Read here what the ESG approach means and how to distinguish it from other sustainable investments.

If you are considering expanding your portfolio to include sustainable investments, you should have a detailed understanding of the ESG criteria and be able to categorise them within the spectrum of green investment forms. 

But what exactly are ESG criteria and to what extent does an ESG investment meet my personal requirements for sustainable investing? These are good questions and in this article, we explain all the fundamentals, the most important differences and the investment options available to you in accordance with ESG criteria.

Sustainability has not yet been fully defined in the financial sector, even though the legal definitions will become ever more precise and binding in the foreseeable future. 

What is “green” or “social” varies depending on the supplier and product. This is because sustainability is complex. Experts around the world are therefore trying to find criteria that are relevant, measurable and comparable at the same time. They are intended to help investors make well-informed investment decisions. 

The financial industry is currently undergoing a process of discovery. To compare, the food industry has already undergone this in the area of organic labelling: here, too, there have been and still are discussions about what is sustainable. For the term “organic”, various seals and guidelines from associations with different levels of sustainability have established themselves – from the EU seal to the Demeter label. 

In the investment sector, many different investment approaches can be found under the umbrella term of “sustainable investments”. One of the most well-known and widely used approaches is the use of ESG criteria. They are intended to bring more transparency to the respective investments so that investors can better recognise what their money is specifically doing in the environment, society and economy. 

ESG stands for Environmental, Social and Governance. Verifiable criteria are established for each of these aspects to make it easier for investors to assess the (non-)sustainable conduct of a company. 

ESG criteria are of an exclusionary nature. If a company or a country does not respect certain values and criteria, they can be excluded from the investment portfolio. This process is also called negative screening or exclusion process. Such negative criteria often include, for example, the manufacture of or trade in weapons. Tobacco, alcohol, gambling and human rights violations are also often on the negative list. Most ESG investments follow this exclusion principle.

Some ESG ratings also apply positive criteria. Positive screening, for example, looks at whether the company is one of the most sustainable players in its industry. If a company is among the best in its industry, it is rated as positive according to the best-in-class principle. 

The ESG approach thus offers information about an investment that goes beyond traditional financial indicators. Equities, funds and bonds can thus be assessed more comprehensively. This not only relates to the environmental aspect, for example, through climate and resource protection, as the term "green investments" often suggests, 

but the criteria also consider the social dimension – for example, how employees are dealt with and the observance of human rights – as well as the principles of sustainable corporate management – such as how corruption risks are handled. 

Together with investors, the United Nations has defined six principles for integrating ESG criteria into the investment process. The investor organisations signing these Principles for Responsible Investment (PRI) undertake to work towards and report on the consideration of the criteria in the investment process.  

Corporate example:

The food company Danone links the variable remuneration of its managers to the achievement of ESG goals. This includes, for example, the extent to which employees are committed to sustainability and the extent to which the Carbon Disclosure Project (CDP) organisation assesses Danone’s climate protection measures.

In the abbreviation ESG, “E” stands for Environment. 

This criterion considers the extent to which a company or country pollutes the environment, emits greenhouse gases or pollutants, consumes resources or uses energy efficiently. Climate risks in particular are gaining in importance here, as

climate change is not only an environmental problem, but also an economic threat. It could “put millions of lives at risk, as well as trillions of dollars of economic activity and physical capital, and the world’s stock of natural capital,” predicted a study by McKinsey in 2020.¹  

The latest risk report of the Davos World Economic Forum (WEF) assigns the three largest global risks for the next ten years to the area of environment with climate change mitigation failures, extreme weather events and biodiversity loss.² The high weighting of these problems could increase the importance of those players in the financial market who contribute to solving the challenges.

A company’s commitment to such environmental requirements can be reflected in various standards. For example, the environmental management systems ISO 14.001 and EMAS indicate whether a company systematically measures and manages environmental key figures at its sites.  

Capital market-oriented companies with more than 500 employees are obliged to report on their non-financial key figures, e.g. in the form of a sustainability report. For this purpose, many companies have followed the guidelines of the Global Reporting Initiative (GRI). Investors who follow the PRI principles for responsible investing can check for ESG factors in the investment process or systematically monitor sustainability risks. 

