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 means "environmental, social and governance" and represents extra-financial factors that can be used by investment teams to help us better understand the material risks and opportunities of the assets we invest in. ESG research can provide valuable information and insight by analysing potentially unacknowledged, yet material, risks that may impact the performance and reputation of our investments.

Environmental

Environmental factors can include a company's energy usage, waste, pollution, natural resource conservation and policy on climate change.

Social

Social factors can include the company's relationships with and auditing of its suppliers, how it looks after its staff in terms of human rights; health and safety, training and issues surrounding diversity and inclusion.

Governance

Governance factors involve how a company is run, such as how transparent and accurate a company is being regarding its accounting, how it deals with conflicts of interest, the suitability and competency of its board members, executive pay, and any issues with bribery and corruption. The factors can vary depending on the sector, geography and company in question. A technology company, a mining company and a bank, for example, will face different key ESG risks and opportunities.

ESG illustration

Fund managers use information on these issues to help them get a picture of how a company might perform.

The ESG framework is based on the belief that these factors can impact a company’s future financial performance.

That is a significant difference when compared with ethical investing, which focuses more on moral and ethical judgements than investment considerations: investment performance is not the main priortity of ethical investing.

That’s not to say that ESG investing might not result in wider societal benefits. Fund managers looking to enhance performance will assess a company’s responses to ESG issues and decide whether to invest. Where fund managers who take ESG factors into consideration as part of their strategy do invest, they will often engage with businesses to foster positive changes, such as on better inclusion and diversity. They may do this by:

  • writing to 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

Their aim will be to encourage good practices at a company, paying attention to things like:

  • its 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 investing to be aware of is that fund managers 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 by ethical funds because of their investor’s stance on nuclear power. That’s not to say ethical fund managers 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, it may have been considered riskier 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.