HomePreqin AcademyLesson 5: ESGWhat is ESG?

What Is ESG?

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ESG stands for environmental, social, and governance. In this lesson, we explore how ESG actively encourages investors to study the values of a company they might invest in. To analyze a company's environmental footprint, employee compensation, or policies on diversity, investors can use an ESG framework to invest responsibly.

ESG Investing

ESG investing is a form of socially responsible investing that seeks to prioritize environmental, social, and governance factors, alongside financial returns, in investment decision-making.

At the core of ESG investing stands the notion that creating value for all stakeholders will drive stronger returns. This is not a short-term strategy for immediate returns, but rather a long-term investment in people, the environment, and the governing structure behind decision-making.

Demand for ESG investing has soared in recent years, and ESG factors are increasingly being embedded into every part of the investment process. Referring to these factors allows investors to make more informed and conscious decisions when screening investments and companies. Investors can also evaluate the way they do business and ensure their business operations are geared toward the future.

Each individual letter (E, S, G) stands for an area of focus when evaluating a firm, a fund, or a portfolio. Explore the drop down to find out more about each aspect of ESG investing.

Environmental Factors

E stands for environment – ‘Environment’ looks at what impact a company has on the environment. This covers a wide range of issues, including climate change policies and attempts to reduce emissions, waste, and consumption of natural resources. It can also include the implementation of strategies that counteract damage to the environment, or ensuring that business operations align with the broader environmental goals of a firm or investor.

Social Factors

S stands for social – ‘Social’ as an ESG factor is about understanding how a company can improve its social impact, both within the organization and across society at large. This encompasses everyone within a supply chain that interacts with a firm or company, whether directly or indirectly (employees, customers, communities). Examples of social considerations include the treatment and compensation of employees, employee safety policies, diversity and inclusion practices, ethical supply chain sourcing, consumer protection measures, and charitable initiatives undertaken by the organization.

Governance Factors

G stands for Governance - ‘Governance’ takes a closer look at a firm’s structure and the composition of a company. This includes shareholder rights, independence and diversity among members of the board of directors, and internal policies which set limits and expectations of day-to-day operations.

ESG commitments as part of alternative asset investments have been growing significantly. An estimated 40% of the industry’s $14tn assets under management (AUM) is currently managed by ESG-committed firms (Preqin source). In previous years, ESG was seen as a niche addition to investment processes. Today, it has become a mainstream component in screening investments.

Preqin conducts research on how ESG impacts the world of alternative investments. Explore our ESG hub here.

ESG, Impact Investing, or Socially Responsible Investing

ESG is not a one-size-fits-all investment process. Varying interpretations provide different realities on what ESG means for firms and investors. As it is difficult to define ESG under one umbrella, numerous other terms are often used to replace or accompany ESG – ‘impact investing’ and ‘socially responsible investing’ are among them.

While these terms are often used interchangeably, there are slight distinctions between these investment strategies. ESG investing considers environmental, social, and governance factors alongside more traditional financial measures. Investors often use ESG scoring systems that use a range of criteria to evaluate companies based on each of the individual E, S, and G components. This provides a metric for comparing different investment opportunities.

Socially responsible investing (SRI) is similar to ESG investing but goes one step further by actively removing or selecting investments based on specific ethical guidelines. For example, an investor may choose to avoid investments in companies engaged in firearms production or the production of addictive substances, while actively choosing to allocate to companies with boards of directors that are gender-diverse, or that contribute to charitable causes.

While financial returns remain an important consideration in both ESG and SRI investing, impact investing goes further still. Impact investing aims to help organizations to accomplish specific goals that are beneficial to society or the environment – it places positive outcomes at the heart of the investment decision.

ESG and Risk Management

The management of risk is often seen as one of the key benefits to ESG investing. Evaluating investment opportunities using ESG criteria can help investors to avoid companies that might otherwise pose a significant risk due to environmental, social, or governance issues – issues that ultimately pose a risk to business operations and performance.

Stakeholders are therefore starting to see ESG factors as integral to a company’s strategy and longevity, and consequently demanding more accountability and transparency throughout the investment cycle. Managing risk is not just about preventative strategies, but about helping a company create more value and plan for long-term success.

Below are some examples of how ESG risks can be managed across each of the factors:

Environmental factors, such as the sustainable use and protection of water, transition to a circular economy, waste prevention, recycling, and protection of ecosystems can be instrumental in managing future business growth, especially in energy and resource-intensive industries. Companies that choose to ignore the risks that come with ESG issues can face long-term economic costs, depleting resources, and reputational damage.

Social factors such as creating a collaborative, diverse, and supportive company culture for employees can have direct impact in performance, employee retention, and innovation. McKinsey’s research of over 1,000 organizations and three million people found that companies with cultures in the top quartile of diversity perform 200% better than those in the bottom quartile.

Governance factors, such as diversity among executives and the board of directors, can improve performance and foster more varied thoughts and ideas. In 2018, McKinsey examined data from 366 public companies in the US, Canada, Latin America, and the UK to find that companies in the top quartile for gender, racial, or ethnic diversity are more likely to generate above-median financial returns.

Risk factors vary greatly based on the industry in which a company operates. For example, risk factors such as natural disasters are top priority for real estate firms. On the other hand, GPs that invest in supply chain might also need to focus on labor standards, or introduce a Modern Slavery Policy, to assure decent pay and working age requirement for all employees.

The ESG Investment Process

To incorporate ESG factors into the investing process requires a high level of engagement with portfolio companies from the GP’s side, because ESG integration does not end at the investment stage. It is important that a GP continues to engage with companies post-investment to ensure that ESG integration is carried out successfully.

The stages of an ESG integrated investment process are:

In this lesson, we revealed all about the meaning of ESG, and how it impacts alternative investments. In the next lesson, learn about the history of ESG.

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Next up: History of ESG