Corporate example: 

BMW is a company that appears to be particularly environmentally committed in green equity indices. It advocates for electric drives, no longer participates in Formula 1, is constantly improving the efficiency of its engines and has set climate targets. Although the vehicle manufacturer generates most of its sales from combustion engines and primarily serves the large car (SUV) market, it has been among the best-in-class in the automotive industry for many years and is listed in the Dow Jones Sustainability Index (DJSI). This index considers positive criteria and applies the best-in-class principle. In other evaluations that use negative criteria to exclude investments in producers of combustion engines, BMW would not be included.

The “S” in ESG stands for social, i.e. the social and societal aspects of the activities of companies and countries. 

Respect for human dignity is paramount. On the one hand, the situation of the employees of the company itself is considered, e.g. diversity in teams and occupational health and safety. 

In addition, the focus is expanded along the value chain, for example with regard to the observance of human rights by suppliers or the prohibition of child labour. The downstream chain can also be about treating customers fairly. 

Furthermore, the social aspect includes the company’s social commitment.

Standards reflecting the social aspect include the OECD Guidelines for Multinational Enterprises, the ILO Core Labour Standards, the ten principles of the UN Global Compact and ISO 26000. 

Corporate example:

The software company Microsoft is regarded as an industry leader in terms of ESG criteria. The company, known for its Windows operating system, has received several awards, particularly in the “social” context. It provides childcare services for its employees, among other things, and has received awards as a good employer that upholds human rights and stands for equality in the LGBT community.

The “G” in ESG stands for governance. 

This term is usually translated as “(responsible) corporate governance” and includes fairness and transparency. In this context, there are, for example, company policies and codes relating to corruption as well as the various compositions of committees or the Supervisory Board. Transparent information on these topics is intended to make it easier for investors to identify the company’s risks.

Recognised standards for good governance include the German Corporate Governance Code, the UN Global Compact, ISO 37000 and the OECD Principles of Corporate Governance. The German Sustainability Code (DNK) and the Global Reporting Initiative (GRI) also provide guidance. 

Corporate example:

the Volkswagen (VW) diesel scandal was due to a lack of governance. Some ESG funds had already removed the automotive group from their investment universe in 2013. The main criticisms were the lack of independence and the composition of the Board of Management. There were also different types of shares with differing voting rights, which perplexed rating agencies and fund managers. When the emissions affair price crashes came in 2015, investors in ESG investments were less affected, or not affected at all. Since then, VW has turned around a lot: today, the company is considered to be well-positioned in terms of sustainability thanks to extensive restructuring, shifts in strategy, changes in management and other measures.

In the history of money, investors’ objectives have always been more than just about pure financial returns. Even in ancient times, political concerns could be influenced, and for many people in the Middle Ages, a heavenly reward lured their funds in a certain direction. The systematic steering of large financial flows towards sustainability began in the middle of the 20th century. 

1950s/1960s
Trade unions managed large pension funds. With the capital assets in these pension funds, they began to influence their wider social environment – for example, for affordable housing or health facilities for miners. 

1970s
Apartheid in South Africa met with ever-increasing resistance in the world. As a result, large investors developed a divestment strategy, withdrawing their funds from the racist regime along ethical lines. The pressure on the South African economy and thus also on the government ultimately contributed to the abolition of the apartheid system. 

1980s
James S. Coleman developed the concept of social capital in 1988, according to which self-interest cannot be the only value of economic activity. At that time, environmental groups also began to use the leverage effect as investors to influence capital markets so that companies would also include environmental and social issues in their decisions. 

1990s/2000s
Gradually, the financial market began to adopt the guiding principle of “responsible investors” and offer corresponding products.  

2000s
Scientific research showed that companies that explicitly conducted themselves with social aspects in mind were more successful. For example, the “100 Best Companies to Work for” companies achieved a 2% to 3% higher equity return over 25 years than their competitors.  

The establishment of ESG investments in the financial market is based on the Principles for Responsible Investment (PRI). With this initiative, the United Nations called for a voluntary commitment to integrate ESG factors into investment decisions and asset management. As a result, more and more institutions decided to align their portfolios based on ESG principles.

