March 04, 2020
4 minutes to read
Although the bonds market is far bigger than the shares market, the ESG criteria are still primarily applied to shares. One of the reasons behind this is that governments are a major issuer of bonds. Yet traditionally, they release far less data about sustainability than companies.
ESG stands for Environmental, Social and Governance – the benchmark nowadays when it comes to sustainable investments.
In order to assess whether an investment is sustainable, a company or government is reviewed according to these three criteria. The result is an ESG score or rating.
Companies that 'behave themselves' receive a high rating, while companies that have connections with corruption, child labour or poisoning rivers, for example, receive a low rating. This system allows investors to assess how sustainable an investment is.
The environment is the first ESG criterion. What efforts are made by the company or government to limit their greenhouse gas emissions? How economical are they in terms of raw materials and water? To what extent are renewable energies used? How sustainable are the company or government buildings? What about the vehicle fleet? And much more besides.
Many ESG investment funds have entered the market in recent years. An ESG fund is a basket of shares and/or bonds that meet certain ESG criteria. Some ESG funds focus on certain themes (sustainable mobility, sustainable energy, gender equality, etc.), while others focus on specific regions or trends.
Sustainable investing through an ESG fund is a simple solution:
- You don't need to select individual shares and bonds yourself.
- A fund can invest in dozens – or even thousands – of companies, spreading the risk.
- A manager monitors the fund's performance and the ESG policy, meaning you don't need to do much homework.
Good or clear governance is also a worthwhile criterion, even though this is a bit more difficult to measure than environmental factors. Which lobbying policy is followed? How transparent is the accounting? What measures are in place to combat corruption? How large is the pay gap between management and employees?
When we talk about sustainable investing, the first thing we think of are 'green' investments. That's easy to explain, as the climate is a key issue nowadays. And things such as CO2 emissions, waste, water consumption, raw materials consumption and energy can easily be shown in figures.
Yet it's not only the 'E' in ESG that plays a role – the 'S' and 'G' are significant, too. Companies that recycle waste in an orderly manner, keep packaging to a minimum and install solar panels on the roofs of company buildings are, of course, doing their bit. But if the same companies bribe officials or allow employees to work in unsafe conditions, sustainability is no longer on the agenda. That's why we talk about ESG integration: all three criteria are important.
For investors, it's not always clear what's involved when it comes to sustainability or ESG. That's why various sustainability labels have been established in recent years. These labels offer an additional guarantee to investors who are wondering what exactly is hidden in their ESG investment. The landscape for such labels, however, is somewhat fragmented at present. It's therefore a good idea to keep an eye out for the Belgian label for sustainable investments, too.
ESG ratings are carried out by (independent) ratings agencies such as Sustainalytics and MSCI, while banks and asset managers also often give ESG ratings to bonds and shares. These ratings are not always the same: company A can receive a score of 87 from ratings agency X and a score of 79 from ratings agency Y. This is because each ratings agency can determine for themselves where they set the threshold. As such, there is no universal standard for ESG ratings (yet). However, initiatives are being developed to achieve more uniformity.
A large number of investors believe that sustainable investments provide lower returns. The figures, however, show that this assumption is unfounded. Almost all studies – and we're talking hundreds of them – point out that sustainable investments can be just as profitable in the long term.
As a rule of thumb, you could say that companies with a lower ESG rating are a riskier investment. This may be because they are more exposed to social unrest, reputational damage, tax fines and more. Companies with a high ESG rating, on the other hand, can benefit from higher productivity due to satisfied employees, and find it easier to attract the top talents. Taking ESG criteria into account can therefore be useful when making an investment decision.
Societal factors also play their part when it comes to sustainability. How many jobs does the company create for local people? How much money goes into the local economy and to local suppliers? What is the ratio of male and female staff, and older and younger employees? Is the number of accidents at work rising or falling? How many trainees can gain work experience at the company each year? How can the company increase our quality of life (by offering healthy food options or developing safer products, for example)? What efforts are made by the company in terms of diversity and equality? How does the company act when it comes to our privacy?
Nowadays, investors are increasingly looking beyond the figures and returns generated by their investments, as the added value that companies can create for society and the environment also count, too. That explains why sustainable investments are increasingly becoming the norm. Furthermore, this is also reflected in the volumes – $13,600 billion was invested according to ESG criteria in 2012, while the most recent study (early 2018) reported this had increased to more than $30,700 billion.