ESG finance for beginners
Some useful terms to get started
I started learning about ESG in 2020 and spent a good amount of my time at the start to get up to speed with the jargons. What struck me was the sheer quantity of acronyms and the number of organizations responsible for setting standards.
Using the 80/20 rule, some of the most important terms to know (at least in the context of finance/portfolio management) are:
Decarbonization/ net zero: Companies and countries have pledged to reduce carbon emissions, and many portfolios now have an additional carbon metric to track if it is green enough. Net zero refers to cutting emissions to an amount such that the greenhouse gas produced almost balances the removal from the atmosphere
Paris agreement: Related to the above, an agreement adopted in 2015 that set a goal of limiting “the rise in mean global temperature to well below 2 °C (3.6 °F) above pre-industrial levels, and preferably limit the increase to 1.5 °C”
Physical risk versus transition risk: The former refers to the risk of lost lives and damaged properties due to climate change, whereas transition risk mostly refers to companies/countries not adapting fast enough
Climate scenarios: A set of simulations that help project returns for differing decarbonization pathways
UN SDGs: United Nation’s Social Development Goals. There are 17 of them, ranging from reducing poverty to protecting the oceans. There are portfolios that claim to be geared toward promoting these goals
Positive/negative screening: Positive screening → picking good ESG companies to be included in a portfolio; Negative → excluding ‘naughty’ companies depending on one’s definition of what that means
Materiality map: Companies in different sectors face different ‘material’ (pertinent) ESG factors. For instance, product safety may matter more to a consumer company than a bank. Materiality map helps to re-weight the significance of ESG issues based on a company’s profile (usually sector)
Board diversity: Composition of gender/race on a company’s board. The hypothesis is that a more diversed board generally leads to better decision-making and hence better company performance
Congratulations! If you are familiar with the above, you can now have a 15-minute conversation with someone at a cocktail party on ESG finance.
These are the building blocks for a basic understanding of what finance people care about when they think about ESG (specifically climate), and also for us to explore some of these topics in depth.
Of course, this field is booming (some call it a bubble) so more and more new terms and concepts are being introduced.
Most important, ESG finance can get controversial as people on opposing camps constantly disagreeing about whether ESG is good or bad for portfolio performance.
This can get frustrating for someone starting out in this field. I don’t have all the answers but I will share and summarize thoughts on research in this space so that you are equipped for the debate.