Over 3,400 companies (as of 2021) have signed the PRI, together managing over 121 trillion US dollars.3 The ESG approach is no longer categorised as a philanthropic endeavour, but is increasingly seen as a practical imperative for long-term financial success.

Intangible factors such as employee satisfaction or species protection are less easy to measure. In addition, not every company, product or investment covers all areas of the ESG universe. As a result, there have been and continue to be a variety of names for the type of investment analysis and valuation. To mention just a few: 

• green, eco, sustainable, ethical, social, non-financial, non-traditional
  
• Long-term investment (Long Horizon Investment (LHI))
  
• Socially Responsible Investment (SRI)
  
• Responsible investment
  
• Impact investment
  
• Enhanced business
  
• Corporate health

The term ESG is now widely used – the majority of experts use this term to describe non-financial aspects. However, other terms such as impact investment or socially responsible investments are used to describe different aspiration levels in sustainable investments. 

Among others, rating agencies specialising in sustainability are responsible for measuring ESG criteria. In contrast to traditional ratings, investors are the customers, not the companies or issuers. The most well-known sustainability rating agencies include ISS oekom, Sustainalytics, imug and Inrate. 

Traditional analysts such as Thomson Reuters, Bloomberg and MSCI Ratings are now also on board. They all use different metrics systems to calculate an ESG score for each company.

In addition to the ESG criteria, other related approaches can be found along the spectrum of sustainable investments.

The range of sustainable investments is very wide – often a product cannot be assigned to just one specific category. It is therefore worth taking a closer look at which values a product such as a fund actually represents and which it does not.

The basis is usually exclusion or negative criteria, which exclude companies or countries that engage in certain activities. These include, for example, weapons and armaments, narcotics, alcohol and tobacco, gambling and pornography, technologies such as genetic engineering and nuclear power, or fossil fuels such as oil, coal or gas. 

Some portfolios also do not contain critical commodities such as gold, because their extraction is often associated with environmental damage and human rights violations. Countries where the death penalty is applied or where child labour is tolerated may be on the blacklist, as may regions with high rates of corruption.  

An ESG investment means that environmental, social and corporate governance aspects are explicitly incorporated in the traditional financial analysis. Certain investments can therefore be excluded – based on negative criteria. For many ESG funds, a number of positive criteria are also included, for example if the examined company operates in the area of renewable raw materials such as wood or is also active in the construction of affordable housing. 

Some ESG funds focus on investing in frontrunners with the best sustainability performance in certain sectors. This best-in-class approach includes measures against discrimination and efficiency measures for improved resource protection, for example. It also looks at the strategy the company uses for sustainable transformation.  

Within ESG investments, there may be contradictions due to the combination of strategies. This is because some of the best-in-class companies are pioneers in sectors or areas that are on the negative list for some investors. This conflict could arise if, for example, you want to exclude genetic engineering from your investment universe, but follow the best-in-class approach.  

Impact investments are a form of ESG investment with high sustainability aspirations. These investment products aim to combine the themes of “sustainability” and “return” and to bring about a positive change in society and the environment. 

The term “impact” describes the approach to achieving a positive and measurable contribution to environmental or social goals. Impact funds thus go one step further than ESG funds in their sustainability claim.

Basically, one should not make the mistake of drawing conclusions about future performance based on past performance. Past performance may be an indication, but it is not a reliable indicator. In particular, crises or unforeseen events – such as the COVID-19 pandemic – can cause significant price fluctuations in equities and funds. 

Funds with ESG criteria tend to be more crisis-proof. There are several reasons for this. Certain risks have already been excluded, investments are focused on promising growth markets such as healthcare or efficiency technologies, or corporate governance is based on a solid, transparent structure. Due to its numerous positive characteristics, the integration of ESG criteria is currently the most frequently used sustainable investment strategy in Germany.⁴

A meta study comprising 2,000 empirical studies was carried out as far back as 2015 and showed that ESG criteria tend to have a positive impact on returns.⁵ This can also be seen from a comparison of the two major MSCI World indices and its ESG-based counterpart, the MSCI World SRI. The annual return of the MSCI World SRI outperformed that of the conventional index in a total of eleven of the last 14 years (2008 to 2021).⁶ 

Many other studies also indicate that ESG products perform just as well or better in terms of performance than products that are not rated using environmental and social aspects. They are also less affected by price fluctuations.  

