ESG. You have definitely heard about it and most likely you have read about it everywhere. What does it really mean? How does it affect your investment portfolio? Find out below... What's ESG?ESG is all the rage currently, and you would have done well not to have heard of it in some context by now. So, what is it? ESG is an acronym that stands for Environmental, Social, and Governance. It's a framework that takes the view that companies should be influenced by more than just the profit motive and instead considers environmental, social and governance matters. Examples of considerations include:
That's a brief 101 on ESG, and many words have been dedicated to its operation and use in modern times. That isn't what we are focusing on in this article. Today we will explore some of the quirks that have resulted as ESG has permeated the investing and finance ecosystem. ESG's Influence on the Finance WorldNaturally, as large institutional investors such as Blackrock, Vanguard et al. have emphasised ESG. Companies have begun providing more and more disclosure spruiking their ESG credentials. This framework has also equipped investors of all types with an additional metric to select companies to invest in. Companies see this as a way to attract a premium to peers. Financial market participants, not ones to miss out on an opportunity, began establishing ESG financial products and investment options in funds; ETFs etc. and fair enough. Some investors are driven by more than just financial returns. So far, so good, and these are signs of progress in the modern world, but this is where things get interesting. Based on a high-level understanding of ESG and climate change receiving unprecedented attention, you would expect an ESG product to include companies that contribute to decarbonisation and exclude those involved in intense emission activities, including the extraction of fossil fuels. You would be right and also wrong! Tesla Kicked from ESG Index?In May 2022, as part of its annual update, S&P 500 booted Tesla Inc (NASDAQ: TSLA) from its ESG index. On the face of it, an electric vehicle and energy storage company contributes significantly to reducing carbon emissions in the future by eliminating the use of fossil fuels to power cars and, in particular, if, over time, those vehicles are charged by renewable means (e.g., rooftop solar). So why was this ESG star (emphasis on the 'E') shown the door? Well, it concerns the 'S'. In February, Tesla was sued by the California Department of Fair Employment and Housing. The suit describes systemic racial discrimination and harassment at Tesla's Fremont factory, including allegations black workers were given the most demanding tasks and denied promotions much more frequently than other workers. This affected Tesla's ESG score, which resulted in it falling below the cut-off for companies in its industry to make the index. We take no view on the validity of the claims in the lawsuit but use it as an example of the effect such matters have in an ESG world. Oil & Gas Giant Added to ESG Index?Tesla was excluded from the S&P 500 ESG index, but it may surprise you that Exxon Mobil Corp. (NYSE: XOM) is in the S&P 500 ESG index. An oil and gas producer would seem contrary to ESG, given their effect on increasing CO2 emissions. So how do they find a spot on the list? First, we need to look at the definition of the index. Per Dow Jones (constructor of the index) it is: "The S&P 500 ESG Index is a broad-based, market-cap-weighted index that is designed to measure the performance of securities meeting sustainability criteria, while maintaining similar overall industry group weights as the S&P 500" (emphasis mine). Therefore, this index needs to mimic the S&P 500 in industries but then allocates the best in class in terms of ESG to the index. So, Exxon made the cut against its oil and gas peers, while Tesla missed the cut against its automotive peers. On its website in January 2022, Exxon announced its goal for net zero greenhouse gas emissions by 2050 (Scope 1 and 2), contributing to its good ESG score relative to peers. Key Takeaway for InvestorsThis brings to the fore another issue for investors. By all means, invest through an ESG lens but ensure you look under the hood and know what you are getting. Product labels combined with your understanding of ESG may lead you to make inaccurate assumptions.
For better or worse, depending on your view, ESG is here to stay, and hopefully, this has provided colour on some of the investments you may see that make you go, "huh?!".
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