The ABC of ESG
There are a lot of terms being thrown about when it comes to ethical investing with the added complication that definitions vary. This makes it almost impossible for investors and sometimes even advisers to understand the differences.
I mention ethical investing, but in truth this itself is only one aspect. It makes sense to step back and look at the subject with a wide lens. The main over-arching concept that sits above all type of ethical, sustainable, responsible, and environmental investing (and others) is ESG.
ESG covers Environmental, Social and Governance factors which are generally best described as non-financial considerations that can help inform investment decisions. Taking into consideration ESG factors on its own doesn’t mean that a fund is being ethical, just that the manager considers the risks and opportunities of those factors to a business.
At its heart ESG investing recognises that to generate long term sustainable returns a business needs to have strong ESG characteristics. They can improve worker satisfaction, avoid fines as well as increase the likelihood of renewing a business license and strengthening a company’s brand.
ESG considerations are increasingly being incorporated into all aspects of investing, no matter what their objectives. After all, managers want to invest in companies with good corporate governance, while the evidence shows a company’s social and environmental policy can have a long-term impact on future growth and financial returns.
Beyond conventional financial investing Social, Impact, Sustainable and Responsible investing all use ESG metrics and methodologies to a greater or lesser degree with the emphasis differing between the importance of financial return and the need to make a ‘social return’.
This is a broad term that covers a few sub-categories such as Socially Responsible Investing. At its simplest, responsible investing aims to mitigate risky ESG practices to protect investors’ capital. To achieve this, the investment manager considers how ESG factors might affect the returns of a company and potential risks to those returns. They also need to consider how the company affects society and the environment.
Socially Responsible Investing (SRI)
SRI has become a popular term in ESG investing. It places a greater emphasis on social and environmental criteria. Funds that look to invest with an SRI approach will often apply strict criteria, which they use to score a company. They also often apply sector limitations – either excluding certain sectors or capping exposure in others.
This allows the fund to implement a filter to create a list of SRI companies which then can be used in combination of investment strategies.
There are a lot of funds with the term Sustainable in their name, but it isn’t always clear what this means. It is a broad term that refers to the selection of assets that contribute to a sustainable economy by minimising the depletion of natural and social resources.
It can also be used to describe companies that have a positive impact, or those businesses that should benefit from sustainable trends.
Managers can also use this approach to filter out those companies which engage in activities considered contrary to long term environmental and social sustainability such as oil exploration in the artic.
Here, investments are made with a specific objective of making a positive social or environmental change. There is still the aim to make a profit, unlike philanthropy. However, some financial return may be sacrificed to support the objectives of the fund, although many still target returns similar to the wider market. Investments are usually directly into private equity, private debt, and property.
The focus of green funds is on environmental issues. Such funds invest in companies which mitigate climate change, biodiversity loss and resource inefficiencies amongst others. It can include low-carbon power, smart-grids, recycling, and pollution control. Whilst the focus of Green investing is environmental, the objectives of funds can vary from impact investing, where the focus is more towards the social aspects to Sustainable where ESG factors are a consideration, but financial returns remain a priority.
For many, ethical investing was the original term used to cover any investment in the ESG space. Today the focus of ethical is more value-driven and often linked to an individual’s faith. As such it frequently applies a negative filter – excluding sectors whose products and services are considered immoral. These include the traditional sin stocks such as tobacco, weapons and nuclear power as well as poor governance practices such as a breach of human rights in a company.
One of the criticisms of ethical investing has been that because it narrows the investment universe it adds risks and limits returns by excluding certain sectors. The ‘Best in Class’ approach uses ESG analysis to identify the best companies in any given sector. It does not exclude a sector. This effectively puts an ESG screen over the market and priorities ESG factors over other financial considerations, although not to their exclusion.
The approach can be useful as it allows for closer tracking of major indices and exposure to sectors such as oil, tobacco and mining which tend to pay higher dividends.
Navigating the world of ESG investing is becoming more important as issues like climate change rise to the top of world leader’s agendas.
Historically, the starting point for an adviser was to be led by the client on their views and beliefs. But ESG has evolved and now advisers need to understand what the benefits of ESG are to a portfolio and how it might help their clients.
The benefits to companies that adhere to strong ESG principles are significant and contribute to long-term returns. Good governance reduces the risk to the business, whilst focusing on environmental and social factors can cut costs and boost demand. It is no longer something that can be ignored.
Published by our friends at: