More and more investors are looking beyond traditional financial metrics when choosing how to allocate their dollars. So-called ESG investing considers factors like whether companies have environmentally friendly operations, foster a great workplace and support the global community. While you might think choosing investments on these factors limits portfolio performance, the opposite may be true. In fact, ESG investing can be a pragmatic risk-management strategy.
That’s because companies that excel across the board on ESG metrics are building businesses that may be more durable to a broad set of emerging risks over the next decade and beyond. To see why, let’s pull apart the three components of ESG and dig deeper into the risks and potential competitive advantages.
Environmental parameters generally measure a company’s energy consumption, pollution output, water usage and more. In general, ESG-leading companies use the planet’s resources efficiently and with minimal impact on their surroundings. It’s certainly good practice to be good stewards of the planet, but it can also be beneficial to a company’s bottom line.
For example, energy costs have soared over the past year and water is an increasingly scarce resource in some regions around the world. Companies that rely on water, oil, and other commodities to produce their end products may be exposed to higher, or unpredictable, input costs as a result. Therefore, companies that have the optionality to shift to renewable energy or deploy technologies that boost efficiency can manage these costs and may be more insulated from volatility that accompanies raw material prices. That can translate into more stable, predictable earnings — in addition to environmental benefits.
There’s an additional benefit: Companies that address environmental risks within their operations may be able to borrow money at lower costs than those that haven’t. The better a company’s ESG score, the less interest it tends to pay on borrowed money, according to an analysis from investment research firm MSCI.
Companies that score well on social parameters provide solid benefits for their employees, women and minorities are well represented at all levels. These companies also tend to be highly regarded in the local and global community through volunteerism, investments and other stewardship. Again, companies that score highly here also tend to reap tangible financial benefits.
Studies have shown that companies that rank highest in gender and racial diversity are more likely to financially outperform their industry and tend to have less volatile earnings. There are a few reasons for this. A wider range of experiences and cultural knowledge are infused in a diverse company’s operations, which can foster better product development, improve customer satisfaction, enhance recruiting, or help companies discover untapped market opportunities. Taken together, these factors can enhance a company’s returns over time, according to consulting firm McKinsey.
On the other side of the coin, there are risks to companies that fall short. Labor disputes can halt operations or increase costs, while unfair hiring or recruitment policies could expose a company to legal liability — particularly if the product or service is harmful to people’s health.
Governance measures a company’s internal procedures, controls, oversight and its ability to conduct business in a transparent and legal manner. Companies that score highly here have rigorous controls to identify fraud, robust cybersecurity policies, and are open and honest with shareholders among other factors.
Over the past several years we’ve seen company operations shut down entirely via ransomware or DDOS attacks, and hackers have stolen untold volumes of sensitive customer data in high-profile incidences. But the risks aren’t always external. Enron is the textbook example of how devasting poor internal controls can be to a company. The lasting financial and reputational ramifications of cyber attacks, accounting fraud, deception, misuse of customer data and more can hamstring poorly managed companies or drive them out of business altogether.
The Bottom Line
It’s important to keep in mind that there isn’t a direct causal relationship between financial performance and ESG. Just because a company scores highly on ESG metrics doesn’t mean it can’t underperform for a host of other reasons and vice versa. To wit, oil and commodities companies which are typically poor ESG performers have outperformed the market in 2022. Research here is more general and has simply identified a positive correlation between ESG achievers and financial performance at a macro level. As always past performance isn’t necessarily indicative of future returns.
However, the takeaway for ESG investors here is that building wealth with the best interests of society and the environment can also benefit long-term performance.