**4. ESG investing in combating climate change**

ESG investing is likely to contribute significantly to steering companies to reduce their carbon footprint. There is increasing evidence that companies which incorporate ESG factors are likely to have higher financial performance, climate change issues are becoming popular among younger investors, the number of investors pledging to evaluate ESG factors when making investment decisions is increasing, and investor and regulatory ESG promoting initiatives are increasing. Taken collectively, these observations are likely to elevate the impact of ESG investing in combating climate change.

#### **4.1 ESG investing and financial performance**

There are competing views on the impact of ESG investing on financial performance. One view is that companies incur costs from socially responsible actions that put them at an economic disadvantage compared to other firms that are less socially responsible. A second, contrasting view is that costs associated with ESG factors are necessary because companies overall benefit through high employee morale and productivity [30]. The pioneering studies of the impact of ESG investing, then

#### *The Increasing Importance of Environmental, Social and Governance (ESG) Investing… DOI: http://dx.doi.org/10.5772/intechopen.98345*

SRI, on financial performance can be traced to [31]. In the study by [31], fourteen companies were selected based on their social responsibility credentials, and the rate of their return on common stock was calculated [31]. The stocks of the selected companies appreciated at a higher rate compared to major market indices [32]. This difference in performance was attributed to responsible investing [32]. A number of subsequent studies have validated the positive correlation between social responsibility and financial performance.

In a review of 2 200 studies on effect of ESG investing on corporate financial performance, 90% concluded a positive correlation [33]. The positive correlation was observed to be stable over time, especially in North America and emerging markets [33]. Age of a company is an important variable since old equipment and buildings might incur more expenses in making them environmentally and socially compatible with modern regulatory standards. After correcting for age of a company, a positive relationship was observed between social responsibility and financial performance [34]. When a Morgan Stanley Capital International (MSCI) ESG rating was applied to study corporate returns over a 10-year period, 2007–2017, it was observed that ESG-rated companies paid higher dividends and showed higher valuation levels [21, 35]. Among 100 American companies, employee satisfaction was associated with positive risk-adjusted returns at a statistically significant level [36]. Similarly, an evaluation of two equity portfolios that differed in eco-efficiency showed that the high-ranked portfolio provided substantially higher average returns than its low-ranked counterpart over the 1995–2003 period [37].

Although there are also some studies refuting the non-negative correlation between ESG investing and financial performance [38–40], orientation towards long-term ESG investing is important for investors to fulfill their fiduciary duties and achieving objectives of society [41]. Companies can build goodwill through ESG investing which can protect against reputational damage from catastrophic occurrences. The widely reported positive financial performance will likely influence more asset managers and investors to consider ESG factors, thereby becoming material in combating climate change.

### **4.2 Investor participation in ESG investing**

Companies are under pressure from shareholders to maximize productivity, and from consumers, workers and communities at large to consider ESG factors [39]. Consumers are increasingly becoming conscious of environmental issues, and are showing preferences for environmentally friendly products. Companies are, therefore, not only concerned about financial performance, but also impact of their activities on the environment, social wellbeing of workers and the broader community. The concern is reflected by the increasing number of companies that are publicly declaring their commitment to ESG investing [16]. In 2019, ESG-themed mutual funds had a net inflow of US \$20 billion, an increase from the previous year by a factor of four [42]. Since the formation of UNPRI, the number of signatories has increased to over 3 000 at the end of 2020, with their assets under management at US \$103.4 trillion (**Figure 1**).

As at January 2021, 61 large companies from diverse sectors had committed to stakeholder capitalism metrics (SCI), a set of environmental, social and governance metrics and disclosures released by the World Economic Forum (WFP) and its international business council (IBC) that measure long-term value creation for stakeholders [43, 44]. In making these commitments, influential companies signaled that ESG factors are increasingly becoming important to success and longterm viability. The commitments to SCI and UNPRI represent the intent of leading global companies to integrate ESG factors into their core strategy and operations

#### **Figure 1.**

*Increase in number of signatories to the United Nations principles for responsible investment (UNPRI) and assets under management (source: UNPRI).*

which is likely to result in tangible action towards reduction of their carbon footprint.

