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You have probably heard a lot of talk about ESG (Environment, Social, and Governance) investing. But what does this acronym actually mean? How is it measured? And what factors do ratings agencies take into account when producing an ESG ranking for a company or fund?
Let’s take a look at what each part of the acronym stands for and what they refer to. We will then proceed to establish how you can verify the ESG performance of your investments. Having said that, there is no one set standard for defining the factors behind ESG metrics.
Each ratings agency and each company takes a similar approach to defining its ESG criteria. However, we still do not have a unified language to label all aspects involved in sustainable investing.
So, under the umbrella of ESG, you will find a general consensus of criteria that is then broken down into subsections. Each player in the field may use a different language or prioritize slightly differently. However, the main concepts under ESG metrics are defined below.
This part of ESG metrics covers those risk factors related to the environment. And can be broken down into three main topics. Many ranking agencies will further break down the areas into further subsections.
- Natural Resources: Are the resources the company uses local, sustainable, and eco-friendly
- Carbon Emissions: How big is the carbon footprint
- Air & Water Pollution: Does the company enact procedures to eliminate or limit pollution
The resource a company uses should be located as close to the place of use as possible. This avoids the negative impact of transportation on the environment. If a company is producing paper the first question that comes to mind is, Does the company source the wood it uses locally? Or is the company importing wood from a distant place?
Are the resources the company uses as natural as possible, and if not are they eco-friendly? This factor helps reduce the impact on the environment. Examples are plastics in packaging or shipping that are not strictly necessary.
Sustainability in the selection of resources is the main factor in the environment part of ESG metrics. Does the company use sustainable resources over time, and that do not damage the environment?
Does the company have a large carbon footprint? What processes does the company implement to reduce it? Such as using solar or wind power where possible, or electricity produced with low-impact energy plants.
Air & Water Pollution
This is a big factor in ESG metrics and needs to be addressed by all companies to create sustainable economic activity. Companies are evaluated on their ability to eliminate the release of industrial waste into the environment.
This ESG metric covers the social impact of a company’s operations. Within its workforce and more broadly in the surrounding community. Companies and ratings agencies use differing language. But basically, it all points in the same direction.
- Workforce: Can employees access the necessary amenities, access to healthcare
- Human Rights: Child labor, or safety conditions
- Community: Do the company’s operations have a negative impact?
- Product Responsibility: Product safety standards, for example
Employees should have all the necessary amenities at their disposal. Some things are obvious in western countries such as restroom access. However, not all countries treat their employees in the same way. Workers should also have access to healthcare and a decent sanitary work environment.
Are companies using child labor? Are companies allowing their workers to unionize if they wish? Are working conditions safe for all employees? These may seem obvious aspects that are taken care of. However, it may not always be the case, and ratings agencies look into these issues carefully.
This aspect within the ESG metrics is relatively new and considers the impact a corporation’s activities have on the surrounding community. Will the company’s activity cause environmental pollution? Will locals benefit from the perks the company may introduce?
This is an aspect that has been around for a long time also. But it is bundled together with the other ESG metrics to make a complete guide. The products the company produces should also be safe and age-appropriate.
We can think of the many toys that reach the western world coming from underdeveloped countries that lack all of the safety standards currently in practice in the US today. Another aspect added recently to this ESG metric is health concerns. For example, is the product high in sugar or fat content?Governance
Governance is all about the stakeholders of the corporation. In this case, they can be internal or external stakeholders. And how the company is governed, ease of access to information, and stakeholder participation.
- Management: Remuneration of the board and top executives
- Shareholders: Do methods of high stakeholder involvement exist?
- CSR Strategy: Policies that ensure company activities are beneficial and ethical to society
Does management transparently conduct its business? Are the decisions taken at the board made known to all stakeholders? Are all top executives and board members’ salaries easily accessible? Is the management conduct of the business fair and visible?
Do stakeholders have the ability to participate in the main events of decision-making events? Are there methods to facilitate the process? Or is stakeholder involvement burdensome and aimed at reducing any meaningful participation?
Corporate Social Responsibility, at one time the main factor of sustainability has now also been incorporated into ESG metrics. These are the measures and processes companies take to ensure that all operations are undertaken ethically.
The company must also guarantee that its operations as a whole are beneficial to society as a whole. For example, a mining company that will not only refill an open pit when mining has finished. But also create a park on top of it and a recreational area for the local community.
How to Establish a Company’s ESG Ranking
The ESG criteria used to establish the ranking are variable among the main ratings agencies. The specific criteria do differ somewhat from agency to agency. Standard & Poor’s, Moody’s, and Fitch all use ESG criteria but do not issue a separate ranking for companies based on ESG factors.
Rather, they use ESG risk as part of their overall approach to credit scores. Other agencies such as Reuters and MSCI do rank companies based solely on their ESG score. MSCI uses an ESG ranking system based on credit ratings that go from AAA to CCC, highest to lowest.
Note that often in the ESG space some expressions overlap. For example, until recently it was common to talk of sustainable, socially responsible investing, or environmentally friendly when making investment decisions.
