ESG investing: pros, cons and how to comply (2024)

ESG investing is a form of investing that takes environmental, social and governance (ESG) factors into account when making investment decisions. ESG factors include things like a company's carbon emissions, employment practices and board diversity. Investors have been looking for investments that align with their morals and values ​​for a number of years – and ESG investing started with the intention of doing just that. Unfortunately, the investment industry wanted to create niche products that did not really integrate these aspects into the portfolio construction. Fund managers want to do what they have in common: provide investors with solutions that generate income (for the managers) and deliver returns (for their investors). For this reason, regulators have stepped in to not only provide guidance and direction, but also monitor fund managers to ensure they meet the requirements to label an investment as an ESG investment.

There are many benefits to ESG investing. First, it can help investors align their investments with their values. For example, investors concerned about climate change may choose to invest in companies that are working to reduce their carbon footprint. Second, ESG investing can help investors manage risk. By considering not only financial performance, but also ESG factors, investors can identify potential risks that may not be apparent from financial data alone; for example, the risk that a factory is located in an area increasingly exposed to flooding. Third, ESG investing has been shown to have a positive impact on the environment and society. For example, a study by the Global Impact Investing Network found that impact investing outperformed traditional investing by 3.2% per year over a ten-year period.

However, there are also some disadvantages to ESG investing. First, ESG funds can have higher-than-average expense ratios. This is because ESG investments require more research and due diligence, which can be expensive. Second, ESG investing can be subjective. There is no one definition of what constitutes an ESG investment, and different investors may have different criteria. This can make it difficult for investors to compare ESG funds and ensure they are investing in a fund that truly aligns with their values. Finally, there is the risk of greenwashing, where a company or fund makes false or misleading claims about its ESG credentials.

Here are some specific ESG factors that investors may want to keep an eye on:

• Environmental factors: a company's carbon emissions, water consumption, and waste disposal practices
• Social factors: a company's working practices, human rights record, and commitment to diversity and inclusion
• Governance factors: the composition of a company's board, management compensation and incentive structure, and internal controls

Investors can monitor ESG factors using a variety of methods and tools, including:

• Self-reporting: Companies are often required to self-report their ESG performance to regulators. This can be done in various ways, such as submitting a report, completing a questionnaire or participating in an audit.

• Third-party verification: Regulators may also require companies to have their ESG performance verified by a third party. This can be done by an independent auditor, a rating agency or another organization specializing in ESG compliance.
• ESG data providers: There are several ESG data providers that collect and aggregate ESG data from companies. This data can be used by regulators to monitor ESG compliance and identify non-compliant companies.
• ESG Ratings: ESG ratings are a way to assess a company's ESG performance. These ratings are often used by investors and other stakeholders to make decisions about where to invest their money.

The specific methodology used to monitor and evidence ESG regulatory requirements will vary depending on the jurisdiction and specific requirements. However, the methods described above are some of the most common approaches.

Naturally, monitoring a new type of investment comes with challenges, including:

• Lack of standardization: There is no one universally accepted definition of ESG. This can make it difficult to compare companies' ESG performance and assess whether they meet regulatory requirements.
• Data Availability: ESG data can be difficult to obtain and expensive to collect. This can make it difficult for companies to comply with ESG legislation requirements.
• Greenwashing: There is a risk of greenwashing, which can make it difficult for investors and other stakeholders to know which companies are actually committed to ESG.

In addition to these challenges, regulators have shown that they are not afraid to impose huge fines on companies that incorrectly categorize themselves as ESG:

• Goldman Sachs: In 2022, Goldman was fined $4 million by the SEC for misleading investors about its funds' ESG credentials.
• BNY Mellon: In 2022, BNY Mellon was fined $1.5 million by the U.S. Securities and Exchange Commission for misrepresentations and omissions related to ESG.
• Deutsche Bank: Deutsche expects Deutsche to pay a $30 million fine from the SEC in 2023 for mismanagement of ESG funds.

These fines remind us that ESG investing is a complex and evolving field. Investors should do their due diligence and select ESG funds that truly align with their values.

Despite these challenges, ESG is becoming increasingly important to investors, regulators and other stakeholders. As a result, we can expect to see more innovative methods developed to monitor and prove ESG regulatory requirements in the future.

In the meantime, companies should consider providers or solutions that help investigate requirements. As these requirements continue to evolve, using accurate data points and accurate analytics will help reduce issues with regulators. Companies must also continue to think ahead in monitoring these topics. As we continue to see the development and use of artificial intelligence, I see myself being able to solve these problems much more quickly and efficiently in the future.