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What is ESG Investing?

December 14, 2020

Even though environmental, social and governance (ESG) investing has quickly emerged into the mainstream business world, it’s growth was neither smooth nor linear. For modern companies, the financial implications of ignoring ESG issues causes the tide to turn.

ESG investing encourages an economically efficient and sustainable global financial system that rewards long-term responsible business practices while benefiting the environment and society as a whole.

ESG criteria are fast-becoming a popular way for investors to determine which companies are worth investing in. Continue reading to explore how stakeholders who integrate corporate ESG considerations into their investment portfolio can improve returns across the global marketplace.

What is Environmental, Social and Governance Investing?

Responsible investing is generally recognised as the integration of environmental, social and governance factors into investment processes and organisational decision-making. ESG investing is supported by a set of standards that encourage companies to adhere to criteria that enables socially conscious investors to screen their potential investments. 

ESG factors cover a variety of issues that were once separate from financial analysis but have since been recognised for their financial relevance. For example, ESG factors may include:

  • the way corporations respond to climate change
  • how robust a business’ health & safety policies are
  • the strategy a company uses to manage its supply chains
  • how organisations treat employees
  • whether the company culture fosters trust, transparency and innovation

Why ESG Investment is Important

ESG investments are currently estimated to make up around 25% of all professionally managed assets around the globe. With that in mind, many investors recognise that a business’ ESG data is a vital component in fully understanding corporate purpose, management quality and strategic competencies. 

Indirectly, ESG investing opportunities are a good indication regarding the ways societies and marketplaces are gradually changing to appreciate the value of a new environment that favours smarter, cleaner and more efficient professional products and services.

Why ESG Matters to Investors

With the rise of responsible ESG investments in the EU and USA, shareholders and investors use ESG criteria to identify the businesses that are well-positioned for future success while avoiding those likely to underperform or fail. 

For individual investors, paying close attention to ESG factors empowers them to vote with their money backed by sound decisions.

ESG in Accounting

While sustainability is a primary concern of many investors, business leaders and consumers, the accounting industry has been somewhat slow to respond. As of yet, there are still no universally adopted finance or accounting standards that offer companies guidance on how to measure and report on their sustainability performance.

That said, the strides made in ESG recognition have sparked change in accounting. Lead by the International Accounting Standards Board (IASB), regulations and best practices for modern companies are in development across more than 140 jurisdictions. In the USA, similar requirements are set by the Financial Accounting Standards Board (FASB). Read our recent guide to find out more about the relationship between the IASB and FASB.

On top of advancing regulations, McKinsey also identified that ESG links to cash flow in five important ways: 

  1. facilitating top-line growth
  2. reducing overall costs
  3. eliminating regulatory and legal interventions
  4. increasing employee productivity
  5. optimising investment and capital expenditures 

McKinsey recommends that each of these five factors should be part of a modern organisation leader’s checklist when approaching ESG investment opportunities.

How to Integrate ESG Considerations Into Investments

Insights from Principles for Responsible Investment have concluded that ESG integration practices are fast becoming more complex, but increasingly that the financial impact of ESG issues is quantifiable. 

Using quantifiable ESG metrics, Investors looking to expand their portfolio and adjust financial forecasts (such as revenue, operating cost and capital expenditure) as well as company valuation models based on the expected impact of ESG factors.

Investors will assess the impact of material financial factors on securities in their portfolio(s) and investment universe and adjust their financial forecasts and/or valuation models appropriately. 

There are two main approaches to integrating ESG factors into quantitative models. They involve adjusting the weights of: 

  • securities ranked poorly on ESG to zero, based on research that links ESG factors to investment risk and/ or risk-adjusted returns; 
  • each security in the investment universe, according to the statistical relationship between an ESG dataset and other factors.

How ESG Engagement Creates Value for Investors and Companies

A strong ESG proposition creates value by enhancing investment returns by better allocating capital in the long-term. On top of that, businesses that prioritise ESG are better positioned to attract B2C and B2B customers with more sustainable products, services and business practices. 

With greater social credibility, modern companies increase public perception as well as increase their opportunity to earn subsidies and government support.  

Today, ESG investment has matured to a point to accelerate market transformation significantly. As organisations and investors continually experience a growth in their influence and power, crucially, their actions and decisions are increasingly shaping the future of the natural world, society and organisational functionality.

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Here at INAA, we connect accounting firms who aim to deliver quality professional services around a shared vision to make global business personal and take personal business global. Our collaborative association of international businesses is committed to being a part of the conversation around investment and ESG.

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