It’s worth getting to grips with how certain terms are used in communications about responsible investment and your workplace pension. So here’s your quick guide to the difference between ‘ESG’ (environmental, social and governance) and ethical investing.

ESG’s three key parts explained

Like any science, profession or industry, responsible investing has its own language. Because investing in your pension is important for your financial wellbeing, understanding the terminology can be important.

‘ESG’ describes three key things that fund managers – the professionals who invest your pension money – look at to weigh up the pros and cons of investing in a company.

Here’s what ESG is about:

1 Environmental How a business impacts the physical environment, such as: climate change; biodiversity; natural resources; air and water pollution; andcarbon emissions.
2 Social The impact on people, society and communities, including: human rights; health and safety issues; labour standards; privacy and datasecurity; and product liability.
3 Governance How companies are governed, including: transparency; ownership; board independence; ethics; and executive compensation.

Fund managers use information on these three key issues to get a picture of the likely future financial performance of these companies. ESG investing is based on the belief that these three issues are critical to a company’s future financial performance and can help a business achieve better returns over the longer term.

How fund managers make ESG investing work

Fund managers will engage with the companies that they invest in to create positive change on issues such as climate change. Although there are no hard and fast rules about how each fund manager engages with the companies in which they invest, we can give you a rough guide to the type of things that ESG investing requires. This should give you a clearer picture.

Direct engagement

This involves talking to and supporting businesses to foster positive change and includes:

  • writing or meeting with the directors of the company to discuss issues
  • setting targets for the company to address concerns, for example implementing a clear climate change policy
  • the fund manager using their voting rights as a shareholder, for example to vote against executive remuneration
  • withdrawing their investment if there’s no improvement following engagement

Crunching the numbers

There are many ways that fund managers can objectively measure how a company is performing in ESG terms. These include:

  • how much tax it is paying and how it operates
  • how it treats its workers, including the proportion of women and minorities it employs
  • whether it pays a living wage
  • how it treats its customers
  • Chief Executive Officer pay
  • its energy efficiency, environmental impact and what it is doing to help fight climate change 

These are a few examples of the things that fund managers examine when they are looking at how a company is doing in the ESG-stakes.

Ethical investing explained

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.

The significant difference between ESG and ethical investment is that the latter focuses more on subjective, moral judgements than performance considerations.

This type of investing depends on an investor’s personal 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.

This time, it’s personal

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 tobacco company may be a sound financial investment, but is ruled out because of the investor’s stance on tobacco.

To sum up, the choice between ESG and ethical investment is a question of how you feel about certain issues and how keen you are to invest ethically for your retirement..