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How to invest in ESG: Ethical investing explained

ESG and ethical investing are not new terms but have become more popular as climate change and new emissions data disclosure laws loom for American companies.

In today's financial landscape, a growing number of investors are not just looking for good returns on their money -- they also want to make a positive impact on the world.

Ethical investing is an approach that integrates personal values, societal concerns and environmental considerations into investment decisions.

With the U.S. Securities and Exchange Commission set to finalize a climate risk disclosure rule by the end of 2023, companies would be legally obligated to disclose accurate climate emissions data, such as Scope 1, 2 and 3 emissions. This requirement will give new significance to the environmental, social and governance (ESG) reporting that investors use to make ethical, green and financially responsible investment decisions.

What is ethical investing?

The goal of ethical investing is to support companies that have ethical practices, divest from companies that don't and generate financial returns.

Investors choose companies they morally agree with. Ethical investing is sometimes used interchangeably with socially responsible investing or impact investing, with slight distinctions. Ethical investing can mean avoiding companies that are deemed unethical or intentionally investing in stocks that have a positive ethical connotation.

History of ethical investment

Historical examples of ethical investing date back more than 100 years, where religious groups would avoid investing in "sin stocks," such as alcohol, gambling, tobacco, slavery and war. In the 1960s, the Civil Rights Movement and the Vietnam War influenced investment decisions. In the 1970s, there were divestments from South Africa to protest the country's system of apartheid.

In 1971, two Methodist ministers created the first publicly available mutual fund in the U.S. -- Pax World Fund -- which used social and environmental criteria for investment decisions.

In 1983, a group of churches and charities created the Ethical Investment Research Services Foundation to aid them in researching concerns related to investment in companies that contributed to South African apartheid.

In 1990, Domini 400 Social Index was created as one of the first indexes for socially responsible investing. It is now known as MSCI KLD 400 Social Index and focuses on companies that maintain high ESG standards.

In 1995, the Social Investment Forum Foundation -- now known as the U.S. Sustainable Investment Forum Foundation -- published a report that said $639 billion in total assets were being managed using socially responsible investing practices. The 2022 edition of that report stated that ESG accounted for $8.4 trillion, which was 12.6% of the total professionally managed investments in the U.S.

In 2004, the term environmental, social and governance was popularized in a report titled "Who Cares Wins" from the UN Global Compact. The report provided recommendations from the financial industry including on ESG issues in analysis, asset management and securities brokerage. In the years since the coining of the term, ESG has grown into a central influence for investors.

ESG investing vs. ethical investing

ESG is a framework for managing sustainability, promoting ethical conduct and fostering mindful consumerism, which is increasingly becoming prevalent in the corporate sector.

Ethical investing and ESG investing are not the same. ESG investing grew out of ethical investing and corporate social responsibility. ESG is more formalized. There are ESG funds, ESG scores, ESG ratings agencies and ESG reporting frameworks. Ethical investing is more dependent on investors' individual beliefs and what they deem ethical.

The three pillars of ESG are usually considered ethical causes. Companies manage ESG programs in part to demonstrate their commitment to the following causes:

  1. Environmental. Environmental components may include energy consumption, clean energy, water usage, net-zero initiatives and overall carbon footprint.
  2. Social. The social component involves the treatment of employees and community members and the social impact the company has. It may include diversity, equity and inclusion programs; workplace health and safety; support of human rights issues; and responsible supply chain sourcing.
  3. Governance. The corporate governance component deals with a company's internal management practices.

Still, companies that would traditionally be considered unethical can be included in ESG funds. For example, ExxonMobil or McDonald's might appear in an ESG fund. An ethical investor might stay away from these companies because they are involved in oil and fast food, respectively. An ESG investor might choose these companies, though, because ESG covers a wide range of criteria. For example, ExxonMobil makes obvious contributions to climate change by being in the fossil fuels industry but might have redeeming -- on paper -- ESG initiatives that qualify it for inclusion in the ESG category. For example, the oil company might have a public initiative that focuses on Scope 1 or 2 emissions but ignores Scope 3 emissions where the company does the majority of damage to the environment. This draws greenwashing criticism because the company still qualifies as an ESG stock, although it has a negative environmental effect.

How to invest in ESG

Despite the differences between ethical and ESG investing, there's a lot of overlap, and ESG investing is one way to invest money in companies advancing ethical causes. Here are some steps to get started investing in ESG:

  1. Open a brokerage account. A brokerage account is an investment account that lets individuals buy and sell various types of investments, such as stocks, bonds, mutual funds and exchange-traded funds. Applying to open a brokerage account requires the applicant to provide personal information, such as name, address and Social Security number, as well as undergo a credit check. Once set up, the user can set up a funding source by linking a checking or savings account. There are many different investment platforms to choose from. Brokerage accounts can have several different fees included.
  2. Know ESG criteria. ESG is a broad category. Determine which investments within that category are ethical or align with personal values. Choose to support industries that align with these values.
  3. Research investments. The investor can do either of the following:
    1. Self-directed investing. Investors screen for their preferred criteria and minimum ESG score. Some brokerage platforms have screening tools that help the user do this.
    2. Robo-advisor investing. A robo-advisor or digital investment manager helps choose investments based an investor's financial goals, age and risk tolerance. Robo-advisors help users build portfolios based on a given framework more quickly.
  1. Choose investment. After doing the research, the investor can place a trade using their investment platform. Users can type in the investment's ticker symbol and buy a dollar amount or number of shares.

Types of ESG investments

There are several types of ESG investments, but two of the main ones are the following:

  1. Individual stocks. This means investment in one company that matches ESG and investor criteria. Remember to diversify the portfolio and avoid having a large portion of it tied up in one or a handful of stocks.
  2. Mutual funds. A mutual fund pools different assets together, including different stocks and bonds. To see the different companies a mutual fund invests in, look at the fund's prospectus, which is a document containing information about the fund.

How are ESG scores determined?

ESG scores are one way to assess a particular company's ESG performance. They are a qualitative metric that rates a particular company's ESG initiatives. There are numerous ways to calculate ESG scores. Companies can do this internally using a standardized framework, such as those from the Global Reporting Initiative or Task Force on Climate-Related Financial Disclosures. Many third-party vendors also all offer ESG ratings, including the following:

  • Bloomberg ESG data.
  • Institutional Shareholder Services ESG.
  • S&P Global Corporate Sustainability Assessment.
  • MSCI ESG rating.

The ratings agency gathers as much data as possible about a given company's ESG initiative and assembles it according to an ESG reporting framework. Then, a scoring agency analyzes and evaluates different ESG issues according to the data. For example, the MSCI ESG rating system uses three different ratings, with a numerical component between zero and 10 and a letter grade based on an issue's timeliness and potential impact. The three ratings are the following:

  • Leader. 7.143-10.000; AA or AAA.
  • Average. 2.857-7.143; BB, BBB or A.
  • Laggard. Less than 2.857; CCC or B.

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