Environmental, social, and governance (ESG) risks have taken a strong hold in the developed investing space. Previously, the concept had resided in the domain of “do gooders” and “tree huggers” seeking to make a better world. So what has changed so much that it is now taking root in mainstream investing? By and large, ESG has been able to make the move because of serious concerns backed by legitimate data around environmental degradation worldwide, its impact on humanity, communities, and countries, as well as its economic impact in the form of damage to properties and loss of man hours in the wake of environmental disasters that are coming at a pace not seen before. The damages extend to business activity, leading to loss of revenues and increasing the cost of insurance.
As the thesis around the reining in of environmental damages with a framework of a 2 degree Celsius alignment for climate change has spread, it has behooved large institutional asset owners with large monetary assets at their disposal to become part of the movement. Since no government can afford to finance this mammoth effort alone, it is increasingly apparent that private funding has to step up in innovative ways.
One way is to invest in the funds at their disposal in a manner that sends a message to the corporate world that companies that willfully pollute, feel no sense of corporate citizenship, and do not invest in clean power or processes, which in turn can cause severe environmental damage, will be overlooked when it comes to buying their stock. This process of under investing in or excluding certain types of stocks from investment portfolios has gained popularity in recent times.
Specialized data vendors, like Trucost, a part of S&P Global, measure the carbon footprint of a company to a fair degree of accuracy. This data is then used to create indices or investment portfolios that deliberately underweight polluters and overweight companies that are making an active effort to keep their pollution levels low. This process of penalizing in an investment framework, which keeps the risk/return tracking error for the investor fairly limited, has gained considerable popularity. It is like buying a free option on the carbon penalty. Indices like the S&P Fossil Fuel Free & Carbon Efficient Indices are designed to overweight cleaner companies at the expense of companies with higher emissions within each sector, which means that the risk/return profile of the company matches that of the underlying beta index. Yet, the asset owner is then able to engage companies and send a powerful message that this is an important aspect for them to address. Globally, billions of dollars of institutional asset owner money has moved to carbon efficient indices to indicate strong support for good environmental practices.
For more content related to ESG, dive into ESG on Indexology®.The posts on this blog are opinions, not advice. Please read our Disclaimers.