Sustainability investing is one of the fastest-growing segments of the asset management industry. It is also one of its most complex. This posts aims to provide some clarity on this increasingly relevant topic.
Sustainable investing means looking at “extra-financial” variables, i.e., environmental, social, and governance (ESG) factors (together or separately) when making investment decisions. Such investing may take various forms, from ethical exclusions to comprehensive ESG integration, on the basis of which portfolios may be constructed as best-in-class selection (to maximize extra-financial benefits) or by simply avoiding what may be perceived as unacceptable companies or industries (to either minimize extra-financial detractions or to promote bottom-up ESG change). ESG is a comprehensive field that comprises many dynamics such as carbon emissions, environmental impact, corporate citizenship, and human capital development.
In the industry lexicon, ESG is often distinguished from carbon (also referred to as “green”). Of course low carbon is, in itself, an important component of the environmental dimension of ESG, but it also stands alone in significance due to the global threat of climate change, which is why S&P DJI typically splits sustainability into two categories: ESG and green/low carbon. For our purposes, the environmental dimension of the ESG framework tends to capture more factors, while green tends to focus on a few factors that are considered key in the threat of global climate change. Figure 1 further outlines the distinctions between the three dimensions.
The environmental component encompasses waste management, water management, and use of other environmental resources. Social includes stakeholder analysis—customers, employees, and all those affected by the presence of the entity-like people living in the vicinity of an industrial unit. Governance focuses on stakeholder impact as it specifically relates to shareholders and management while also addressing board structure, management compensation, and shareholder rights. These three factors have combined in different ways to shape distinct periods in the history of the sustainability movement (particularly as it relates to finance).