What are risks to ESG investing?

What are risks to ESG investing?

ESG investing analyses a company’s ability to follow and embed positive environmental, social, and governance principles (ESG). Investors are increasingly keen to align their portfolios with ESG-related organisations and fund providers. This makes ESG investing a very exciting area of growth. 

ESG investing not only aligns with a robust business sustainability strategy, but it also yields positive effects on the environment and society. This approach underpins the value of integrating environmental, social, and governance factors into investment decisions, offering numerous advantages for businesses and contributing to the broader sustainability agenda. However, it’s important to be cognizant of the risks associated with ESG investing. As the current ESG landscape continues to evolve, it presents both opportunities and challenges. Understanding these dynamics is crucial for developing a comprehensive business sustainability strategy that navigates potential risks while capitalizing on the opportunities ESG investing brings.

The current ESG landscape 

Before we jump into the risks of ESG investing, it seems only right to provide a picture of the current ESG landscape. It is clear that investment is required to push for renewable energy development, enforce ethical business practices, establish social advancement opportunities, and help businesses improve their operations by incorporating ESG values and managing their ESG risks. 

Environmentally conscious investors employ environmental, social, and governance (ESG) investing to identify potential investments based on a set of principles for an enterprise’s behaviour. The environmental criteria look at how a business safeguards the environment. For instance, whether they have corporate policies that address the climate crisis. The social criteria assess how a business manages relationships with suppliers, employees, customers, and communities where it operates. 

The governance component then deals with an enterprise’s leadership, shareholder rights, executive pay, internal controls, and audits. New ESG funds and ETFs are frequently increasing, and research is showing younger generations, Millennials, in particular, place great importance on socially responsible investing. ESG investing can take several forms. For instance, making investments in organisations is considered to be positively addressing social or environmental challenges. 

Another example would be choosing to exclude organisations in specific industry sectors viewed as concerning from an ESG point of view. Additionally, embedding ESG data into an assessment of risk-adjusted returns to make decisions regarding investment. Many mutual funds, Robo-advisors, and brokerage firms now provide investment products that employ ESG principles. This form of investing can also assist portfolios to ensure businesses engaging in unethical practices are held accountable.

Advantages of ESG investing

There are many advantages of ESG investing. For one thing, ESG criteria can assist investors in avoiding working with organisations that have risky or unethical practices. Additionally, this allows these businesses to be held accountable for their actions and the consequences of these practices. A brilliant example of this is the BP 2010 Gulf of Mexico oil spill. Another good example is Volkswagen’s emissions scandal. Both of these scandals rocked the companies’ stock prices and ultimately cost them billions of dollars. 

Organisations that prioritise ESG values gain more traction, and investment firms are increasingly tracking their performance. There is huge value to ESG investing. In saying that, its value is dependent on whether or not the investors push businesses to drive genuine change and use their business as a force for good. They must do more than simply tick off some boxes and publish sustainability reports. 

For businesses, embedding ESG principles means crafting a corporate strategy that focuses on the three pillars of environmental, social, and governance. It also means taking action and measures to reduce waste, pollution, and CO2 output. In addition, working to have a more inclusive and diverse workforce, all the way up from the entry-level to the board of directors. While ESG may appear to be a time-consuming and costly practice, it can be incredibly rewarding for businesses. 

Challenges to ESG investing 

With the above in mind, what are the main challenges to ESG investing? What exactly is preventing customers and clients from embracing environmental, social, and governance investment? 

Fear

The biggest factor is something very close to home, and that is fear. If we’ve learned anything from the climate crisis, fear can be a great motivator. Our fear often encourages us to make the drastic changes needed to tackle the climate emergency we are facing. 

However, in the face of investing in ESG, fear can also act as an inhibitor. Many people worry about a conflict between returns and ESG. They grow concerned the returns will be compromised in the interests of sustainability.

Alternatively, they will be compromised by a conflict between social and environmental factors. However, this is a misconception. The belief that embedding ESG values into investor decision-making places income at risk couldn’t be further from the truth. 

In reality, there is no evident conflict of interest between E, S, and G. In the long-term, businesses that act responsibly or sustainably to some degree, who do not have responsible practices in place and are poorly governed will be much more challenged regardless. 

Greenwashing

Another significant threat or challenge is the unethical practice of greenwashing. These kinds of tactics mask the value of ESG and prevent it from having a full impact. Misleading and misapplied metric analysis plays a part here too as it makes it very difficult for advisers and investors to comprehend ESG ratings

Ultimately, one single data-driven ESG rating should never try to be everything at once, nor can it ever be. At the very least, there must be two distinct ratings. One of these ratings should be for its negative externalities, while the other should reflect the enterprise’s positive impact.

For instance, the ESG rating could assess the negative effects a business has while the other system could assess the positive effects of business activities. A framework that could be utilised here would be the UN’s Sustainable Development Goals (SDGs). These goals will help a business identify what areas we should be focusing on as a society and drive innovation with products and services that tackle the climate crisis.

Consumer pressure and regulation

There is a lot of scope for greater accuracy to allow for improved and more transparent reporting and metric analysis. In saying that, we must still acknowledge the consumer pressure that currently exists and our current regulations. There is pressure both on the consumer side and regulatory side. 

With this, it seems plausible to expect an organisation’s behaviours to be shown mainly through social media and disclosure. This is what encourages people to buy their products and avail of their services or to go elsewhere. We are currently dealing with a cost of living crisis, and this is not something that is going away anytime soon. 

This is one challenge the recent IPCC focused on in addition to where we are with the climate emergency. The kind of stress consumers are currently dealing with is a big inhibitor for ESG. Due to this shift in well-being, prioritising social elements is necessary before looking to caring for the environment. The challenge and question always remain whether consumers will make the more responsible or sustainable decision. 

Everyone is at a different level of coping, so some are unable to make the more planet-friendly choice or cannot justify it currently. This is where government regulation can make a big difference to increase the demand for environmentally-friendly products and services to increase demand and make them more accessible. 

The opportunities within this space 

Just as there are many threats and risks to ESG investing, there is also a plethora of opportunities for sustainable investing for investors. These opportunities come in various forms, ranging from methods to invest to the amount of choice available. Other opportunities consist of ways an adviser’s role concerning clients can be readjusted to consider new potential investments on the horizon. 

One thing advisers could discuss with their clients is the advantage of double materiality. It has a double impact on societal and financial issues and holds immense promise for ESG. People are too becoming increasingly aware of how an enterprise’s actions and measures can enhance both the world it operates in and its profit margin. It is also important to acknowledge that businesses that act responsibly on environmental and social problems will have stronger brands than those that don’t. 

In addition, today’s youngest consumers expect businesses to act on climate. They have grown up learning about the environmental crisis we are taking and have taken considerable action to raise awareness and inspire action. Businesses must appeal to the new, ESG-aware generations of savers and spenders if they want to succeed in the future. Without a long-term, adequate approach to sustainability, brands will find themselves unable to sustain their own profit growth. 

Summary

ESG investing is an exciting space, and it presents a lot of exciting opportunities for businesses and investors alike. However, there are still risks, and it is vital to recognise these so we can move forward. Some of these include fear, greenwashing, and consumer pressure and regulations. 

These risks act as barriers to encouraging and driving investment flow. While the risks are understandable, we must overcome them, and the best way is to craft a long-term, realistic sustainability strategy that considers the planet, people, and profit at each stage.

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