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ESG Trading

Written By

James Barra

Written By

James Barra

James is an investment writer with a background in financial services. As a former management consultant, he has worked on major operational transformation programmes at prominent European banks. James authors, edits and fact-checks content for a series of investing websites.

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Edited By

Jemma Grist

Edited By

Jemma Grist

Jemma is a writer, editor and fact-checker focused on retail trading and investing. Jemma brings a unique perspective to the forex, stock, and cryptocurrency markets and works across several investment websites as a researcher and broker analyst.

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Fact Checked By

Tobias Robinson

Fact Checked By

Tobias Robinson

Tobias is a partner at DayTrading.com, director of a UK limited company and active trader. He has over 25 years of experience in the financial industry and contributed via CySec to the regulatory response to digital options and CFD trading in Europe. Toby’s expertise and dedication to financial education make him a trusted voice in the industry, including a BBC investigation into digital options.

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Updated

Aug 15, 2024

ESG is becoming a bigger part of the trading landscape. Many capital allocators have sustainable development goals they’d like to pursue in their portfolios. 

Traders are thinking more and more about how the assets they hold in their portfolio interact with the world and how certain assets drive real-world outcomes. 

New to the world of ESG? This guide will get you started.

Quick Introduction

• ESG, also commonly known as ‘impact’ investing, involves any information related to environmental, social, and governance factors that pertain to a real-world outcome. 
• ESG is commonly thought of as something that revolves around ideological inclinations, preferences, or factors that don’t explicitly tie to return. But it’s not just about preferences – e.g., ‘I don’t want to invest in carbon-intensive companies’ – but about assessing a broader range of criteria that drive trading outcomes. 
• ESG takes more of a stance that instead of thinking of investments as a two-dimensional trade-off – i.e., between risk and return – there is an extra dimension of ‘impact’ from environmental, social, and governance factors. 

Understanding The ‘E’, ‘S’ And ‘G’

ESG stands for ‘Environmental, Social and Governance’. This form of sustainable trading considers an investment’s financial returns and impact on the world using an ESG score based on the following principles:

• Environmental – This relates to a company’s impact on the environment. This can include its carbon footprint, climate change policies and goals, renewable energy usage and even employee benefit programs i.e. cycle to work schemes.
• Social – Social factors are concerned with stakeholder relations. Examples include a company’s commitment to gender and racial equality, diversity and inclusion programs, community development, charity work and ethical supply chain sourcing.
• Governance – Governance, or corporate governance, relates to a company’s board and management team. Issues range from reasonable executive compensation, protection of shareholder rights, the diversity of directors, plus litigation history and relationships with regulatory bodies.

Impact: Another Lens

Impact is another way of thinking about the real-world implications of your entire portfolio. 

For example, if you’re investing in the stock of a company, you are essentially putting up a lump sum in exchange for a stream of income over time. That income comes from what the company is doing. They are selling products and services in some form. 

What are those products and services? What is the behavior that goes into making those goods and services? And what is the real-world outcome?

Are some providing clean water, education, reducing poverty, and adding other benefits that may accrue outside the traditional analysis? 

If you’re buying commodities, what’s the process for getting them out of the ground or harvesting them and is that sustainable? And when utilizing the commodity, what are the effects of that in the world? 

If you’re buying a sovereign bond, what are the actions, outcomes, or commitments that that sovereign country is doing to impact the world around it? The money that it raises in the capital markets is influential in how it goes about this. 

Can an assessment be made in terms of what assets are having a positive influence on the world, which are most neutral, and which are having a more negative impact?

Everybody is accustomed to explaining why they hold something from a risk and return perspective, but the second- and third-order effects of the process might be thought of in a more limited way. 

Examples Of ESG Perspectives

An ESG perspective will look more at sustainable development goals (SDGs) as it pertains to different assets. 

Stocks

For example, a utilities company might be thought of as something with a fairly predictable year-to-year cash flow and a certain amount of volatility, but what is it really doing beyond that?

Let’s say a utilities company contributes to providing clean water and sanitation services and it does so in a way that’s less carbon-intensive than the average utility and that carbon intensity is falling over time. 

Someone looking through an ESG perspective – or at least to some degree more cognizant of ESG factors – might tilt its portfolio more toward an asset like that relative to its normal weighting in a standard index. 

It might underweight companies that are deemed to have less environmental and social impact and/or goes about its business in a less exemplary way.

Bonds

In the case of the bond market, governments are the big players, providing most of the depth to the market. 

So, you might look at all the governments in the world that tap the bond markets for capital raising and look at their behavior. 

For instance, an investor with an interest in environmental effects might try to understand governments that are subsidizing fossil fuels use versus those that are making progress in cutting back. 

Commodities

Commodities can be viewed through the lens of looking at the sustainability of their consumption and production.

Pick any commodity – e.g., oil, lithium, silver – when it’s being mined, how sustainable are those processes? And what are they being used for?

Some might shift away from oil and oil companies because of their carbon intensity. 

Some might view lithium as more beneficial because of its use in developing batteries for more sustainable transport. Then you can get into topics like the battery supply chain and its sustainability. 

Silver might be considered more neutral. Some silver is used for industrial use, while some is used in a more gold-like manner (as a type of reserve asset that people hold as an alternative currency). 

But it’s up to each market participant to determine what questions they want to ask about the asset and develop data to answer those in the best possible way. 

