Leveraging ESG for Investment Decisions

Environment, Social, and Governance (ESG) is a new term in the realm of social and overall development. Previously, the focus was mainly on assessing the financial and operational sustainability of businesses when evaluating them. The concept of responsible finance was coined by major international development organizations in the context of financing various financial and non-financial institutions that serve the impoverished segments of society.

While profit-making companies working towards social causes needed to demonstrate their financial and operational sustainability to investors and stakeholders for compliance or to attract additional funds, civil society organizations dependent on donations had to showcase their social impact to secure more support from donors. Recognizing the importance of addressing these issues, governments and large corporations embraced the idea of corporate social responsibility. This created a platform for commercial companies to showcase their social development work to all stakeholders, including investors.

Furthermore, policymakers and environmental advocates scrutinized these companies, particularly those involved in manufacturing and value addition, for their impact on the environment and local communities. The introduction of ESG coincided with a period when large enterprises were examining their social development projects and seeking to leverage their impactful work for large-scale funding. This was also a time when social enterprises proliferated, and global efforts transitioned from the Millennium Development Goals (MDGs) to the Sustainable Development Goals (SDGs). Sustainability became the focal point of all development ideas, with social, economic, and environmental sustainability forming the core strategies. Governance was later incorporated into this core group, culminating in the definition of ESG as we know it today. However, ESG remains a work-in-progress.

ESG investing has experienced rapid growth over the past decade, exceeding USD 17.5 trillion according to industry standards. These investments were part of professionally managed ESG-focused portfolios worldwide. ESG-related traded investment products also surpassed USD 1 trillion across various financial markets globally. This growth reflects the increasing interest of investors in ESG factors, including the assessment of risks and opportunities that impact the long-term performance of companies and influence policymakers. Although definitions of ESG may vary in terms of risks, indicators, sub-indicators, weightage, and probability, most developed countries, institutions, and think tanks acknowledge its importance and future potential. In general terms, ESG investing seeks to integrate environmental, social, and governance factors into asset allocation and risk decisions, aiming for sustainability and long-term financial gains. The extent to which the ESG approach incorporates long-term financial, environmental, and social risks and returns is crucial.

Recent academic and non-academic research highlight numerous benefits and long-term sustainability strategies associated with incorporating ESG at the core of financial and social development agendas. Several factors contribute to the significant attention ESG receives:

a) ESG investing, under certain conditions, can enhance the overall risk management of an entity. Furthermore, financial returns are comparable to traditional business approaches, making compliance with globally accepted standards a worthwhile endeavor.

b) Climate change risks, responsible business conduct, workplace diversity, and social influence on investors, consumers, and stakeholders are topics people worldwide are now more aware of.

c) Corporations and economies increasingly prioritize long-term strategies for sustainable development, giving equal importance to internal and external factors, including environmental, social, and governance perspectives.

d) Investors and philanthropists interested in enhancing sustainability in the long run tend to favor investments that have a positive impact on societal values and benefit the local community.

In addition to these reasons, evidence suggests that incorporating external factors into financial sustainability maximizes social, environmental, and financial returns. ESG has become a topic of discussion in numerous public sectors, including central banks, as institutions support the transition of traditional financial systems toward greener, low-carbon, and equitable economies. Central banks in developed and developing economies have demonstrated their commitment to incorporate ESG assessments in their decision making process.

Moving forward and become future ready finance industry is developing new products and services related to ESG ratings, indices, and funds. New companies are growing fast to capture the market looking for ESG assessments, indexes, equity and fixed income funds and ETFs. Investors are allowed to engage with ESG investment through low-risk products and models like money market funds, passive smart beta ETFs, they are also allowed to take suitable positions through hedge funds. There are number of products available to suit different kind of investors, like one looking for a low-carbon economy can put their funds in green transition and renewables funds. Financial markets are now agile, transparent and customer-oriented to capture upcoming clients for their new innovative products.