ESG stocks have become one of the hottest sectors of the market. In 2020, millennial investors contributed $51.1 billion to sustainable funds in 2020. That was over 10x the amount of money going to similar funds just five years prior to that. This makes sense as the wealth transfer is shifting to that generation.
For many investors investing in ESG stocks is a way to allocate their capital in a way that aligns with their personal values and beliefs. Companies are finding that many investors require that a company have and post their ESG rating (also referred to as a Sustainability rating). Not surprisingly, many corporations are creating executive positions and entire departments that focus on a company’s ESG efforts.
In this article, we’ll look at various aspects of ESG Stock including what ESG means. It also covers the benefits and potential risks of ESG stocks including an explanation of greenwashing. The article will conclude with defining ways that investors can invest in ESG stocks.
What Does ESG Mean?
The letters “ESG” stand for the three pillars of
Environmental – This pillar addresses how a company’s products and/or operations affect the environment. This category encompasses measurable criteria such as carbon emissions as well as less tangible areas such as restoration projects or charitable initiatives.
Social – This pillar considers the satisfaction that customers and employees have with the company. As the term has evolved the social pillar has come to refer to social justice.
Governance – This pillar looks at the internal operations of the company with particular emphasis on its leadership. Some of the areas being looked at include transparency, accountability, and political activity. This term is shifting more to highlight corporate governance.
As of August 2022, companies are not mandated to report on their ESG initiatives. Therefore, the absence of an ESG rating should not be the only way for investor to evaluate a company. However, according to the CFA Institute, a worldwide, not-for-profit organization, here are the broad criteria for each pillar:
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Environmental
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Social
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Governance
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Carbon Emissions
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Labor Standards
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Board Composition
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Air and Water Pollution
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Human Rights
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Executive Compensation
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Waste Management
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Data Protection and Privacy
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Audit Committee Structure
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Energy Efficiency
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Community Relations
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Political Contributions
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Deforestation
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Gender and Diversity
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Bribery and Corruption
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Water Scarcity
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Customer Satisfaction
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Lobbying
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Biodiversity
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Community Relations
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Whistleblower Schemes
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The Upright Project publishes a report with the net impact ratio using its proprietary net impact model. As MarketBeat says, “Net impact ratio is the (positive impacts - negative impacts) / positive impacts. The maximum value for net impact ratio is 100%, representing a theoretical company with no negative impacts. The minimum value is -∞. Net scores depend on the value sets that determine the importance of different impact categories. All scores for these companies are based on a value set where each category is given equal weights.”
What are Value Sets?
Value sets are ways for investors to examine how different shareholder values may be affecting a company’s net impact ratio. Here are some of the most common value sets that are used to determine a company’s net impact ratio.
- Millennials – Not surprisingly, millennials are one of the demographics that are driving the growth of ESG investments. This number reflects the percentage of millennials surveyed that found the stock desirable for ESG purposes.
- Most Wanted Workforce – This number reflects the percentage of those who believe that the company is desirable to work for based on ESG metrics.
- Society First – This value set measures a company’s performance in the following areas: taxes, societal infrastructure, societal stability, and equality & human rights
- Knowledge First – This value set measures a company’s performance in the following areas: knowledge infrastructure, creating knowledge, distributing knowledge, and scarce human capital
- Health First – This value set measures a company’s performance in the following areas: physical diseases, mental diseases, nutrition, relationships, and meaning & joy
What are the Benefits of ESG Ratings?
As said above, the principal benefit of investing in ESG stocks is the ability of investors to align their investments with their personal values. This is allowing investors to promote socially conscious businesses in the way they distribute their investment dollars. Also, having metrics such as a net impact ratio makes it easy for ESG investors to compare one stock to another.
What are the Risks of ESG Ratings?
One risk related to ESG ratings is a lack of clarity on ESG guidelines. Many companies, particularly fund companies, use proprietary formulas to create an ESG rating. However, the weighting that one company assigns to a particular aspect of ESG is likely to vary from company to company. This also means that investors must pay close attention to the method used in assigning an ESG rating. Some ratings may be more heavily weighted to one aspect over another.