#### **4.3 Regulatory initiatives**

The number of policy initiatives to encourage ESG investing has also increased in tandem with the number of investors and assets. For example, the sustainable banking network (SBN) was formed in 2012 by financial sector regulatory agencies and banks in emerging market economies (EME). The aims of the SBN are to support companies to adapt to environmental and social sustainability and to contribute to national development goals [21]. In 2015, the taskforce on climaterelated financial disclosures (TCFD) was formed by the G20. The task of TCFD is to identify information needed by investors to asses climate-related risks, among other sustainability issues. The TCFD drafted recommendations on climate-related financial disclosures which have been widely adopted [45]. The high-level expert group (HLEG) on sustainable finance was formed by the European Commission in 2016 to channel public and private capital flows towards sustainable investments and to protect stability of financial systems from climate change related risks [21]. These and other policy initiatives are likely to influence more asset managers and investors towards ESG investing.

#### **4.4 Popularity of environmental factors among investors**

Environmental factors topped the list of individual investors as far back as 1991 [46]. A 1991 survey of 4 000 individual investors in two mutual funds that incorporate ESG factors in investment decisions established that environmental and labor issues were a top priority [46]. The majority of the investors were generally young (below 44 years of age) and better educated, with at least a college degree. In a similar study among members of the American Association of Individual Investors (AAII), it was observed that environmental factors dominate in their decision making [14]. A company's environmental performance and the environmental impacts of its products are important considerations for ESG investors. With the continued increase in the concentration of atmospheric greenhouse gases, environmental factors, particularly climate change, are likely to attract most investor concern [47, 48].

*The Increasing Importance of Environmental, Social and Governance (ESG) Investing… DOI: http://dx.doi.org/10.5772/intechopen.98345*

Climate change activism, especially among the younger population, is making international headlines. Climate change threatens both financial performance of companies and social well-being of communities. Rising sea level will impact nearly 40% of the US population and other coastal communities around the world [48]. Hurricanes, storms, heat waves and floods will disrupt company activities and community cohesion. Investors and asset managers are likely to continue reducing climate change risk in their portfolios, especially with carbon-intensive companies [48].

#### **4.5 Investor initiatives**

Investors worried about impacts of climate change are taking their own initiatives to reduce greenhouse gas emissions. Climate Action 100+ is an investor-led initiative to ensure the world's largest corporate greenhouse gas emitters take necessary actions to reduce emissions. The Investor Agenda aims to accelerate actions that are critical to tackling climate change and achieving goals of the Paris Agreement. The Investor Agenda encourages investors to set science-based portfolio emissions reduction targets that allow global net-zero emissions by 2050 or sooner, with credible intermediate targets. It provides actions to meet the emissions reduction targets that align with the goals of the Paris Agreement. The investor led initiatives and the resultant decarbonation actions by companies are vital in reducing climate change risks and exposure.

### **5. Challenges of ESG investing**

ESG investing has been fraught with challenges since its early days. The lack of common terms, huge volumes of data to be processed from company reports and other sources, and heterogeneity of rating methods are noteworthy drawbacks.

#### **5.1 Terminology variability**

The variety of terms that are used under ESG investing may create confusion among investors. For example, the term "environment" to describe a fund with positive environmental impact may alternatively be substituted with "sustainable", "green" and "eco" [16]. There are also terms that are sometimes used interchangeably with ESG investing, such as SRI, responsible investment, sustainable investment, impact investing and ethical investing [16]. There is need to resolve such terminology variability so that evaluation can be more consistent. Apart from terminology ambiguities, scoring some ESG factors may be highly influenced by context. For example, a company that accords its workers a worshipping hour may score highly under social factors in a predominantly religious society than in an atheistic one. A company may be negatively screened in one community while positively screened in another due to cultural, religious, ideological and ethical differences.

