The fundamentals of ESG investing

ESG investing, also known as impact investing, is a recently popularized method of investing centered on three main pillars: environmental conservation, social good and government, and the term itself is an acronym for the phrase: Environmental, Social and Governance. Investors who choose this form of investing seek to earn solid returns on their money while investing in companies that are sustainable and yield positive benefits to their consumers.

For a company to be classified as an ESG leader, it needs to meet a certain set of requirements in each of the three categories.

According to the Motley Fool, Morgan Stanley Capital International, or MSCI, has created the most popular ESG scoring system to rank companies on their ESG performance. The lowest score a company can receive is a CCC, meaning that it is an ESG laggard, and the highest score a company can receive is an AAA, meaning that it is an ESG leader, according to the MSCI. Only 24% of companies rated by the MSCI have received an ESG score of AA or AAA, according to the Motley Fool.

But how does the MSCI ESG scoring system work?

Well, the organization rates companies on hundreds of metrics under the three main categories of ESG, and assigns them a score out of ten, according to Business Insider. But not all metrics have the same effect on a company’s overall score. Metrics that have the shortest timeframe are given higher weights and contribute more to a company’s end rating than metrics whose effects are not expected for decades to come.

Some important environmental metrics that rating agencies often use include carbon emissions, pollution, deforestation or environmental destruction, oil spills and resource consumption, among many others, according to Investopedia. In this category, many oil and energy companies falter because of their unsustainable practices and pollution.

On the other hand, companies that are revolutionizing society to be more environmentally friendly, like Tesla, excel in this category; Tesla achieved a score of 9.1 out of 10 on the environmental metric, compared to an industry average of 6.5, according to Reuters.

When it comes to the social aspect of ESG, Investopedia notes that some of the most important metrics are workplace conditions and a company’s relationships with its community. Companies that have strong employee retention and an array of employee benefits are likely to achieve high ratings in this category.

For example, Microsoft was given a social score of 98 out of 100 by the rating agency Refinitiv, according to Know ESG. Companies notorious for high employee turnover and unfavorable working conditions, intuitively, are among the companies most likely to receive very poor social ratings.

Underneath the governance umbrella of ESG is a set of metrics pertaining to how a company is run. They include diversity among leadership, corporate accountability and avoiding conflicts of interest when selecting board members, according to Investopedia. In light of the company’s unethical corporate actions, U.S News reports that Wells Fargo is an ESG laggard, especially when it comes to governance.

So, after understanding what ESG investing is, and the key characteristic of both ESG leaders and ESG laggards, how can the investor get the most value from this investment strategy?

Well, investors can invest in special ESG funds, made up of many companies with strong ratings. The Vanguard FTSE Social Index Fund, the iShares MSCI USA ESG Select ETF and the Shelton Green Alpha Fund are all very common options for ESG investors, according to Forbes.

But for investors who want more autonomy than simply investing in a pre-made fund, there are many free charts, screeners and tables to help them find the ESG stocks that are best suited for their portfolios, according to Kiplinger. ESG investing has the potential to yield great returns to the investor, but an even bigger potential to make a significant impact on both society and the environment.