What It Is & How It Works

What Is Environmental, Social, and Governance (ESG) Investing?

ESG stands for environmental, social, and governance. ESG investing refers to an investing approach that prioritizes how companies score on these metrics. Environmental criteria gauge how a company safeguards the environment. Social criteria examine how it manages relationships with employees, suppliers, customers, and communities. Governance measures a company’s leadership, executive pay, audits, internal controls, and shareholder rights.

How Environmental, Social, and Governance (ESG) Investing Works

Environmental, social, and governance (ESG) investing is sometimes referred to as sustainable investing, responsible investing, impact investing, or socially responsible investing (SRI). To assess a company based on ESG criteria, investors look at a broad range of behaviors and policies. ESG investors seek to ensure the companies they fund are responsible stewards of the environment, good corporate citizens, and are led by accountable managers.

• Environmental: Investors evaluate corporate climate policies, energy use, waste, pollution, natural resource conservation, and animal treatment. Considerations might also include direct and indirect greenhouse gas emissions, management of toxic waste, and compliance with environmental regulations.
• Social: This is how a company’s relationships with internal and external stakeholders are evaluated. Does the company donate a percentage of profits to the local community or encourage employees to volunteer? Do workplace conditions reflect a high regard for employees’ health and safety?
• Governance: This ensures a company uses accurate and transparent accounting methods, pursues integrity and diversity in selecting its leadership, and is accountable to shareholders. ESG investors might require assurances that companies avoid conflicts of interest in their choice of board members and senior executives, in addition to not using political contributions to obtain preferential treatment or engage in illegal conduct.

ESG investors help inform the investment choices of large institutional investors such as public pension funds. In Q4’24, sustainable funds reached $3.2 trillion in assets under management (AUM) globally, according to a report from the Morningstar. Brokerage and mutual fund companies offer exchange-traded funds (ETFs) and other financial products that follow ESG investing strategies. Robo-advisors, including Betterment and Wealthfront, have promoted these ESG-themed offerings to younger investors.

ESG Metrics

Investment firms, such as Trillium Asset Management, use a variety of ESG factors to help identify companies positioned for strong long-term performance. The criteria are set by analysts who identify the relevant issues facing specific sectors, industries, and companies.

Some of the positive qualities Trillium looks for when evaluating companies include limiting harmful pollutants and chemicals, using renewable energy sources, paying employees a fair wage, operating with an ethical supply chain, maintaining a diverse board, and demonstrating corporate transparency.

Trillium’s ESG criteria preclude investments in companies that earn 5% or more of their revenues directly from coal mining or hard rock mining, gambling, tobacco, private prisons, and weapons. The firm doesn’t invest in companies involved in major controversies related to human rights, animal welfare, environmental concerns, governance issues, or product safety.

Investors and ESG

As ESG business practices gain traction, investment firms track their performance. Financial services companies, such as JPMorgan Chase (JPM), Wells Fargo (WFC), and Goldman Sachs (GS), publish annual reports that extensively review their ESG approaches and the bottom-line results.

The ultimate value of ESG investing depends on whether it encourages companies to drive real change for the common good or merely check boxes and publish reports. That, in turn, will depend on whether the investment flows follow ESG tenets that are realistic, measurable, and actionable.

Tobacco and defense are two industries avoided by many ESG investors, but they’ve historically produced above-average market returns and can buck recessionary trends. To support ESG, investors may be sacrificing returns in exchange for values. Many ESG investors are willing to make that tradeoff, however; according to a survey of Investopedia and Treehugger readers, nearly half of ESG investors said they’d be willing to take a 10% loss over five years to invest in a company that “aligns exceptionally against ESG standards.” But 74% of respondents said that valuation/price was “very or extremely important to them.”

The Bottom Line

Environmental, social, and governance (ESG) investing focuses on companies that follow positive environmental, social, and governance principles. Investors are increasingly eager to align their portfolios with ESG-related companies and fund providers, making it an area of growth with positive effects on society and the environment.