
- Environment: This refers to an organization's impact on the environment. This may include energy consumption, CO2 emissions, water consumption, waste management, and other environmental factors.
- Social (Social): This concerns the social aspects of an organization in relation to its employees, suppliers, customers and the communities in which it operates. Topics here can include working conditions, labor rights, diversity and inclusion, human rights and social commitment.
- Governance: This refers to the way an organization is managed and controlled. Governance factors may include board composition, governance transparency, compensation practices, and ethical guidelines.
Weak economy depresses ESG fund assets
These sustainability goals have attracted numerous investors. As a result, ESG bond markets, for example, have seen a breathtaking growth in supply over the past seven years. In 2021, a peak of one trillion euros in self-labelled ESG bonds was reached. In view of persistent inflation, high interest rates and fears of recession, the ESG market declined in 2023. Collected worldwide sustainable funds raised around 14 billion dollars in the third quarter of 2023, compared to 23.7 billion dollars in the second quarter of 2023. However, assets under management fell by 4.2% to 2.7 trillion dollars compared to the previous quarter.
With 85% of global sustainable fund assets, Europe continues to account for the largest share of the sustainable fund landscape. It also remains by far the most developed and diversified ESG market, followed by the United States.
Beware of “greenwashing”
In the ESG market worth billions, ratings from agencies such as MSCI, Refinitiv or Sustainalytics (Morningstar) are an important tool for evaluating sustainable investments. Specifically, they represent assessment tools that measure company performance in terms of ESG. However, as there is no uniform definition of ESG, there is a risk that these ESG ratings will also result in the so-called “Greenwashing” be able to contribute.
The way ESG ratings work usually involves five steps:
- Acquiring data: ESG rating agencies collect information about companies from various sources.
- Weighting and prioritization: ESG factors are weighted and prioritized, depending on their relevance for the respective industry and region.
- Data analysis: The collected data is analyzed with regard to ESG factors.
- Calculation of an ESG score: Based on data analysis and the weighting of factors, the rating firm creates an ESG score for the company in question.
- Publication: ESG rating agencies publish ESG scores and analysis, which can help investors make their investment decisions.
Many companies now publish comprehensive ESG reports, and investors use ratings and other tools to assess ESG practices. Governments and regulators also recognize the importance of ESG factors for a sustainable economy.
But the ESG boom is also increasing the number of greenwashing allegations directed against both rating agencies and non-financial companies. As a result, politicians and regulators want to regulate the market more closely. In June 2023, for example, the European Commission presented new rules for ESG rating providers. For example, rating agencies must disclose their weighting of the E, S and G ranges and indicate whether a rating is absolute or relative.
Initiatives are also being planned in the USA: The US federal regulations on the disclosure of climate data are expected to be final in 2024 and come into force from 2026. The Securities and Exchange Commission (SEC) will then require publicly traded companies to provide a higher standard of climate data transparency.
