Going green has never been more difficult, or has it?
ESG investing, meaning environmental, social, and governance investments investing, aims at investing in companies that strive to make the world a better place.
If we take a quick leap to the past, to the thriving 1950s, the possibility of going green not only was not a priority but also a far vision.
Whereas this year, the pace of green change has profoundly accelerated as a byproduct of the pandemic. Just think about shopping; instead of there being 40 people driving to the shops, there was one single Amazon van delivering the goods straight at your doorstep.
Many reasons lie behind the big wave of the ESG movement; while some investors want their money to go towards companies and projects that will have a positive effect on the world, others just want to minimize the harm that their investments have on communities and ecosystems. There is also a third group that takes advantage of ESG principles to protect their own portfolio from potentially negative impacts.
However, it is essential to remember that all ESG investors want to make a return on their money no matter the motivation.
Nonetheless, this is much harder in practice than in principle. Consider the following example, how do you decide whether a company deserves the halo of being classified as ESG friendly?
If you look at Tesla that makes electric cars that are better for the environment than the traditional ones, you would think that this investment would positively impact the environment.
But this is not straightforward. What about the environmental impact of mining nickel which Tesla uses in its batteries? And is the electricity used to charge your car coming from renewable or non-renewable sources? Tesla has also stated that it made a $1.5 billion investment in Bitcoin, which is, as Bill Gates observed, an environmentally damaging activity because of the energy required to mine Bitcoins. So, what should you do? Do you buy Tesla shares or not? The answer is not so clear-cut. However, these days most people don’t have to make that decision. As a matter of fact, there has been a rise in passive investing that means that most investors choose an index tracking fund like an ETF (Exchange Traded Fund) or a mutual fund which puts their money into a basket of companies stocks that track an index to create an ESG focused index.
This means that the companies present in that basket have met specific criteria that define them ESG friendly.
But how is this established?
This is still up for debate, yet the numbers of indices that provide an ESG focus have definitely exploded from 2019 to 2020, increasing by 40% according to the Index Industry Association survey. In fact, the amount of money invested ESG assets has also increased in the US wherein 2016, there were $8.1 trillion in professionally managed ESG assets according to the Forum for Sustainable and Responsible Investment, and by 2020 that number grew to $17.1 trillion, which is more than a 100% increase in just four years.
Regarding who establishes which companies to put in those indices, there are many index providers that rely on different metrics that score companies based on their ESG score. What are the metrics that are considered?
ESG impact examples of metrics are factors like exposure to carbon-intensive operations, energy efficiency, human rights concerns, etc.
Nevertheless, there can be differences between the rating agencies even if they’re scoring the exact same company. Generally, index providers have a committee that helps make decisions on which companies to include and which to exclude. This is quite important because the companies’ stocks they include will actually benefit from more investor cash. However, the subjectivity of classification has led to controversy over whether some funds are genuinely investing in companies that fulfill the vision of ESG or whether some index providers are merely using it as a marketing term and putting the ESG label on funds that don’t really deserve it. This is why it’s fundamental for investors to cautiously read the methodology and perspectives behind an ESG index before they invest in it to ensure that what they are investing in actually mirrors their final goal and intent.
But are the returns of these ESG funds better or worse than traditional investments?
In this chart showing an ESG fund’s performance versus a standard fund, you’ll notice that they perform pretty much in parallel to one another.
Of course, this is just one example; some ESG funds may do better than the benchmark and others that may do worse, but the beauty of ESG is that in general, investors don’t need to worry about sacrificing performance for the common good. Maybe this is why so many investors are joining this “green wave”.