What are ESG Stocks?

Investors are increasingly interested in companies committed to a sustainable future. Environmental, social and governance (ESG) criteria are a set of metrics that guide sustainable and responsible companies. 

You can build a portfolio that promotes a better future by seeking out stocks that fulfill ESG criteria. Learn more about ESG criteria and stocks now to incorporate ESG rating into your investing strategy.

Strong ESG Programs Can Increase Stock Liquidity

Because ESG stocks typically boast better operational performance and a lower cost of capital, they are favored by investors in all markets, even bear markets. This makes them highly liquid. 

High stock liquidity means ESG stocks are easy to buy and sell rapidly. When stocks have high liquidity, your trade can be executed soon after you place it, and get in or out at the price you want.

This is especially important during down markets. In the event you need to sell off a portion of your portfolio to protect against loss or cover an emergency expense, you need stocks that sell rapidly. Otherwise, the bid-ask spread could be far greater than you were prepared for.

ESG Investing Trends

As ESG investing grows in popularity, the market is seeing new trends in how investors incorporate that ESG data into their portfolio. There is a shift toward renewable and alternative energy stocks and a growing global interest in tracking ESG criteria in international markets.

With stronger cap and trade legislation imminent and growing public demand for cleaner solutions, now is the time for investors to rebalance their energy portfolio toward wind, solar, and other renewables. Using ESG criteria to identify the strongest stocks in those categories can minimize your risk exposure while still allowing you to get in early on stocks that are poised to become the new energy giants.

Interest in ESG investing is even spreading internationally as KraneShares jumps into the ESG fray with its new China fund. Incorporating international companies into your portfolio is key to fully diversifying your portfolio, and ESG criteria can help you manage risk exposure and ensure you invest ethically on a global scale.

ESG Metrics

While different databases use different metrics to evaluate ESG stocks, they all generally look for similar indicators of risk and responsibility. 

Here are some of the key ESG metrics used:

• Dependence on carbon-intensive supply chain
• Land or ecosystem disturbance caused by company’s operations
• Environmentally controversial investments
• Toxic emissions and waste
• Discrimination and diversity
• Labor standards controversies
• Human rights concerns
• Tax gap
• Anti-competitive behavior
• Bribery and corruption controversies

Databases typically use dozens or even hundreds of different metrics to evaluate ESG criteria in a stock. The list above is only a small subset. When you’re exploring different ESG databases, you can look at the specific metrics they rely on to make to give their ratings. Then, decide which metrics best reflect your investing goals.

CFA Institute to Develop ESG Disclosure Standards for Investment Products

While interest in sustainable investing strategies has been increasing for the last 30 years, mutual funds and asset managers have yet to establish a consistent way to evaluate investments by these criteria. 

ESG data has become somewhat more readily available thanks to the internet. However, a major roadblock still exists: companies aren’t yet required to report on a specific, standardized set of ESG criteria. The lack of standardization can make it harder to compare stocks as one company might voluntarily announce its environmental policies while another only announces its labor policies.

To address this gap in data, the CFA institute published a proposal for developing voluntary ESG disclosure standards for investment products. The disclosures would allow the CFA to evaluate a company’s ESG programs and then provide investors with an easy-to-use reference for identifying ESG stocks. A first draft of the standards is expected in May 2021. 

What are Environmental, Social, and Governance (ESG) Criteria?

ESG criteria are a broad set of criteria in each of the 3 categories ESG investors evaluate. There are no mandatory reporting requirements, so it’s not always possible to evaluate stock by these criteria.

Among those who voluntarily report, these are the criteria as laid out by the CFA:

Environmental Criteria

Environmental criteria include measures of how a company’s operations affect the environment. This includes harm reduction criteria like low or no carbon emissions as well as proactive, positive impact criteria like restoration projects or charitable programs.

Here is a list of the basic environmental criteria:

• Carbon emissions
• Air and water pollution
• Waste management
• Energy efficiency
• Deforestation
• Water scarcity
• Biodiversity

Social Criteria

This is a broad category that considers both customer and employee satisfaction with the company. 

The criteria include:

• Labor standards
• Human rights
• Data protection and privacy
• Community relations
• Gender and diversity
• Customer satisfaction
• Community relations

Governance Criteria

Governance refers to the internal operations and leadership of the company. The criteria measure levels of transparency, accountability and political activity. 

