ESG and ethical investing: what’s in a name?
In recent years, ESG and ethical investing have moved from niche strategies to a mainstream part of investing.
But what’s the difference between ESG and ethical investing? Is it all the same thing called by different names or is each one a different thing? Let’s find out.
What’s ESG all about?
ESG describes three key factors used by fund managers to assess corporate behaviour:
This concerns interaction with the physical environment, such as climate change, biodiversity, natural resources, carbon emissions, air and water pollution and so on.
This looks at the impact on society and communities, including human rights, health and safety issues, labour standards, product liability, privacy and data security and so on.
This focuses on how companies are governed, including diversity, transparency, ownership, board independence, ethics, executive compensation and so on.
Fund managers use information on these issues to get a picture of the likely future financial performance of companies.
The ESG framework is based on the belief that these factors are critical to a company’s future financial performance. The theory is that companies that don’t impact the environment, have a social conscience and are well governed will out-perform other companies.
That’s a significant difference between ESG investment and ethical investment, which focuses more on moral and ethical judgements than investment considerations.
That’s not to say that ESG investing doesn’t result in wider societal benefits. Fund managers looking to improve returns will assess a company’s responses to ESG issues and decide whether to invest. Where they invest, they’ll engage with the company to improve their ESG credentials and potentially their future financial performance. They may do this by:
- writing or meeting with the directors of the company to discuss the issue
- setting targets for the company to address their concerns
- using their voting rights
- withdrawing their investment if there’s no improvement
The fund managers aim to encourage good practices at a company, paying attention to things like:
- it’s environmental impact
- its energy efficiency
- its transparency on tax and business practices
- how it treats its workers
- the proportion of women and minorities it employs
- whether it pays a living wage
- its relationship with stakeholders and shareholders
- the independence of the board in representing shareholder interests
- CEO pay
- the company’s contribution to climate change or air pollution.
These are only a few examples of the kind of things ESG investing looks at. Fund managers will scrutinise every company they consider before deciding whether to invest.
So, what’s ethical investing?
As the name implies, ethical investing is about investing using ethical principles as a guideline. Often, it means filtering out certain types of companies and sectors – usually ‘sin stocks’ like weapons manufacturers, tobacco producers, companies involved in animal testing and so on.
This type of investing depends on the investor’s views. It gives investors the opportunity to channel their money into companies whose practices and values match their personal beliefs, whether these are environmental, political or religious.
Another aspect of ethical investment to be aware of is that investors may not necessarily be choosing a company based on its investment performance. For example, a nuclear company may be a sound financial investment, but is ruled out because of the investor’s stance on nuclear power. That’s not to say ethical investors will put money in a poorly performing investment. Of course, they will look to make money, but they may rule out certain strong financial performers because they don’t fit their ethical preferences.
Are ESG and ethical funds higher risk?
In the early days of ESG and ethical investing, fund managers and investors may have considered it risky to invest in these types of funds or investments. That’s no longer the case. With a wider range of stocks available to ESG and ethical investors, they can now easily spread the risk to their money, just as with traditional investing.
What does this type of investment mean for workplace pensions?
ESG investing means investing money as sustainably as possible in every sense of the word. It looks at environmental and social sustainability and makes sure companies have governance in place to improve that sustainability year on year.
By you choosing a scheme that has a strong ESG investment strategy as a default, or giving your employees the option to invest their pension contributions into ESG or ethical funds, you and your employees can help put pressure on companies to continually improve their position. And taking steps to make the world a better place to live is good for all of us and future generations.
Want to find out more about ethical investing? Read our article on investing sustainably through your pension.