As the Bank of America describes it “good companies make good stocks”. But ESG factors are more than a feel-good factor by investing in a company. Companies with higher ESG ratings tend to have lower stock price volatility. In addition, investors owning businesses with high ESG rankings have fewer value declines in their portfolios. [1]
ESG stands for the environmental, social, and governance information of a business.
Environmental: Describes the impact of a company on the environment. This metric includes factors such as carbon footprint, substances used for manufacturing, and sustainability efforts across the value chain.
Social: Describes the social impact of a business. This metric includes factors such as contribution to communities, racial diversity, and gender equality.
Governance: This metric targets directly the companies board and management. Factors such as executive payments, leadership diversity, and shareholder communication are measured. [2]
Why ESG Matters To Investors?
Companies with a higher ESG ranking gain more and more attention from investors, due to growing evidence that sustainability is linked to the performance of a company [3].
What does that mean?
To understand that we need to take a look at the consumer side. Future consumer generations also called millennials and Generation Z are much more concerned about topics such as environment, social responsibility, diversification, gender equity, and corruption. Researches show that the most important issue for these two generations is climate change. The consumer of these groups is much more aware of what they buy and where it comes from. Not only the brand they buy is in focus, but also the supply chain of the companies. One example is the fair trade label for cocoa or coffee.
Besides the consumer side, governments and regulators are highly focused on these topics. They need the corporate sector to fight issues such as climate problems, diversification, racial equality, or corruption. [3]
And here, another factor that comes into play is the cost of capital.
There is growing evidence that businesses that are taking more action in ESG topics have a 10% lower cost of capital. Businesses that are not focused on ESG topics may face a difficult time finding capital. Regulators and investors may avoid businesses with low ESG ranking, which leads to limited access to capital. In addition, consumers may also avoid goods from low-ranking ESG firms, which results in lower returns.[4]
Article Sources
[1] Bank of America Merrill Lynch, Equity Strategy Focus Point – ESG: good companies can make good stocks, December 2016
[2] Forbes, Environmental, Social And Governance: What Is ESG Investing?, https://www.forbes.com/advisor/investing/esg-investing/, March 2021
[3] McKinsey & Company, Strategy & Corporate Finance Practice – Why ESG is here to stay, May 2020
[4] Harvard Law School Forum on Corporate Governance, ESG Matters, https://corpgov.law.harvard.edu/2020/01/14/esg-matters/, January 2020