#### **5.2 Huge volume of data**

To score ESG factors, huge volume of data needs to be processed. These data may be mined from company reports, regulatory agencies' reports and other mandatory and or non-obligatory disclosures, a very laborious and cumbersome process for investors. Scoring of factors is to some extent subjective. Some investors may score environmental factors highly compared to social factors while others score

vice versa. An environmentally-friendly company could mistreat workers [42], and thus it is challenging to balance such factors when evaluating the company. There is also a risk of evaluating greenwashed and impact-washed data. Greenwashing is a false claim to deceive consumers into believing that a company's products and actions are environmentally friendly [48]. Impact washing is promoting the positive impact of a company to society while it engages in other damaging activities [48]. For example, a mining company may tout how its solar power plant will result in decarbonation, while simultaneously the company will be releasing toxic chemicals that cause deforestation. To circumvent the problem of scouring over enormous amount of data, asset managers and investors usually rely on ESG indices prepared by vendors. There is a possibility in future of using artificial intelligence and machine learning methods to score the huge volume of ESG data [48].

#### **5.3 Heterogeneity of ESG rating methods**

ESG rating agencies analyze publicly available data reported by a company, sector-specific NGOs, government agencies, trade unions and other sources to produce an ESG rating for a company. The rating agencies are paid by investors who use the ratings to evaluate investment decisions. Leading international ESG rating agencies include Vigeo Eiris, MSCI, ISS-oekom, Inrate and Sustainalytics. The rating criteria, however, differ among agencies and business sectors. As no common standard exists for ESG rating, each agency develops its own method, and as a result, ratings from different agencies sometimes disagree [42]. ESG investing is a rapidly evolving field, and rating agencies are adapting to the evolution by making continuous improvements and changes to their rating criteria.

There are ongoing efforts to create standards in ESG investing in order to have consistence and reliability. In Europe, the EU taxonomy was drafted to provide a list of environmentally sustainable economic activities. It is a classification system that enables grouping of economic activities that are crucial in climate change mitigation and adaptation [49]. The EU taxonomy is crucial in scaling up sustainable investment and implementation of the European green deal. It provides appropriate definitions to companies, investors and policymakers on which economic activities can be considered environmentally sustainable. It is, therefore, expected to protect investors from greenwashing and impact washing, help companies to transition to decarbonation, and move investments where they are most needed [49]. Internationally, the SCI is another important endeavor to create universal standards in ESG investing. The SCI are a set of 21 universal, comparable disclosures that were derived from voluntary standards and are focused on people, planet, prosperity and principles of governance that companies can report on regardless of sector or region [43, 44]. The regional and international standardization efforts will likely lead to convergence of ESG rating methods.

#### **6. Conclusions**

Environmental, social and governance factors are becoming vital determinants of investment decisions. It is apparent that environmental factors, especially climate change, pose a substantial financial risk to companies. Increasing frequency of extreme events, rising sea level and destruction of biodiversity are some consequences of climate change that impact financial performance. ESG investing is likely to influence more companies to implement strategies to reduce their carbon footprint. Reduction of scope emissions will contribute to holding the increase in average global temperatures to below 2°C above preindustrial levels, a goal of the Paris Agreement. Reduction of scope emissions will also help to achieve net

*The Increasing Importance of Environmental, Social and Governance (ESG) Investing… DOI: http://dx.doi.org/10.5772/intechopen.98345*

carbon neutrality by 2050, a target considered crucial to combat the current climate change. The high financial performance of ESG investing, increase in the number of ESG investors and financial assets, environmental consciousness among younger investors, and regulatory and investor ESG promoting initiatives are likely to influence more companies to implement strategies towards carbon neutrality. The lack of ESG scoring standards, terminology variability and enormous amount of data to process are some challenges of ESG investing. There are initiatives, however, to have standards in ESG rating, and attempts are also being made at using artificial intelligence to process huge volumes of data. Despite the challenges, and going forward, ESG investing is likely to play an important role in combating climate change.
