Setting the Context:
With the rise of collective awareness of the importance of sustainability in our social, corporate and economic actions, Environmental, Social & Corporate Governance (ESG) based Investing has amassed vast popularity. This concept is definitely not a new one and the thought of being more “environmentally-friendly” or “consciousness” has prevailed for decades, however, as humans we have a tendency to miss the “Prevention is better than Cure” memo. And we often end up facing the wrath of our irresponsible actions to truly come into grasps of the gravity of the situation. That being said, let’s dive in and understand why this concept of “ESG investing” is not just another fancy theme to accrue greater returns but it’s a must have philosophy in every responsible investor’s portfolio.
Story Time
Long long ago in the year of 1970, there was this theory called the “Shareholder Value Theory” popularised by Milton Friedman. Friedman proposed that a corporations’s sole responsibility is to maximise shareholder value. However, holding time as a testament, we can safely say, that overemphasis on increasing shareholder value without any concern to the actual social impact (think, environmental effect, employee benefits, governance, climate change, etc) has led to serious disasters. Remember Enron? if not, I got you covered, their story is narrated below! Their tale displays a gross deviation from effective governance the “G” of ESG. Obviously pursuing profits is not an evil thing, at the end of the day corporations need to sustain their businesses in order to thrive and provide services to society, their customers, employees and shareholders. But just like chocolates, anything in excess is toxic. Companies constantly striving to increase their bottom line without any regard to the impact their corporate actions have on society would consequently lead to dire situations. Additionally, lack of building meaningful relationships with employees and failing to support their needs can lead to higher employee churn. Plus, when the profit-maximising, consciousness-minimising culture prevails it’s more likely that employees take risky or even illicit decisions out of the pressure to perform. So, short-term gratification of boosting their financial ratios, might lead to a long-term downfall of the corporation (again, remember Enron?).
What is Social Responsibility Investing?
So with all this going on, we had the uprise in popularity of Socially Responsible Investing (SRI), which relies on strategies that emphasise sustainable, responsible and impact investing. Although it was introduced in the early 70s, it’s only since the past decade have modern investors realised the shortcomings in the pigeonhole view of placing profits on a pedestal. The current situation in the world; high pollution, rise in global warming, climate change, poverty and mass decline in mental health, have pointed to the fact that the pursuit of profits is just not enough to sustain a modified capitalistic world of the future. This collective realisation helps explain why ethically focused investing techniques like SRI and ESG Investing have become the new norm. In SRI investing, negative screening methodology is used to exclude companies which belong to industries such as tobacco, gambling, guns and other vices. The philosophy behind this is that, investments must be utilised to fund “morally” good companies.
What is ESG?
ESG investing comes under the umbrella term of “sustainable investing”, but it differs from SRI in the aspect that it focuses on companies which are proactively opting to enhance their Environmental, Social and Governance aspects regardless of the sector they belong to. While a traditional SRI investor focuses on excluding certain industries or companies altogether, ESG is more flexible and open-winded in it’s selection criteria focusing on actions taken by corporations rather than the industry they belong to.
How can ESG help investors and the society as a whole?
According to Gitterman Wealth Management, “A successful ESG money manager typically engages in the following strategy: First, he will identify a set of compelling investments, based on his traditional investment selection criteria. Subsequent to doing so, he will apply an ESG lens to this set of viable investments. Last, but not least, he selects those investments that are anticipated to generate a scalable, profitable impact. The reason why impact and returns need not be mutually exclusive is because the ESG lens is only applied to profitable investments that have been identified pre-lens.”
And that’s a wrap for this week! Stay tuned for new articles every week, simplifying Finance for Gen A to Z.
Happy Learning,
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