ESG investing incorporates elements of sustainable, socially responsible, and impact investing and is a method for evaluating how a company’s environmental, social, and governance practices may impact its stock return potential.

Below is a closer look at the three criteria for ESG:

• Environmental considerations include carbon emissions, waste, natural resource efficiency, renewable energy usage, and climate change initiatives.
• Social factors can be elements such as workplace diversity, human capital and supply chain management, product integrity and safety, and community impact.
• Governance generally incorporates board and executive diversity, corporate structure, accounting practices, transparency, and executive compensation.

There are various ESG rating systems set up by different ratings agencies; some of the rating systems are ESG performance-based while others are ESG risk-based.

The major ESG rating agencies include MSCI, RobecoSAM, CDP Global Environmental Information Research Center, and FTSE Russell, among others.

These companies provide ratings based on their ESG policies and systems and measures, and they gather information from multiple sources including companies’ publications, the government data bank, media, nongovernmental organizations (NGOs), and other stakeholders. Questionnaires may also be used to collect additional information from the companies.

During the rating process, the agencies will use a specific mechanism to adjust the score of the company based on its industry. At the same time, the relative performance of the company against its peers will also be used as a benchmark to obtain a universal rating that’s comparable across industries.

A Note on ESG Scores

Some ESG investments use negative screens that exclude or underweight companies that don’t score well, while others use positive screens to weight high-scoring companies more heavily.

Still others will completely exclude certain parts of the market—such as weapons, tobacco, or companies who rank poorly on carbon emissions.

Investors should do their research if there are specific products or practices they want to avoid. However, it’s important to remember there’s no such thing as a perfect company.

For that reason, many institutional ESG investors also use their power as shareholders to engage in direct dialogue, proxy voting, and shareholder proposals. Shareholder practices can encourage companies to follow ESG guidelines and continuously improve in these areas.

There are several terms often used interchangeably when referring to investing with a cause in mind.

However, each strategy typically has different goals and methods. Here’s a look at the different investing practices and how ESG incorporates elements of each.

What Is Sustainable Investing?

Sustainable investing typically focuses on an investment’s impacts on the environment. In a portfolio, it involves underweighting or excluding companies with poor environmental considerations or overweighting companies with positive environmental practices.

For example, a sustainable mutual fund manager may select companies that use environment-friendly product designs or exclude companies that emit harmful toxins and pollutants as part of their manufacturing processes.

Socially responsible investing generally screens out companies associated with undesirable social practices, such as child labor, or entire product categories, such as gambling, tobacco, alcohol, and certain pharmaceuticals.

The primary focus of impact investing is to make a positive social or environmental impact alongside a financial return.

Investments into impact-oriented institutions or funds provide capital to address a multitude of challenges, such as sustainable agriculture, renewable energy, and affordable and accessible health care, housing, and education.

Investors have varying reasons for using ESG criteria to evaluate their portfolios. Most share a sense of responsibility to use the power of their dollars to improve business practices. Many believe that companies focused on remaining sustainable in the future will do well over the long haul.

The growth speaks for itself. ESG funds captured $51.1 billion of net new money from investors in 2020, a new record, and more than double the prior year of $21 billion, according to Morningstar.

At the same time, ESG funds accounted for about a fourth of the money that flowed into all US stock and bond mutual funds last year. That’s a record and a big leap from the 1% share around 2014.

The growth comes as investors—primarily younger cohorts—are more concerned with systemic issues like climate change and wealth inequality. 2020 tied for the warmest year on record, and Black Lives Matter protests took place globally in the wake of George Floyd’s death in police custody. President Biden is trying to make climate change a core focus of his administration, which could provide more interest in ESG funds.

According to Morningstar research, young millennial investors have more assets to invest and are moving into decision-making roles at institutions that make investments like endowments and pensions.

Investors also have more choices than ever. The number of sustainable funds available to US investors grew to almost 400 in 2020—up 30% from 2019 and a nearly fourfold increase over a decade.

From a performance perspective, there’s been much debate as to whether ESG investing outperforms over time. A recent analysis by S&P showed ESG funds had stronger returns than their peers and the broader market during the pandemic.

Morgan Stanley, Morningstar, academic researchers, and others offer similar analyses that suggest ESG-focused funds and companies were better shielded from economic downturn during the COVID-19 pandemic.

That said, longer-term studies are mixed, and it remains to be seen whether ESG performance trends will continue. It does stand to reason that companies that score highly in ESG measures may be more efficient in resource usage and more resilient to ethical lapses and climate risk.

Either way, if you’re concerned with the impact your invested dollars have, it’s important to know your options and make sure your investments align with the issues that are important to you.