ESG Investing For Dummies. Brendan Bradley

effect on a given percentage of pretax income, total assets equity, or total revenue. Sliding-scale or variable-size methods apply given percentages to different levels of gross profit. In general, companies use blended methods to combine some or all methods by using appropriate weighting for each element.

Within ESG there are currently no industry norms or globally recognized practices for evaluating and measuring materiality weighting. Moreover, each ESG data provider has developed a method to aggregate and weigh materiality for its summary scores, but these are proprietary judgments made by each provider. Indeed, analyzing the different methodologies used by leading ESG providers highlights the challenge that investors face. There are distinct differences in the way they collect and analyze ESG data, resulting in low correlations between their aggregation metrics; this increases the difficulty in extracting weights given to material issues.

      Furthermore, not all weightings have the same importance to every industry (see Chapter 14 for more information). Some providers use levels of data disclosure as a proxy for the relative weight of materiality issues for each industry. This data highlights which sectors contribute most, and their proportion of the contribution to the total is used as a proxy for the level of materiality for that sector. For example, greater disclosure on carbon emissions data suggests that they are more material to companies in that sector. In addition, if given companies in a sector aren’t reporting relevant metrics, they may be arbitrarily assigned a score of zero to encourage disclosure and transparency.

      

Size matters! Given that larger market capitalization companies have more social media hits than smaller companies, some providers have applied a greater weighting on a small company’s material issues as they are likely to have a greater adverse effect. Likewise, every business is impacted by global macro trends and events (such as the coronavirus pandemic) that shape the world and businesses within it. It’s important to monitor those trends to assess their impact on a company’s material issues.

Understanding Why ESG Is Important

      If it wasn’t clear already, ESG and sustainability issues are counted as important long-term factors, and they are the focus for ever-increasing amounts of research to identify them as catalysts for long-term corporate and investment performance. This has encouraged advisors, consultants, investment platform providers, and ratings agencies to develop tools to identify asset managers with the ability to pinpoint those factors and companies and to highlight the advantages in this rapidly increasing market.

      There have been major advances in the understanding of how ESG factors may impact performance. The growth in academic and other research is providing evidence to underpin that belief. For the world’s major asset owners and other stewards of capital, how a company classifies and oversees its operational and reputational risks as well as the economic and commercial opportunities from ESG issues is a fundamental gauge of the quality of its board of directors and the overall business. Investors are now seamlessly integrating an assessment of ESG quality with financial analysis to form a holistic view of an enterprise’s risk and the potential to deliver long-term earnings growth and therefore value. This section highlights some of the issues that are driving the need for ESG investing.

      Global sustainability challenges

      The year 2020 marked the start of the “decade of delivery” for the 17 Sustainable Development Goals (SDGs; see Chapter 1 for more information). In light of the impact of the COVID-19 pandemic, these words may have more resonance than they did previously for most people, and there is more awareness of the sustainable development issues that impact us all. Indeed, the international community could use the pandemic as a way to get back on track to achieve the SDGs and accelerate progress during this decade to deliver sustainable development. More recently, many countries have carried out Voluntary National Reviews (VNRs) of their implementation of the 2030 Agenda, and companies are reviewing their ESG agendas in tandem.

      

The science is clear: As greenhouse gas emissions have decreased during the pandemic, there has been a greater focus on the target to continue decreasing emissions by 3.5 percent per year between 2020 and 2030 so that the average temperature on the planet stays well below 2 degrees Celsius by the end of the century. Meanwhile, businesses are paying much more attention to the scarcity of resources than climate change or related natural disasters. While both factors directly affect businesses, and one often causes the other, businesses may feel that they can more proactively tackle resource scarcity with core business practices, such as supply chain management, whereas climate change is a factor over which they have less control. With an estimated addition of 2 billion people by 2050, global demand for resources will drive the need for improvements in infrastructure associated with a growing population. Either way, these factors help explain further why companies and investors are keen to embrace ESG principles. Moreover, businesses are responsible for much of the greenhouse gas emissions that contribute to climate change, so they must adapt in order to help address climate change issues.

      The interest of millennial investors in ESG

      Millennials, those youngsters born between 1981 and 1996, are part of the generation entering their prime earning years. Numerous surveys have indicated that the vast majority of high net worth (HNW) millennials consider a company’s ESG track record before investing, or alternatively they want to tailor their investments to their personal values. This reflects a need for their money to not just earn a decent return but to contribute to the social good and how it impacts society and the planet at large.

Why is that important? Millennials are a large demographic, representing about 25 percent of the world’s population and a greater percentage of the workforce now and into the future. Moreover, this group is due to inherit a large amount of wealth as their parents, the baby boomers, pass on their considerable nest eggs. Furthermore, surveys have suggested that wealth management firms typically lose more than 70 percent of assets when they are transferred from one generation to the next. Subsequently, asset managers that offer millennials ESG investment options will be well positioned to attract new assets as well as retain beneficiary millennial clients.

      

So, millennials will require more active involvement in their investments, as they need to feel they are controlling their own destiny, and consequently they will have more activist tendencies. They are interested in ensuring that their financial return is linked to positive, or at least not unduly negative, environmental and social impact. In summary, while ESG investing will be used to create a competitive advantage, asset managers have to adopt socially responsible practices to continue gaining business in the investment industry.

      More systematic, quantitative, objective, and financially relevant approaches

      As the significance of the ESG market has grown, the financial industry has evolved the definitions of which ESG factors are relevant and how they can be applied to the performance of a company. Using this more informed data from companies, combined with enhanced ESG research and analytics capabilities, the industry is producing more systematic, quantitative, impartial, and financially applicable approaches to highlight the core ESG factors.

      In turn, this has generated more research that advocates a better understanding of ESG investing and resultant data points to feed the new AI approaches to filter unstructured data through Natural Language Processing (NLP) and Machine Learning (ML) to drive predictive analytics (find more information on this later in this chapter). There are tens of thousands of company issuers and hundreds of thousands of equity and fixed-income securities — combined with an increasing array