'ESG' and ethical investing – what are the differences?

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:

• Environmental - How a business impacts the physical environment, such as: climate change; biodiversity; natural resources; air and water pollution; and carbon emissions.
• Social - The impact on people, society and communities, including: human rights; health and safety issues; labour standards; privacy and data security; and product liability.
• 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 perform better and potentially achieve better returns for investors over the longer term.

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 usually involves. 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 policy to help combat climate change
• 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 from the business 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
• 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 taking environmental, social and governance factors into consideration.

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 tobacco products and companies involved in animal testing.

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.

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.