Another risk is that while ESG stocks as a group may outperform other stocks, there can be poor-performing stocks that have high ESG ratings. A good example of this would be some clean energy stocks such as hydrogen stocks. The long-term outlook for these stocks may be promising, but as of 2022, the payoff remains years away. However, the same was said of solar stocks. But since the Covid-19 pandemic, solar stocks have been among the best performers.
Yet another potential risk of ESG ratings is that making a commitment to companies with a high ESG score may mean that investors are excluding some of the top-performing stocks which can affect their total return.
This brings up another potential risk of ESG ratings. As of August 2022, there are still many companies that haven’t received an ESG rating.
Do ESG Stocks Outperform the Market?
This is still a relatively young area of the stock market, but there is some evidence that ESG stocks do outperform the market. Or at least they have the potential to do so. That’s because adhering to ESG principles can be financially material to a company’s bottom line. In fact, in many studies, companies that scored high on ESG issues have tended to deliver higher profits and stronger overall financial results.
However, this is an area where investors must “know what they own.” There are companies that have a high ESG score but they may not have much impact on the climate at all. If that is an investor’s primary focus, the company may not align with their values. Or an investor may be highly concerned about equity among the management team, but a company could have a high ESG rating for other reasons.
What is Greenwashing and How Does it Affect ESG Stocks?
Greenwashing is the practice of communicating false or misleading information about the environmental benefits of a company’s products. This doesn’t mean that the claims aren’t true in some fashion. But the intention is that the company is trying to make their claims sound better than they are.
If greenwashing makes you think of whitewashing that’s intentional. The term was coined as an environmental twist on the conventional term. There is a distinction. Whitewashing refers to the practice of providing misleading information to gloss over bad behavior. Greenwashing doesn’t mean a company is hiding bad behavior, but they are embellishing their “good” behavior to materially impact their share price.
In response to greenwashing, the United States Federal Trade Commission (FTC) has enacted laws to punish companies that engage in greenwashing. Furthermore, the agency has issued guidelines to help consumers understand the claims that companies make. Some of these include:
- Any “green” claims need to be explained clearly and visibly on a company’s packaging and advertising.
- A claim needs to be specified as being attributable to the product itself or the packaging of the product and to what extent is the claim being made.
- Claims should not be overstated
- Substantiation needs to be supplied for any competitive claims
ESG Stocks Are the Inverse of Sin Stocks
In the 1980s, the term “sin stocks” was coined to describe companies who sold products tied to popular vices. Tobacco stocks fall under the list of sin stocks as do stocks of companies who sell alcoholic beverages. The list also includes gambling stocks, stocks linked to adult entertainment, and in the last decade has expanded to include marijuana stocks.
As an investment strategy, investors chose to invest in their values by avoiding placing these stocks in their portfolio. This included putting pressure on fund managers to design funds that didn’t include these funds as part of its holdings.
However, while sin stocks helped provide a framework for what many investors were against, it didn’t express what they were for. That’s where ESG stocks come in. Here investors can contrast what companies they won’t invest in against the companies they will invest in.
How to Invest in ESG Stocks
The first step in investing in ESG stocks is to identify the stocks that meet your specific criteria. MarketBeat has an ESG stock screener that is available to Premium members. This tool allows investors to sort through a list of the top 100 ESG stocks based on selectable criteria such as:
- Value Set (i.e. the importance of different impact categories)
- Sector
- Market Cap
- Media Sentiment
- Analyst Consensus
Investors can invest in individual stocks. Or, if they want to get the benefits of immediate diversification, they can choose to invest in an exchange-traded fund that focuses on ESG investing. Some of the more popular ETFs that focus on companies with a high ESG score include:
What Do ESG Stocks Say About the Economy?
ESG stocks can be found in virtually any stock sector. For that reason, there are no specific economic indicators that measure the impact that highly rated ESG companies are having in the economy. However, since some of these stocks tend to focus on issues like sustainability and clean energy, investors can expect ESG stocks to climb along with interest in these sectors.
With that in mind, as more investors demand to know a company’s ESG score, it may lead to more and more scores carrying less and less meaning. This will be an area for investors to watch in the coming months and years.
