What Is ESG Investing?

1.1 Three letters, one question

ESG stands for environmental, social and governance. It describes a family of non-financial factors — things that do not appear directly as lines in a company's income statement — that may nonetheless affect the company's long-term value, its impact on the world, or both. ESG investing is the use of these factors in investment decisions: which securities to buy, how much to hold, and how to behave as an owner.

The idea is old — religious investors avoided certain businesses centuries ago (Chapter 2) — but the scale is new. Since the mid-2000s, large pension funds, insurers and asset managers have adopted ESG language, data providers score thousands of companies, and regulators in many countries set rules on what companies and funds must disclose.

Several terms are used, often loosely, for overlapping ideas:

• Ethical or values-based investing — investing in line with moral or religious beliefs, usually by avoiding certain activities.
• Socially responsible investing (SRI) — an older term for portfolios built with social and ethical screens.
• Responsible investing — the broad practice of considering ESG factors and acting as an engaged owner; the term used by the UN Principles for Responsible Investment.
• Sustainable investing — today often used as an umbrella for all of the above.
• Impact investing — investing with the intention of generating a measurable positive social or environmental effect alongside a financial return (Chapter 10).

In this book, ESG investing means using ESG information in investment decisions, and sustainable investing the wider set of practices that also aim at real-world outcomes.

1.2 Three letters, many issues

Each letter covers a long list of issues (Figure 1.1). None of the lists is official: data providers, standard setters and investors group the issues in slightly different ways, which is one reason ESG ratings disagree (Chapter 5).

Environmental

The environmental pillar covers how a company affects, and depends on, the natural world. Climate change dominates the debate: greenhouse gas emissions (Chapter 6) and exposure to carbon policy and extreme weather. Other issues include energy and water use, pollution, waste, and land use and biodiversity (Chapter 21).

Social

The social pillar covers relationships with people: employees, workers in the supply chain, customers and local communities. Typical issues are health and safety, wages, forced and child labour, discrimination, product safety, data privacy and relations with communities near mines, plants or plantations. Social issues are harder to measure than environmental ones and are often revealed through incidents rather than reported figures.

Governance

The governance pillar covers how the company is directed and controlled: board independence, executive pay, minority shareholder rights, related-party transactions, accounting quality, tax practices and corruption. Governance is the foundation of the other two: a company with weak controls is unlikely to manage its environmental and social risks well, and it is the pillar most clearly linked to large losses for investors (Chapter 3).

1.3 Why investors care: values, risk and impact

Two investors may buy the same "ESG fund" for completely different reasons. Being clear about one's own reason is the most useful first step, because it decides which strategy and product fit.

• Values. Some investors do not want to profit from activities they consider harmful — tobacco, weapons, gambling, coal — whatever the financial consequences. Their question is: does this portfolio reflect what I believe?
• Risk and return. Other investors use ESG information to identify risks, and perhaps opportunities, that financial analysis misses: a carbon price that raises a cement maker's costs, a supply-chain scandal that costs a clothing brand its customers. Their question is: does this information improve my risk-adjusted return?
• Impact. A third group wants its money to contribute to real-world change. Their question is: would the world be different without my investment?

The motives can conflict. Excluding an oil company may satisfy an investor's values while having little effect on the company, which simply finds other shareholders. Engaging with it may achieve more change but means owning a business the investor dislikes. None of these choices is wrong; each answers a different question.

1.4 Financial materiality

In accounting, an item is material if leaving it out could change the decisions of a reasonable user of the accounts. ESG investing borrows the word. An ESG issue is financially material if it can reasonably be expected to affect a company's cash flows, its risks or its cost of capital — and therefore its value.

Materiality depends on the industry. Water scarcity is a major risk for a beverage company or a rice exporter and nearly irrelevant for an insurance broker; data privacy is critical for a bank but minor for a cement maker. This is why most rating systems use industry-specific weights (Figure 1.2): the same score on the environmental pillar counts for half of the total for an oil company but only a small fraction for a software firm. The standards originally developed by the US-based Sustainability Accounting Standards Board (SASB), now maintained by the ISSB, are built on this idea, identifying the disclosure topics most likely to be material for each of dozens of industries (Chapter 4).

Materiality also changes over time. Twenty years ago, few investors called carbon emissions material for a carmaker; carbon prices, fuel-efficiency rules and electric vehicles have since made them central. Issues that look like ethics today can become finance tomorrow — dynamic materiality.

1.5 Double materiality

Financial materiality looks from the outside in: how does the world affect the company? Double materiality adds a second direction, from the inside out: how does the company affect the world — people, communities and the environment — whether or not this affects its profits today?

A factory that pollutes a river may face no fines or lawsuits, so its pollution is not, for now, financially material; under double materiality it still is. The European Union adopted this approach in its corporate sustainability reporting rules, while the global baseline standards of the International Sustainability Standards Board (ISSB) focus on information that is material to investors (Chapter 7). Impacts ignored today often return as regulation, litigation or lost customers tomorrow (Chapter 3).

1.6 A map of ESG strategies

Investors put ESG into practice through a small number of strategies; the classification below is close to that of the Global Sustainable Investment Alliance. Module 3 gives each strategy its own chapter.

Exclusions are simple and easy to explain, but say nothing about the companies that remain. Integration is invisible from the outside. Best-in-class keeps sector weights close to the market, but can include "the best of the oil companies". Thematic and impact strategies are concentrated and volatile. Stewardship changes no holdings at all; its results show up, if at all, in the behaviour of companies.