All have now come under the umbrella of ESG investing and their factors are incorporated into the ESG metrics. Although there is still a lot of talk or mention of the above on separate occasions. However, it does seem the general consensus is that they all fall under the label of ESG investing.
Greenwashing ESG Metrics
Greenwashing is the procedure companies use to create a false impression that their products and operations are ESG friendly. In other words, it’s an unsubstantiated claim or misleading claim about the environmental friendliness of the company’s activities.
Companies undertake greenwashing to cash in on the growing perception that investors are looking for products that are ESG friendly. At times, companies may overestimate the impact of their ESG process or make deceptive claims.
For example, hotels in the past devised a blatant episode of greenwashing when they asked customers to reuse their towels to save the environment. In reality, it was an excuse for hotels to reduce laundry costs.
Other examples include carbon-based energy companies advocating themselves as green champions of the environment. Products can also be greenwashed through rebranding or repackaging to give a healthier greener appearance.
Top ESG Funds & Selection Methodology
Some of the biggest asset managers have whole funds dedicated to ESG investing. Vanguard and BlackRock have funds that aim to invest in companies that have high ESG metrics. Although neither of these funds has specifically common language in their criteria the concepts are similar.
Both also use an inclusionary or exclusionary method of selection. With the inclusionary method, the fund manager only includes shares of companies that meet a criterion as defined by investors. Such as a company that does not use fossil fuels for energy needs:
While the exclusionary method excludes companies that may use child labor, for example.
Vanguard ESG Metrics Funds
Vanguard is an international asset manager with $7.3 trillion in assets under management as of 2021. This asset manager currently has four ESG ETFs on offer covering shares and bonds. The four funds are listed below:
- Vanguard ESG US Stock ETF: (BATS: ESGV)
- Vanguard ESG International Stock ETF: (BATS: VSGX)
- Vanguard ESG US Corporate Bond ETF: (BATS: VCEB)
- Vanguard FTSE Social Index Fund Admiral Shares: (NASDAQ: VFTAX)
Vanguard uses a discretionary method to include the stocks that are held in the fund. They base their method on exclusion. Meaning that they automatically exclude shares of companies that operate in specific businesses. Further, they also exclude from investment corporations that do not uphold the desired standards in ESG metrics.
The chart below shows the YTD of the four ESG funds listed above. The best performer of the four YTD has been the ESG US Corporate Bond ETF. And the laggard of the group of ETFs is the ESG International Stock ETF. All of the four funds have been outperformed by the Dow Jones Index.
BlackRock ESG Metrics Funds
Blackrock is the world’s largest asset manager with $9.6 trillion in assets under management as of the first quarter of 2022. Not surprisingly, Blackrock has a wider selection of ready-made funds. Currently, the asset manager has 4 fixed income ESG ETFs and 11 equities-focused ESG funds. Of the equity funds, 10 of them are ETFs.
Blackrock makes a clear statement about some of its funds in terms of what sectors the asset manager includes for consideration within a fund. For example, the ESG US Equity Fund does not invest in any controversial companies such as tobacco, firearms, coal, or oil. This seems complacent with the theory of ESG investing, although it may not always be practical.
The eleven equity funds are named below:
- BlackRock Advantage ESG U.S. Equity Fund (NASDAQ: BIRIX)
- iShares MSCI USA ESG Select ETF: (NYSE: SUSA)
- iShares MSCI KLD 400 Social ETF: (NYSE: DSI)
- iShares ESG MSCI USA Leaders ETF: (NASDAQ: SUSL)
- iShares ESG MSCI EAFE ETF: (NASDAQ: ESGD)
- iShares ESG MSCI EM ETF: (NASDAQ: ESGE)
- iShares ESG MSCI USA ETF: (NASDAQ: ESGU)
- iShares ESG MSCI USA Small-Cap ETF: (BATS: ESML)
- iShares Global Clean Energy ETF: (NASDAQ: ICLN)
- iShares MSCI ACWI Low Carbon Target ETF: (NYSE: CRBN)
- iShares MSCI Global Impact ETF: (NASDAQ: SDG)
Above is a chart showing the performance of BlackRock’s ESG equities ETFs compared to the Dow Jones Index YTD. All the funds have underperformed the broad stock market index except one. The iShares Global Clean Energy ETF has managed a positive return of 8.46% YTD.
Here are the fixed income funds
- iShares ESG U.S. Aggregate Bond ETF: (NYSE: EAGG)
- iShares ESG USD Corporate Bond ETF: (NASDAQ: SUSC)
- iShares ESG 1-5 Year USD Corporate Bond ETF: (NASDAQ; SUSB)
- iShares Global Green Bond ETF: (NASDAQ: BGRN)
The chart below shows the performance of BlackRock’s ESG bond ETFs compared to the performance of the iShares Core US Aggregate Bond ETF YTD. We can see that three out of four of BlackRock’s fixed income ESG ETFs have outperformed the standard broad US Bond ETF.
Using ESG metrics to guide your investing can get tricky as not all the factors or criteria are aligned uniformly across the industry. Adding the greenwashing activities of many companies and even funds complicates matters even further.
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