Now that you have some background about ESG investing, we will a dive a little deeper and address the criteria that underlies the “E”, “S” and “G” in ESG, as well as explore some relevant strategies for making investments in the green asset sphere.
You can generally consider environmental, social and governance issues as risks to a company’s financial performance, and a further means of conducting due diligence when making investment decisions, alongside other critical factors that may affect your returns, such as revenues, cash flows, creditworthiness, and operational performance.
As performing ESG analysis may be a daunting task – considering the multitude of known, unknown, and debatable variables that underpin environmental, social and governance topics – there are more discrete criteria that you, as an investor, may use to decide whether a particular company is aligned with those values you deem important, and whether it is effectively mitigating ESG-related risks to protect or bolster its bottom line.
Environmental Risk Analysis
If you are interested in investing in a company that has been historically involved in practices that have adversely impacted nature in some way – whether the air, the land, water, or forests and the wider habitat – you may consider whether these risks, posed by that company, will have an adverse effect on its financial performance. Certainly, you may decide not to invest in the company at all – purely on principle – but if you choose to investigate further, you may ask, for example:
- Does the company produce toxins that are deemed by a regulator, say the U.S. Environmental Protection Agency, or EPA, to be harmful – for instance, is it involved in any way with PCBs, or asbestos or lead-based paint?
- Is it responsible for creating pollutants such as greenhouse gases? Is it a chemical manufacturer, for example, that uses CFCs, or an agricultural company that produces methane, or an energy company that produces carbon dioxide?
- Is it a food manufacturer or a cosmetic or a pharmaceutical company that experiments on or otherwise mistreats animals?
- Is it a company that cuts down trees to manufacture wood-based products or supply timber?
If the answer to any of these examples is ‘yes’, you may then want to examine whether any of these risks could hamper that company’s future financial performance.
- Could it face regulatory fines for not complying with federal or local laws?
- Could it face litigation?
- Could its practices damage its reputation, spurring distrust in its management?
When conducting your fundamental analysis, you may also want to consider different views concerning environmental issues, such as scientific findings that drive those government and corporate policies that are aligned with, for example, climate change or forest management.
For instance, while many federal agencies and scientists may agree on the causes of global warming, others may argue about the lack of a single model that reveals repeatable and reliable evidence for their claims.
Also, while initiatives to protect the world’s forests seem to be on the rise recently, some contend that products manufactured from wood, such as building materials, are not only significant carbon stores but can also substitute other, non-renewable materials, such as concrete or steel, whose production contributes large amounts of carbon emissions into the atmosphere.
As an investor, conducting due diligence can only help better inform your investment decisions, and factoring-in as many variables as you can into your analysis can help you draw a more objective picture of the risk landscape.
If, for instance, one argument seems more plausible to you than another, you may decide whether certain companies are deploying their capital to strategies that will benefit them financially.
Social Risk Assessments
When analyzing a company for social risks – or risks related to its business relationships – you may want to ask how it treats its internal and external customers.
- Are its employees, for example, subject to hazardous working conditions?
- Does it abide by the rules of the Occupational Safety and Health Administration’s (OSHA) policies?
- Does it promote workforce diversity, while maintaining a meritocracy?
- Has it engaged in any human rights violations?
- Do its suppliers mirror the company’s values?
- Does it engage in profit-sharing with local communities or inspire volunteer work?
A government, agency or corporation may have social projects as part of its ESG strategy, and these may include providing or promoting affordable basic infrastructure such as clean drinking water, or sanitation systems, or access to healthcare, education and financial services, jobs, food security, or socioeconomic advancement, including reducing income inequality.
Again, since governments, agencies, or corporations may devote capital to social projects, as an investor, you would want to decide whether these projects will help protect, or improve, their financial performance.
Governance Risk Analysis
For a corporation, governance issues may include whether there is any corruption conducted by their management or employees.
- Do they have adequate policies that address money laundering?
- Are they breaching federal or local laws in other ways such as through bribery or monopolistic behavior?
- Are their shareholders voting on all material decisions?
- Do any of its board members have conflicts of interest?
- Is compensation too far skewed towards top management?
- Does it use political donations in exchange for political favors?
- Is it transparent about its tax and accounting practices?
- Does it change its external auditor too frequently? Is that auditor credible and well-established?
- Is the company involved in a pyramid or Ponzi scheme?
In effect, when performing your analysis, you would want to determine whether any of the company’s policies, or actions taken by its workforce, vendors, or others in its ecosystem, pose any risk of fines, litigation, or reputational harm that could adversely impact its financial future, with an eye on whether this could lead to its bankruptcy, or default.
Further Due Diligence
Moreover, although you may review companies’ ESG disclosures, you may find that many of the variables that may be instrumental to your fundamental analysis are inaccessible through available reports.
Information, for example, could include rumors – whether founded or unfounded – which may be stirring controversy and causing a company reputational harm.
In general, ESG-related data analysis is a daunting task, and many companies and organizations have been working to address these issues, including constructing more advanced, technological tools and scoring systems to aid in the effort.
While we’ll address ESG scoring more in depth in a later lesson, we’ll next turn our attention to how ESG has impacted the markets and disrupted various business sectors.
Disclosure: Interactive Brokers
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