Frequently Asked Questions
ESG stands for environmental, social, and governance. ESG investing adds factors like greenhouse gas emissions to financial metrics such as revenues or profits. It is also called socially responsible investing (SRI), sustainable investing, and impact investing.
The explosion of interest in ESG dates back to the 2015 Paris Agreement. The Agreement’s signatories pledged to limit the increase in global temperature to under two degrees Celsius above pre-industrial levels.
ESG investing evolved out of Socially Responsible Investing (SRI), popular in the 1970s. Initially, SRI followed religious principles. SRI funds excluded tobacco, weapons, gambling, and alcohol companies. Some SRI funds boycotted companies doing business in South Africa during the apartheid in the 1970s and 1980s.
SRI is exclusionary, meaning that it seeks to exclude companies in controversial industries, such as tobacco. In contrast, ESG investing is inclusionary: it seeks to add more companies that have high ESG scores relative to their peers. At the same time, many ESG funds continue to ban tobacco, weapons, and gambling. Today, the terms SRI and ESG are often used interchangeably.
Impact investing aims to generate measurable outcomes through direct investments. It often takes the form of venture capital or private equity.
The field of ESG investing is new, and the amount of data is limited. Though ESG investing was once thought to generate lower returns, we have more data showing that the opposite may be true.
According to Morningstar, in 2020, three out of four ESG funds exceeded their category average.
And there is now plenty of academic research showing that ESG stocks or funds generate better returns:
- A June 2021 study by Pastor, Stambaugh, and Taylor found that stocks with high ESG ratings outperformed stocks with low ratings by 35% between 2012 and 2020. The authors believe that green stock outperformance was related to growing concern about the environment
- A 2020 report by the NYU Center for Sustainable Business analyzed over 1,000 studies on ESG and performance, finding a positive correlation
- Morningstar’s research from 2020 found that most ESG funds they tracked outperformed their conventional counterparts over ten years. They looked at 745 Europe-based funds over three, five, and ten years (ESG has been around in Europe longer than in the U.S.)
- A 2019 report by the Morgan Stanley Institute for Sustainable Investing found that between 2004 and 2018 ESG funds had lower downside risk than traditional funds
- A 2018 study by the UN Principles of Responsible Investment found that ESG portfolios outperformed the MSCI index over ten years
- A Harvard Business School study from 2015 found that firms with good performance on material sustainability issues significantly outperform firms with poor records
- A 2015 Journal of Sustainable Finance and Investment analysis of over 2,200 studies on the impact of ESG on equity returns found that 63% had positive findings (ESG improved performance), and only 8% were negative
Over two hundred rating agencies rate stocks and funds based on ESG criteria. Some of the best-known are Sustainalytics (owned by Morningstar), S&P Global, MSCI, FTSE, Bloomberg, Thomson Reuters, and Vigeo Eiris (owned by Moody’s). Most exchange-traded funds (ETFs) rely on ratings from MSCI, S&P Global, or FTSE.
There is no standardized way of calculating ESG scores. An MIT study found that the ESG rating correlation among different agencies was only about 60%, compared to 99% for corporate bonds.
This happens because rating agencies weigh environmental, social, and governance factors differently. Some emphasize environmental issues; others are more focused on governance. Even the definition of good governance can vary: some agencies include corporate lobbying into ratings, others exclude it.
Moreover, environmental, social, and governance factors can conflict. A highly polluting oil and gas company can be governed well or have a diverse leadership team. For example, oil giant Exxon has three women on its Board.
Rating agencies also use different data sources and a different mix of self-reported and external data. ESG disclosures in the U.S. are voluntary and not comparable, which makes the agencies’ jobs harder.
Greenwashing is when companies or funds try to get an edge by overstating their “green” and “sustainability” practices. In effect, they are slapping a “green” label on a conventional investment for marketing reasons.
It is not a secret that many environmental, social, and governance (ESG) funds invest in oil and gas companies. For example, iShares ESG MSCI USA ETF (ESGU), the biggest ESG ETF, has holdings in oil companies ExxonMobil and Chevron. The newly launched BlackRock U.S. Carbon Transition Readiness ETF (LCTU) also owns Chevron and Exxon.
The largest ESG funds generally try to mimic the broad market’s risk and return profile while adding ESG criteria. The broad market includes fossil fuel stocks. As a result, many ESG funds include them, too (though they pick fossil fuel companies with better than average ESG scores.) In other words, they invest in best-in-class companies in sectors that are not deemed ESG-friendly to replicate the broader market’s risk and return characteristics.
Shareholders get a say in how the companies they own shares in are run. For example, investors get to submit proposals for a vote during the companies’ annual meetings. These proposals are known as shareholder resolutions. The resolutions increasingly target ESG issues, such as carbon emissions or workplace diversity.
Notable 2020 proposals included deforestation at Procter & Gamble and climate lobbying at oil major Chevron. In 2021, more ESG resolutions received majority support from shareholders. For example, a small activist investor, Engine No. 1, got to appoint three directors to the Board of oil giant ExxonMobil with the goal of reducing Exxon’s carbon footprint.
Shareholder votes aren’t generally binding, but even so, it’s getting harder for management to ignore them. Even if the shareholder resolution doesn’t pass but garners support, it can help by bringing certain issues to the management’s attention.
Shareholder resolutions that pass are generally filed by institutional investors such as asset management firms. Doing it as an individual investor is nearly impossible. There are multiple rules outlining minimum ownership requirements and the length of stock ownership.
Divestment (selling fossil fuel company stocks) is controversial, and there is no clear answer.
Those in favor argue that divesting will punish fossil fuel companies by making their share prices go down. By making their financing more expensive, investors starve “bad” businesses of capital and promote the shift to renewables. Oil and gas companies will have to clean up their act and be more eco-friendly.
Some divestment proponents also think that oil and gas stocks will underperform. Businesses like ExxonMobil sit on huge reserves of oil and gas but may not be able to develop these “stranded assets” due to the shift to clean energy. Divestment is then a good financial move.
Those against divestment argue that, given that we can’t end dependence on oil right away, climate goals are better achieved by engaging with oil and gas companies. Divesting doesn’t reward polluters for decarbonizing, and many of the biggest investors in renewables are polluting companies. Impact investing should be about staying invested and encouraging better behavior as a shareholder.