What are the benefits and drawbacks of ESG investing?
The pros and cons of implementing ESG factors
There are three main potential benefits of ESG investing:
First, it can help you put your money where you want to make an impact by targeting issuers with, for example, low carbon footprint, strong pay practices, or community involvement. This creates another reason to invest besides generating returns: contributing to a more sustainable future.
Speaking of generating returns, ESG investing can often be associated with diminishing returns. However, evidence suggests that solid ESG practices can result in better financial performance, and that integrating ESG considerations into the decision-making process may help drive outperformance.
Lastly, regulators and asset owners have joined forces to improve consistency and transparency in corporate disclosures. However, although many initiatives have been launched in recent years, we’re still far from adequate financial and non-financial reporting. The global Task Force on Climate-related Financial Disclosures (TCFD), for example, reported in 2019 that disclosures have increased since its creation in December 2015, but are still insufficient for investors. This means that companies already disclosing ESG risks may trade at a premium versus those with inferior sustainability reporting standards.
ESG investing also comes with three main potential drawbacks:
Some ESG investing techniques such as negative screening exclude entire sectors, industries, or regions with low ESG scores (e.g., tobacco, oil, Russia). This means that if the energy sector, for example, outperforms thanks to a surge in oil prices, ESG portfolios may lag for a certain period because of limited to no exposure to that sector.
The second potential drawback is greenwashing. As ESG investing has become one of the most popular investment strategies in recent years, some corporations and fund managers may be tempted to take advantage of this trend and provide misleading ESG-related information—for example, a fund name that falsely implies a greater degree of ESG integration than there really is. Scrutinizing portfolio managers’ investment processes has thus become even more critical.
As mentioned in the benefits section, we’re still far from reaching a level of data standardization that is sufficient for investors. Moreover, methodologies used by ESG data providers may differ greatly. This means that it’s hard for investors to compare companies and funds from an ESG standpoint.
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