ESG stands for Environmental, Social and Governance. This is the one of the more recent phenomenon of investing. Investors look at these three factors when they are investing their money in a company. But how feasible is it in the long run?
So, before jumping into the main subject lets first understand what it means. When investors decide to on the basis of ESG they look at a company and rate it on these three factors. There are many indexes now which do it and have a number of companies included in them.
- Environmental – This aspect mainly looks at the environmental impact that a company has. Lets take the example of two energy companies. Company A produces solar energy and Company B produces energy using coal. Now when you compare these, Company A would have a higher score than Company B because its using a method which is less dirtier than its counterpart. Companies might also announce plans to reduce their carbon footprint or take up initiatives to plant more trees or clean the oceans and this too would have a positive impact on their scores.
- Social – The social ratings are based on how good a company manages its relationships with the internal and external stakeholders. Here, a company would be rated higher if it promotes diversity and inclusion than a company which does not. A company which also helps the local community thrive by donating and running programs which benefit its overall growth would be rated higher.
- Governance – This aspect measures the leadership of a company based on transparency, leadership and interactions with the shareholders. Their accountability is also taken into consideration. Simply put, if the leadership of a company use unethical ways to obtain business or a competitive edge then their ratings in this category would be downgraded.
There are many ESG indexes around the world which measure the ESG ratings or ESG reportings of companies and design and include them accordingly. Many Exchange Traded Funds (ETFs) also track these and invest directly in them. Many investors put their money in these ETFs as they believe that the indexes already do their research on evaluating these companies based on their ESG scores. But are they flawed?
Now, I am not saying that ESG is a bad thing. Its good for the society in a broader sense as it helps the businesses focus on their goals along with the betterment of the world. But at the end of the day, its still business. No matter, how much these principles are taken into consideration the end goal of a business is still profit. Let me explain.
Investing in a company in the purest sense is capitalism. The basic objective of capitalism is to earn a profit. When an investor puts their money into a company they look at it from a long term perspective of how much return they are going to earn. Investors usually do not think how well a company is doing in terms of helping the world. Sure, with more innovation in the future we might be able to cut down on pollution but until that happens a company will still need to run their business in a not so environment friendly way.
Green bonds are something which are closely related to ESG in my opinion. A company might announce extremely ambitious plans to reduce or eliminate their carbon footprint in the next 10 years, only to get money at a cheaper rate. When they announce such plans, there is also a lot of hype around it and investors pool in their money to buy the shares of that company giving it a boost. But if looked at it from a fundamental perspective the share price would not really make any sense. Now, over the course of 10 years if it does manage to achieve their targets, then its great news and the money was put into good use. But it rarely happens.
Sometimes companies are forced to take decisions based on the government rules and policies but portray it in a way that shows them in a positive way. Lets say, the government of a country decides is debating about bringing a policy where companies are to recycle 30% of the waste they generate. A company might announce that they are taking up the initiative of doing it even before the policy comes into effect. The reason for this would not be them coming up with this idea, but rather they do on the basis of the governmental pressure that they would have to face eventually.
Companies are also given carbon credits which allow them to emit a certain amount of carbon dioxide. There have been many instances of companies with lower carbon credits buying them up from other companies. This simply translates to profit or paying an amount to be able to pollute the environment.
Now, like I said ESG is not a bad thing. Its a great concept of making sure that these companies work in the right manner which is favorable for everyone. But with profit being the end goal, does it sometimes give up on its core values? And like many other investing concepts or principles before it could it also be just a temporary phenomenon?
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