Here are the key measures used to evaluate good governance:

• Board composition
• Executive compensation
• Audit committee structure
• Political contributions
• Bribery and corruption
• Lobbying
• Whistleblower schemes

Pros and Cons of Environmental, Social, and Governance (ESG) Criteria

There are a lot of important reasons to use ESG criteria to build your investing portfolio. However, there are also some important limitations to consider.

Here are some of the major pros and cons of ESG criteria:

Pros:

Enhanced Reputation and Brand Loyalty

Companies that follow ESG criteria are generally seen more positively by consumers, investors, and other stakeholders. A solid commitment to environmental and social responsibility can foster brand loyalty, as customers are progressively inclined to support responsible organizations.

Attracting Investment

Paying attention to ESG practices can appeal to socially responsible investors seeking sustainable investment options. This may lead to more capital and financial backing, as investors tend to support companies that show good governance and ethical behavior.

Risk Management

Using ESG criteria helps businesses recognize and handle possible risks tied to environmental, social, and governance matters. By addressing these issues in advance, companies can prevent regulatory penalties, damage to their reputation, and disruptions in their operations.

Operational Efficiency

ESG initiatives can improve operational efficiencies. For instance, sustainable environmental practices can lower waste and energy use, leading to cost savings. Moreover, effective governance practices can facilitate decision-making and improve overall business performance.

Long-term Sustainability

Using ESG criteria helps companies look beyond immediate profits and prioritize sustainable practices that are good for both the planet and society. This approach can result in more sustainable business models, supporting long-term success in a world that is changing quickly.

Cons:

Lack of Standardization

A significant drawback of ESG criteria is the lack of a universally recognized framework for measuring and reporting ESG factors. This can result in inconsistencies in data and interpretations, which makes it challenging for investors to compare companies effectively.

Potential for Greenwashing

Some companies might practice greenwashing by overstating or misrepresenting their environmental, social, and governance (ESG) initiatives to attract socially aware investors. This could result in diminished trust and improper allocation of investment funds, which can hinder the true objectives of ESG investing.

Limited Short-Term Financial Focus

Some critics believe that prioritizing ESG criteria too much could negatively impact a company's short-term financial performance, which is important for stakeholders like shareholders and employees who depend on quick returns and job stability.

Subjectivity in Scoring

The criteria for evaluating ESG performance can be quite subjective and differ significantly among rating agencies. This variability may result for different scores for the same company, potentially causing confusion for investors and stakeholders.

Higher Compliance Costs

Adopting ESG practices can be resource-intensive and costly for smaller businesses, leading to financial challenges. These expenses may arise from the need for specialized personnel, compliance with reporting standards, and investment in sustainable methods or technologies.

How Environmental, Social and Governance (ESG) Criteria Work

When you use a resource like MSCI, Bloomberg or any of the sources that offer ESG ratings data, you’ll find a proprietary score given by that source. This will often be a letter grade or a point-based score. 

The main ESG rating will be an averaged score across all the metrics that source uses to grade ESG stocks. Many sources also provide individualized scores for each of the categories grouped together under the ESG umbrella. 

With this, you could base your strategy on which of these categories you prioritize most. If environmental criteria are your top concern, check out this easy, profitable way to nail the “E” in ESG investing. 

As an investor, you can use this information to build an investing strategy based on your goals. An impact investor would want only the best ESG stocks which have high grades across all the categories. A conservative investor, on the other hand, may use ESG as a measure of risk exposure rather than social or environmental responsibility.

What are the Best ESG Stocks?

If you’re ready to join in on the ESG investing boom, start by adding a few of the best ESG stocks that consistently receive the best ratings. For an effortless approach, consider an ESG ETF like these 3 ESG ETFs you don’t know about but should. These ETFs enable you to invest in all the best ESG stocks in one fell swoop.

To incorporate higher growth potential into your ESG investing strategy, here are 3 penny stocks to watch if you’re searching for ESG stocks right now. 

You can also check out our list of the best ESG stocks below:

Use ESG Ratings to Build a Low Risk, High Impact Portfolio

ESG ratings are a useful method for evaluating the risk of a stock from a broader, more future-oriented lens. These criteria allow investors to uncover exposure to risk that doesn’t typically show up on a financial statement. 

For impact investors and anyone looking to build a portfolio that promotes a greener, more socially responsible future, ESG ratings are also a useful measure for identifying the best stocks to include in that portfolio. Whatever your investing goals are, start incorporating ESG ratings into your stock picking process today!

Frequently Asked Questions