The acronym “ESG” stands for environmental, social and governance. More importantly, the term ESG has become synonymous with the concept of “sustainability.” In the capital markets, ESG criteria are a set of standards that should help to assess an organization’s operations and evaluate potential investments in securities issued by those organizations.
- Environmental criteria assess how an issuer safeguards the environment, including internal policies addressing climate change, for example.
- Social criteria assess how an issuer manages relationships with employees, suppliers, customers, and the communities where it operates.
- Governance deals with an issuer’s leadership, executive pay, audits, internal controls, and shareholder rights (if the issuer is a corporation).
The term “ESG” was first popularized in 2004 in the UN Global Compact’s report Who Cares Wins, which outlined recommendations by a consortium of financial institutions to “better integrate environmental, social and governance issues in analysis, asset management and securities brokerage.” The UN’s Principles for Responsible Investing (PRI) was also formed in 2004 and is an international network of investors working together to understand the implications of sustainability for investors and support signatories in incorporating these issues into their investment decision-making practices. Today, most of the world’s largest investment firms are signatories to the UN PRI.
ESG Investing in the U.S.
After a slow start, investors in the U.S. have been deploying capital into ESG investment strategies at an accelerating rate, as indicated by the following chart:
Source: US SIF - Report on US Sustainable and Impact Investing Trends 2020
Although the US SIF has not published data from 2021 or 2022, other sources have indicated that this trend continued throughout the COVID pandemic.
ESG covers a broad range of sustainability factors. However, given the increased attention being paid to climate risk around the globe, the focus of ESG investing has traditionally been on the environmental (“E”) component. In fact, most of the existing or proposed ESG regulations in the European Union and the U.S. primarily address climate risk disclosures:
EU Regulations in place:
- Sustainable Finance Disclosure Regulation (SFDR) requires all financial market participants in the EU to disclose on ESG issues to avoid “greenwashing.”
- The Non-Financial Reporting Directive (NFRD) significantly expands the scope of mandatory sustainability disclosures by issuers of securities, including information on how and to what extent their operations are associated with environmentally sustainable economic activity.
Proposed U.S. Regulations by the SEC:
- Enhanced and standardized climate-related disclosures for public companies providing information about greenhouse gas (GHG) emissions within their registration statements and annual reports.
- Disclosures by investment managers who promote funds or strategies that claim to be ESG-aligned that would describe specific strategies and metrics to achieve positive social or environmental outcomes.
Examples of ESG-Aligned Investments
- Green bonds are generally issued to have a positive environmental impact, such as to fund projects like the construction of renewable energy power generation plants or facilities with energy-efficient amenities.
- Social Bonds are generally issued to achieve certain socially desirable outcomes such as funding the construction of health care or medical facilities or financing affordable housing projects.
The Future of ESG
Although ESG investing is well-established and has many supporters, there are also detractors that view some sustainable or responsible investment practices as undesirable. Examples include certain state-level government entities that are cutting off opportunities in their states for investment managers that are perceived as boycotting investments in companies associated with fossil fuels. The one certainty is that ESG investing will continue to evolve and create opportunities as well as challenges for both issuers and investors in their efforts to achieve positive societal and environmental outcomes.
Join the SS&C Learning Institute for a training webinar covering the latest in Environmental, Social and Governance (ESG) Investing. This webinar identifies key ESG factors that motivate investors and shows how "buy side" and "sell side" participants incorporate them into responsible investing strategies and sustainable finance. It uses examples from debt and equity markets to show how responsible investing is transforming capital raising and fund management. Finally, it discusses evidence on how including ESG factors affects returns: can we do well by doing good? Explore the agenda and register for the complimentary webinar.
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