As with conventional funds, there is also a default risk with ESG funds. In their product descriptions, the issuers state which events or developments could cause one or more equity positions to fall sharply or drop to zero. This includes extreme weather events or unforeseen regulatory changes.  

Diversification is important in order to avoid risks. An investment portfolio should be divided into various themes (e.g. renewable energy, microfinance, sustainable raw material cultivation) and asset classes (e.g. equities, funds, bonds). Those who take this into account tend to have less risk in the portfolio with the ESG approach, as many of the environmental, social and governance aspects focus on long-term sustainability.

The market for sustainable investments is growing rapidly. Ever more funds are flowing into investment products that select their assets according to environmental, social and governance criteria. While Germany was still worth 200.6 billion euros in 2020, the investment volume increased to 336.6 billion euros in just one year.4 Retail investors in particular are considered to be the engine for the rising investment volume of ESG-based investments. 

The upward trend could continue. With its 17 Sustainable Development Goals (SDGs), the United Nations aims to protect the climate, promote sustainable production methods, eradicate hunger and poverty and expand the role of clean energy. All this requires a more sustainable economy and the related financial resources to boost this development.  

Due to the increasing support of the population for future-proof solutions and innovations, politicians are also increasingly providing incentives for more environmental protection, ethical conduct and social commitment, for example with the CO2 tax or the debate about a supply chain law. 

The regulatory requirements for achieving ESG goals are also increasing in the financial world. In particular, the European Union’s Taxonomy Regulation is intended to ensure transparency and consistency in the financial market. Its aim is to establish a uniform classification of the environmental sustainability of economic activities for financial market participants. 

Investments designated as sustainable are also growing around the world. For example, the Global Sustainable Investment Review mentioned over 35 trillion US dollars that were sustainably invested in 2020 – 15% more than two years prior.⁷ However, such figures must be viewed with caution. This is because a product with merely a few exclusion criteria could be regarded as “sustainable” here.  

Products that aligned their investment strategy with ESG criteria amounted to 25.2 trillion US dollars.

If you looked at ESG criteria for each potential company, it would take a lot of work and time. In addition, investing in only one or a few companies and not diversifying would increase your risk. ESG issuers therefore use the ratings by sustainability rating agencies and develop corresponding fund products from them. 

Are ESG funds a sensible addition to your portfolio? First of all, it depends on your personal values and your situation: How much return do you want to generate? Which risk class would you put yourself in? How much money would you like to keep freely available – how well could you cope with short-term price fluctuations? And last but not least, would you like to include sustainability criteria in your investment and, if so, which ones? 

For example, if your aim is sustainability, you can answer the following questions for yourself:

Some funds indicate in their name which sectors they exclude, for example, an investment product with “ex weapons” specifically excludes weapons. Animal testing or livestock farming, on the other hand, are not necessarily excluded.

Once you have clarified which values are important to you personally, the next step is to select products that best meet your requirements. Eligible offers can vary greatly, because 

while some exclude only certain sectors, others focus on individual topics such as forestry and timber. Yet others choose best-in-class leaders who are most likely to act ethically, environmentally friendly and responsibly within a given sector. 

ESG investments are most suitable for you if you have a medium to long-term investment horizon. Ethical financial market products are less suitable for short-term speculation, as sustainability goals are designed for the long term, e.g. to achieve the SDGs by 2030 or the Paris climate goals by the middle of the century. 

From a risk and return perspective, you can also benefit from the on average lower price fluctuations and the on average higher returns of sustainable investments with a longer investment period. 

For many people, ESG criteria are an approach to “make the world a little better” as the companies, properties and governments in the portfolio obverse social or environmental factors to a greater extent. But – for more and more people this is not enough: they want to drive concrete social change. This is the specific form of ESG investment, namely impact investing, which pursues a specific sustainability-oriented objective and at the same time generates returns. 

When investing effectively, your financial resources often flow into the real economy, for example into tangible assets such as wind farms. Retail investors in Germany can now also invest in such assets of the real economy. 

Long-term investment funds (also known as the European Long-Term Investment Fund (ELTIF)) can be used for this purpose. This type of ESG investment is suitable for investors who want their funds to generate measurable and concrete added value for sustainability.