What is ESG investing?

Introduction

Environmental, Social, and Governance investing, or ESG investing for short, is a growing but controversial topic within long-term equity investment. The basic idea is that fund managers should make investment decisions based on non-financial, moral considerations. In practice, this means divesting from oil and gas, arms companies, and other ‘vice’ industries such as tobacco, and instead investing in the shares of companies that promise to address these social problems. The phenomenon is of indirect relevance to CFD traders, but given the proliferation of ESG ETFs and indices in recent years, there are now more and more ways for CFD traders to share in this developing theme.

ESG has been around for a while but shot to global prominence during the early 2010s, though the practice has since come under sustained criticism by analysts as an inefficient way of allocating capital, and the dubious ESG credentials of some of the funds involved are increasingly apparent. Although ESG divides opinions, it is important to understand the criteria used to judge equity investments as they are used by many investment managers and private investors worldwide.

ESG

ESG, sometimes known as sustainable investing, impact investing, or socially responsible investing, began as simple boycotts; often of South African stocks in the 1960s, or of mining companies, sometimes of tobacco and alcohol shares. Over time fund managers realised there was a large market interested in this type of investing, so gradually dedicated funds appeared that included (or excluded) shares based on social criteria. In the 21st century the previous social focus of these funds expanded to include environmental damage, with sovereign wealth funds and other public investors put under pressure to divest from unpopular industries such as energy. The term ESG achieved popularity from around 2010, and describes a style or theme of investment that – in theory at least – respects these considerations. More recently, even passive investors, with a mandate to track an index, have come under pressure from parts of the financial press to apply ESG principles to fund inclusion.

The exact criteria used by ESG funds varies significantly, but they all share a focus on a few key issues. Generally speaking, firms involved in extracting fossil fuels are excluded from ESG funds, unless they meet certain other criteria for sustainability, as are firms commonly viewed as unethical, such as tobacco and sometimes alcohol companies. The governance section of ESG includes accountability of the board, and sometimes (more controversially) levels of compensation. ESG requirements may be as light as reporting, charitable donations, and providing updates on key issues, or could involve actual substantial changes to the business model or governance of large businesses. ESG investing assumes international standards about ethical behaviour, but unlike legal action in the form of regulations does not come with any official authority.

Private investors have always taken their personal views of specific companies into account when making trading decisions. What is new about ESG investment is the application of broad, general criteria to businesses, with indices often managed by ratings agencies or even investment management companies. This creates obvious conflicts of interest as especially on the social side of ESG there is not international agreement as to what qualifies as best practice, so the requirements set by agencies can be random, and present many opportunities for workarounds. The idea behind ESG investment is that it would start a ‘virtuous circle’; as ESG indexes take off more and more investment managers look to prioritise environmental, social and governance considerations in fund and stock selection, often under the impression that this would result in improved market returns: after all, shouldn’t better governed and more responsible companies outperform the general market?

Claims and criticisms

There are three main claims made by ESG investors: that choosing stocks based on ESG factors will result in better outcomes in the real world (positive externalities); that widespread adoption of ESG metrics and scores will motivate corporations to take more account of ESG factors when running their business; and finally that ESG-compliant companies, being orientated towards the common good, will outperform the general market. ESG in finance is supposed to ensure that publicly traded businesses take seriously their social and environmental responsibilities, and that investment managers will profit from making long-term investments in ESG compliant companies. This should help encourage and facilitate technological change and improvements to corporate governance, with companies then leaving a reduced footprint on the climate and local environment.

ESG has been challenged on all of these claims. Critics claim that ESG factors are arbitrary and non-standardised, that ESG compliance is easy to fake or work around, and most importantly that there is no evidence high-scored ESG businesses outperform their peers, in some cases analysts even finding the opposite. In some markets these criticisms have led already to a declining interest in ESG factors as an investment theme. On the business side too, there have been criticisms of ESG from directors who find the entire system overcomplicated and counter productive. For stock investors, sectors such as tobacco and armaments manufacturers have historically produced market-beating returns, and are often amongst the best performing equities during market downturns, due to their stable order flows and sticky customer base. This means equity investors who refuse to invest in these markets could limit their potential returns.

Because many private investors have a desire to be ethical in their financial planning, an industry has grown up around ESG funds that are marketed to consumers as environmentally friendly or ethical. It is common for financial advisors to ask clients whether they want to invest in an ethical fund, with the implication of course that other funds are ‘less ethical’. ESG investments then become an attractive brand for investors concerned about social issues or the environment, and who trust ratings agencies to make effective decisions and assign fair scores to companies on these factors. This is potentially tricky as there is no universally agreed standard for environmental and social best practice, and also the presence of an ‘ethical’ investment option may lead some retail investors to make bad financial decisions.

ESG and impact investing

Where ESG has always differentiated itself from broader terms like impact investing is in its claim that effective ESG practices would produce better business performance. Advocates for ESG believe that accountable governance and environmental sustainability will contribute to future performance, and that the motivation for complying with what amounts effectively to voluntary regulation is to improve prospects for growth as well as create positive externalities. It is exactly this claim that is most hotly contested by critics of ESG, who do not (normally) find its stated goals objectionable but rather are sceptical that the ESG investment system is an effective way to achieve them. Because the requirements for ESG compliance are complex, it is sometimes simple even for highly environmentally damaging companies to ‘tick boxes’ on many other requirements, winning an average or even good overall score. This practice is known as greenwashing and has attracted some controversy in financial media.

Trading around ESG

ESG is a long-term phenomenon, and so has limited direct impact on stock CFD traders. Even so, the practice affects stock prices, with a good ESG rating or inclusion on ESG indices bringing shares to a broader market. Conversely, pressure to divest from oil and gas or other controversial industries under the ESG framework can depress prices in certain sectors, potentially creating value investing opportunities in those markets when shares are available at a price below their fair market value. The call to make here is whether or not you believe the ESG phenomenon will continue to grow, perhaps with formal requirements being forced on stocks as requirements to list on a certain exchange or join a particular index, or whether it will remain a fringe phenomenon within global markets, either through a drop in interest or the term ESG itself becoming meaningless through loopholes and workarounds.

The current evidence – which may always change – seems to lean on the side of ESG having little market impact. ESG funds (again, so far) have tended to either equal or slightly underperform the general market in most regions. This may indicate traders can safely ignore the trend, since if it fails to generate outsized returns its market impact will be limited. CFD traders are confronted with two options for how to deal with the rise of ESG indices – they can either bias their technical trading to long positions, if they believe ESG will work through its current difficulties and continue to be an important investment theme, or bias trading strategies towards shorting these funds. Because the ESG landscape is not standardised, different ESG funds or ETFs will have different rules on what qualifies as environmental, social and governmental responsibility, so a stock may be included on one ESG index and not another. This means most CFD trading of this theme should take place with indices, and not individual stocks.

Conclusion

ESG is an important topic in the wider market, but not something that interests most day traders . Despite the huge amount of discussion generated, and the minute there is scant evidence ESG investment principles make any difference to final market returns, and so stock CFD traders can for now just observe. It is certain though that markets will continue to face pressure to comply with social and environmental regulation, either through voluntary score-based systems such as ESG or government regulations and fines. This has potential to roil markets, as investors move out of sectors like energy and tobacco and into businesses which comply with these regulations. At the moment though, this risk is very much theoretical, and it may even be the case that interest in ESG has already peaked. Either way, there is no harm in being as informed as possible about the different trends in the equity market, and ESG is certainly an important one to watch going forward.

FAQs