A Guide to Socially Responsible Investing and How It Can Create Value

By David Rosenstrock, CFP®, MBA

As residents of New York City, we are all exposed to environmental pollution and social conflicts on a daily basis. More than 2,000 New Yorkers are estimated to have died prematurely in a single year from the effects of pollution from vehicle emissions—even before the COVID-19 pandemic, according to a study published in 2021 by Environmental Research Letters (Calvin A. Arter et al 2021). At least 1,400 of those deaths were in the New York City metropolitan area. Interestingly, fewer than half of the estimated deaths in New York State were caused by pollution that originated in the state itself, while 42 percent were instead linked to harmful emissions from Pennsylvania, New Jersey and Maryland. In those states, the biggest polluters were light-duty vehicles, including SUVs, and passenger cars. A cleaner, safer environment would improve the quality of life for all of us. 

An increasingly popular path to being part of the solution is to make sure that you support companies whose values align with your own environmental concerns. Environmental, social, and governance (ESG) allows consumers, investors, and other constituents to have increased transparency in evaluating companies. This can involve which consumer products and services you buy or which companies you invest your money in as a shareholder, through the purchase of stocks and bonds for your personal investments. Consumers are able to evaluate the sustainability of their purchases and how much good or damage they are doing to society and the environment, and investors are able to see the long-term value of their investments.

ESG, or environmental, social, and governance scoring relies on independent ratings that help you assess a company’s behavior and policies when it comes to environmental performance, social impact and governance issues. 

The “E” or environmental portion of ESG, which is the area this article will focus on, considers how a company performs as a steward of the physical environment.  The “E” takes into account a company’s utilization of natural resources and the effect of their operations on the environment, both in their direct operations and across their supply chains.  The environmental factor might focus on a company’s impact on the environment, or the risks and opportunities associated with the impacts of climate change on the company, its business and its industry. ESG reports serve to outline how a firm deals with: climate change and carbon emissions; air and water pollution; biodiversity; deforestation; product innovation; green research and development; and related issues.

The “S” or social factor might focus on customer satisfaction; data protection and privacy; gender and diversity; human rights; and health and safety.

The “G” or governance factor includes everything from issues surrounding executive pay to diversity in leadership as well as how well that leadership responds to and interacts with shareholders. This component may reflect a rating of how well executive compensation is tied to performance in meeting the goals it sets forth, including environmental ones.

ESG reporting encompasses both qualitative disclosures of topics as well as quantitative metrics used to measure a company’s performance against ESG risks, opportunities, and related strategies. ESG reports are communication tools that play an important role in convincing observers that the company’s actions are sincere.

The majority of companies that are listed on major stock exchanges publish annual ESG reports. The reports are released to show their current levels of corporate sustainability and can often be found on a company’s respective website and/or SEC filings.

Independent third-party rating agencies use ESG factors to assess companies on their environmental footprints by assessing factors including: greenhouse gas emissions, water use, waste and pollution, land use and biodiversity. It is estimated over eighty percent of the world’s largest companies are reporting exposure to physical or market transition risks associated with climate change and a similar share are engaging in reducing corporate emissions.

Over the past two decades, a large body of research has shown that companies (stocks) that score favorably on ESG ratings have endured downturns better than their conventional counterparts. ESG investments have been found to be more resilient during market downturns that were driven by different types of global crises, including: the financial crises, the COVID-19 pandemic, and the long-term crisis of climate change.

There are different theories as to why companies with strong ESG credentials may be more resilient. According to an NYU Stern and Rockefeller Asset Management study in February 2021, often it comes back to the fact that these companies tend to be better prepared to address material risks – from better governance to policies that help them address social and environmental challenges within their operations.

Sustainable investing often focuses on investing with a very long-term view, not solely for short-term gains that can lead to systemic problems and long-term value destruction. A significant amount of research finds that a strong ESG proposition correlates with higher equity returns. Better performance in ESG also corresponds with a reduction in downside risk, as evidenced, among other ways, by higher credit ratings, according to a report published by consulting firm McKinsey & Co. in November 2019. A strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities (for example, renewables, waste reduction, and scrubbers). It can also help companies avoid stranded investments that may not pay off because of longer-term environmental issues.

There are many approaches investors can take towards developing and integrating ESG ‘scoring’ data in their investment strategy. One approach is screening investments for ESG specific characteristics. Negative screening means excluding one category or sector of stocks from a portfolio. For example, companies associated with tobacco, alcohol, or weapons. Positive screening techniques work to identify and highlight organizations that are actively functioning to further environmentally sustainable and positive social practices, rather than simply avoiding bad behavior. Investors can also implement an ESG strategy by investing based on defined sustainability themes. This approach enables investors to invest in a specific aspect of ESG such as companies focused on environmental solutions (ie. renewable energy, sustainable agriculture) or social issues (gender/ racial equity, diversity, etc.).

While important progress has already been made, improving the quality, transparency, and usefulness of disclosures related to environmental issues is a large challenge.  There is much further to go to create a robust system for nonfinancial disclosures for ESG scoring and evaluation to help better address and solve more of the environmental problems we face today. ESG investments can provide both better financial performance and lowered risk (versus non-ESG portfolios), as well as ways to invest responsibly. ESG information and scoring can provide a better way to invest responsibly and address and improve many of the problems we experience on a daily basis as New York City residents.

David Rosenstrock, CFP®, MBA is the Director and Founder of Wharton Wealth Planning, LLC (www.whartonwealthplanning.com).

He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.  David lives in New York with his wife and their two very active children.

For more information, contact David Rosenstrock, david@whartonwealthplanning.com