1.7 How strategies combine

Almost every ESG portfolio combines strategies. A common recipe: exclude controversial weapons, tobacco, thermal coal and norm breakers; overweight the best ESG scores in each sector; then vote and engage. The NXW Global ESG Leaders index (NXWGLESG, simulated), used as a running example in this book, follows a similar logic: 50 components, rebalanced once a year, with cap weights tilted towards companies with higher ESG scores. Chapter 15 describes its methodology, and Chapter 19 shows how to build and back-test such an index.

The usual way to summarise the ESG profile of a portfolio is a weighted average of the scores of its holdings.

1.8 What ESG investing is not

Because the term is used so widely, it helps to clear up a few common misunderstandings.

• Not a single strategy. "ESG" on a label tells you little until you know the strategies, thresholds and data behind it.
• Not a measure of goodness. An ESG rating usually measures how well a company manages the ESG risks material to its industry, not how beneficial its products are. A tobacco company can receive a better rating than an electric-car maker if it manages its own risks well (Chapter 5).
• Not automatically a sacrifice of return, nor a guarantee of outperformance. The evidence is mixed and depends on the period and the method (Chapter 13).
• Not the same as impact. Buying listed shares rarely gives a company new capital; impact needs other channels such as engagement or primary financing (Chapters 10 and 11).
• Not static. Standards and rules change quickly; a fund "sustainable" under one rulebook may need a new name under the next (Chapter 17).

Critics argue that ESG mixes incompatible goals, relies on poor data and invites greenwashing; supporters reply that ignoring material risks is itself a failure of fiduciary duty. This book takes a practical position: ESG information is useful when it is material, measured carefully and used for a clearly stated purpose — and much less useful as a slogan.

1.9 ESG for a Vietnamese investor

ESG may seem like a concern of large Western pension funds, but it already shapes Vietnamese companies, banks and capital markets.

For a Vietnamese investor the questions are the same as everywhere — which issues are material, what should my money achieve, which products deliver it cheaply? — but data are thinner and products fewer. Chapter 20 returns to these questions, and Chapter 18 builds an illustrative ESG portfolio in VND.

1.10 A map of the book

This book follows the same path as its companions, Index Investing: From Theory to Practice and Commodity Investing: From Theory to Practice. It is organised in six modules.

• Module 1 — Foundations (Chapters 1–3). What ESG investing is, how it developed from ethical exclusions to the Paris Agreement, and why ESG issues can affect risk and return.
• Module 2 — Data and ratings (Chapters 4–7). ESG data and their reliability, ratings and why they disagree, the climate risk and carbon footprint of a portfolio, and the taxonomies and rules that define what is green.
• Module 3 — Strategies (Chapters 8–12). Exclusions, ESG integration and best-in-class, thematic and impact investing, stewardship and voting, and green, social and sustainability bonds.
• Module 4 — Theory and evidence (Chapters 13–15). What research says about ESG and performance, how portfolios are aligned with climate goals, and how ESG indexes are built, with the NXW Global ESG Leaders index as a case study.
• Module 5 — Products and practice (Chapters 16–19). Choosing ESG funds and ETFs, spotting greenwashing, building an ESG portfolio, and building and back-testing your own ESG index in Excel and R.
• Module 6 — Invest (Chapters 20–22). ESG in Vietnam and Asia, carbon markets and nature, and the future of sustainable investing.

Each chapter ends with key takeaways, a practice lab with an Excel workbook and further reading. Simulated and illustrative data are always labelled.

Key takeaways

• ESG stands for environmental, social and governance factors: non-financial issues that can affect a company's value, its impact on the world, or both.
• Investors care about ESG for three different reasons — values, risk and return, and impact — and each leads to different strategies and different measures of success.
• An ESG issue is financially material if it can affect cash flows, risk or the cost of capital; materiality depends on the industry and changes over time.
• Double materiality adds the company's impact on people and the planet, whether or not it affects profits today.
• The main strategies are exclusions, norms-based screening, integration, best-in-class, thematic and impact investing, stewardship and labelled bonds; most portfolios combine several.
• ESG is not a single product, a measure of goodness or a guarantee of returns; for Vietnamese companies and investors it is already a practical matter of exports, finance and climate exposure.

Practice lab 1

Download the workbook Lab01_What_Is_ESG.xlsx from the companion site.

• Sheet 1 — Classify the issues. Sort the list of 30 issues provided into E, S and G, then mark which ones you think are financially material for a bank, a cement maker and a garment exporter.
• Sheet 2 — Materiality weights. Reproduce the example of Section 1.4; change the pillar weights for each industry and see how the overall score and the ranking of the three companies change.
• Sheet 3 — Portfolio ESG score. Reproduce the five-company example of Section 1.7, then test other exclusions and a best-in-class rule and compare the resulting scores and sector weights.
• Sheet 4 — Your motivation. Answer the short questionnaire on values, risk and impact, and record which strategies of Table 1.3 fit your answers best.

Further reading

• UN Principles for Responsible Investment (PRI) — "What is responsible investment?" and other introductory guides.
• Global Sustainable Investment Alliance — Global Sustainable Investment Review (periodic reports and definitions of strategies).
• IFRS Foundation — SASB Standards and the SASB materiality map; ISSB — IFRS S1 and S2 standards.
• Alex Edmans, Grow the Pie: How Great Companies Deliver Both Purpose and Profit, 2020.
• Florian Berg, Julian F. Kölbel and Roberto Rigobon, "Aggregate Confusion: The Divergence of ESG Ratings", Review of Finance, 2022.