If the world is serious about transitioning away from carbon-intensive commodities, then a lot of different industrial commodities will be necessary to build modes of transport and charging and electricity infrastructure to get along well without energy sources that do emit a lot of carbon. 

Sustainable Development Goals (SDGs)

For most ESG investors, their number one concern is climate and how their portfolio is impacting that. 

So, a trader might look at the emissions of a company or the products they’re providing. 

Moreover, let’s say in the future companies start being penalized financially for carbon emissions. What would their earnings be if such policies were enacted to various levels of severity?

In the realm of bonds, are governments pursuing SDGs that help cut emissions or are helping bring along research and development that helps them in the world in terms of sustainability initiatives?

On commodities, they can look toward the commodities that can be produced and consumed sustainably and the ones required to get the economy away from carbon-intensive processes.

A lot of the ESG/impact framework fits more of a climate change angle, but it could be applied to virtually any issue that one wants to tackle.

It could be for things like clean water and sanitation, labor rights, education, biodiversity conservation, or any other issue. What are the causes you care about and what are the first- and multi-order consequences that these portfolio investments are having?

This can lead to new insights and new approaches that can better help inform a standard risk and return framework as well.

ESG Data

Reliable and consistent data is the biggest roadblock for capital allocators looking to adopt an ESG framework into their investing process. 

Data is based on what kinds of questions market participants are trying to answer and what kind of assessments they need to make. 

In terms of traditional risk, people want to understand their standard risk of capital loss. As a result, they came up with various ways to measure volatility over time – e.g., volatility expressed as a daily, monthly, quarterly yearly, or some customized time horizon.

And they also want to understand the distribution of this risk. Equities, for example, have large left-tail risks. For this, people came up with measures such as Value-at-Risk (VaR) and expected shortfall. 

They also want to know how different assets work together, so they study things like covariance. 

ESG data might try to answer questions that relate to the economic costs of production and consumption of a commodity. 

What would be the knock-on effects in other parts of a portfolio? 

If one commodity becomes less favored and another becomes more favored due to regulations, secular shifts, and/or other causes, how does this impact the revenues, cost structures, and/or the overall profitability picture for certain types of companies and their credit and equity? 

How would it impact the finances of certain governments?

For example, it’s widely known that the oil market has a material effect on the finances of Saudi Arabia, Norway, Qatar, among other countries. 

As the questions become more well-defined, the data will become better as more providers spring up in the industry and become more effective at providing investors with the kind of data and information they need.

Whatever data is used will also need to be compared alongside other providers.

Scoring

An ESG score can be assigned to an investment based on environmental, social and governance criteria. Today, many mutual funds, brokerage firms and robo-advisors offer products with ESG ratings.

However, investment firms use varying methodologies and indicators, meaning there is no universal authority on ESG scores. Ratings are often determined by analysts who identify issues faced by a particular industry. Alternatively, data can be collected from company disclosures or NGO databases.

For example, the DowJones Sustainability Index obtains data from companies through self-reported industry-specific questionnaires.

Additionally, MSCI ESG Research is one of the largest independent providers of ESG ratings. For each ESG score, it is rated on a scale from CCC (laggard) to BBB (average) to AAA (leader).

Morningstar is another leading provider of ESG ratings, analysing 20,000+ ETFs.

Benefits Of ESG Trading

Trading Strategies

Socially Responsible Investing

SRI frameworks use negative screening to eliminate companies and industries that don’t align with an investor’s value criteria.

For example, an ESG investor could exclude weapons, tobacco, alcohol, carbon or specific commodities.

Instead, they could start trading shares in healthcare companies, such as Aviva or environmentally-conscious real estate firms.

Quantitative Analysis

This form of ESG trading involves quantitative equity investing using non-financial ESG information i.e. environmental, social and governance data.

ESG quant funds rely on data gathered from corporate sustainability reports or external providers. The aim is to invest in sustainable companies that are better positioned for future stock price performance.

Level Systems

This ESG trading technique is based on the prediction that short-term returns from high-scoring ESG stocks won’t be fruitful, but that profits will come in the long run.

Thus, this strategy suggests going long on stocks with high ESG scores and going short on stocks with low ESG scores.

Factor Momentum

This system takes a view that companies who have greatly improved their ESG score will outperform competitors. Similar to the strategy above, financial returns are most apparent in the long term.

Thus, traders could focus on companies with a significant upswing in recent ESG ratings.

Bottom Line

ESG frameworks are becoming more popular as another subset of data and information that can help make effective trading decisions. 

However, there remains inhibitions surrounding ESG and impact integration within the investment process, especially in public market assets. These include:

• Lack of availability of reliable and consistent data
• Worries over giving up too much return
• Availability of sustainable investments at scale
• Communication with members and stakeholders
• Challenges concerning ESG and impact acceptance

To get started, see DayTrading.com’s pick of the best ESG trading platforms.

FAQ

How Can I Optimize My Impact With ESG Investing?

By practising ESG trading, you are arguably making a positive impact through your investments. ESG trading encourages companies to focus on stakeholder issues and to ensure good practices when operating in the environment and communities around them.

Is ESG Investing A Fad?

ESG investing is becoming more mainstream and has grown into a trillion-dollar market. Therefore, it’s arguably not a fad or a bubble waiting to pop.

With that said, ESG trading is much more popular in the US compared to other regions like Europe or Asia.