Investing For Impact: The Evolution of “ESG”

Our team at Two Point Capital Management likes to ensure our clients are up to speed on critical trends shaping the investment industry. And there is no doubt that the ESG space is a hot topic today.

The growth of ESG reporting has significantly expanded the concept of “corporate fundamentals,” making a wealth of new data points available to assess the strengths and risk factors of any company. In the first of two blog posts on ESG, we share important background on how the term is defined, its evolution over recent decades, and why it matters for investors and their advisors. In the next blog post in the series, we’ll take a deeper dive into how individual investors can start to think about ESG relative to their own portfolios.

Those who follow the financial or business press have likely noticed an increase in coverage of the acronym “ESG” in recent years relative to both corporate practices and investing.

Short for “environmental, social and governance,” ESG describes a set of criteria that establishes standards for a company’s operations. These standards then allow institutional or individual investors to make choices regarding the companies they wish to support with their dollars, aligned with personal values.

Financial education website, Investopedia, shares this helpful definition of each component of ESG: “Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.”

An Evolution Decades in the Making

The idea of judging corporations by the actions they take – or the impacts they make – is not new. This was common even before the latter part of the Twentieth Century from a legal and regulatory perspective, as well as in the realm of investigative journalism. Just think back to journalistic “muckrakers” like Upton Sinclair who exposed dire working conditions in the meat packing industry in 1906. Yet the question of how corporate practices in areas like environmental or social responsibility should impact investment choices has gained increased attention in recent decades.

Our founder, Jack McGowan, recalled the 1980s as a key turning point. This was when calls for divestiture (or divestment) from companies operating in South Africa increased along with a growing resistance to Apartheid. While this was a macro global issue that ultimately prompted United Nations sanctions as well as U.S. Federal legislation, the movement focused a spotlight on investment choices driven by social issues and awareness.

This market has evolved in some obvious ways since the 1980s. First there is the name itself. Until the mid 2000s, the more common nomenclature was “SRI” or socially responsible investing. In 2005 and 2006, the United Nations helped to establish principles for responsible investing with a focus on environment, social and governance factors. This set the stage for today’s prominence of ESG as the dominant term and set of processes.

Second, there has been massive growth in investment choices. Four decades ago, options were few to none for those looking to invest in funds tied to an ESG (or SRI) strategy. Today, there are scores of ESG options among mutual funds or exchange traded funds. And for those seeking to invest in individual companies, there is a wealth of additional information now available to help dig deeper into corporate fundamentals – that is, the fundamental strengths or weaknesses of a given company across many dimensions.

Growing Interest Drives Investment Questions

Along with the global disruption caused by the pandemic, 2020 also brought renewed focus on social issues. At the same time, the disasters caused by changing weather patterns have focused scrutiny on these growing challenges. These factors, among others, have further energized discussions about corporate responsibility across the spectrum covered by ESG.

Research fielded in early 2021 by PwC documented growing interest in this area – as well as growing expectations for corporations. The firm’s 2021 Consumer Intelligence Series survey on ESG polled several thousand consumers, employees and executives in March and April 2021 and found that:

  • 83% of consumers think companies should be actively shaping ESG best practices
  • 91% of business leaders surveyed believe their company has a responsibility to act on ESG-related issues
  • 86% of employees prefer to support or work for companies that care about the same issues they do

The increased emphasis on ESG has more individuals wondering how to incorporate this kind of investing style into their own portfolios. Given there is also an avalanche of information regarding ESG online, it can be overwhelming to know where to start.

While there are many components to understanding ESG, transparency is at its foundation. One of the most notable aspects of today’s emphasis on ESG is the increased transparency it provides into corporate strategy and execution. This offers a wider window into everything from the quality of the relationship between management and its workforce, or an organization’s ability to attract and retain truly diverse talent, to the potential environmental impacts of climate change on a company’s supply chain, or how sustainable (literally and figuratively) a company’s products or services may be in the years ahead.

This increased access to an expanded range of metrics has been a boon for investment managers like Two Point Capital Management, given our focus on building client portfolios based on the quality and value of individual companies (rather than relying on funds). The whole concept of “corporate fundamentals” has expanded due to the growth of ESG reporting. There are simply more data points to assess regarding strengths and risk factors relative to any corporate entity. For those with a long-term investment mindset, this fuels even better investment choices tailored to an individual’s goals.

Beyond the focus on ESG practices and investment choices, recent trends have also driven increased interest in giving back once wealth is created. That can be through charitable giving or by finding new ways of directing support where it is needed most. 2020 prompted many of our clients to consider increasing their emphasis on giving. This is a topic we will explore further in a future blog post.

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