ESG investing is on the rise, but what is it and how does it work?

A 2020 survey conducted by the Chartered Financial Analysis (CFA) institute found that 85% of its members take ESG factors into consideration in their investing and that client demand rose by 65%.

ESG is an acronym for Environmental, Social and Governance. Each of these represents broad areas of consideration when it comes to ethical investing.

The Environmental element relates to a company’s impact on the natural world and considers factors such as its energy consumption, policies on climate change and their waste production.

The Social category considers factors like how well a company protects human rights and how it addresses modern slavery or gender diversity issues i.e. its impact on society.

Examples of factors relating to the Governance category are a company’s quality of management, and if there have been any cases of bribery or corruption.

So how does it actually work?

An ESG investment strategy incorporates companies that score highly in the above areas. As with traditional investment strategies, the aim is still to achieve positive returns but by including companies that are deemed to be environmentally and socially aware.

Companies are rated by individual third party assessors and given an appropriate ESG score which investment managers can then integrate into their fund offerings.

As with traditional investment strategies, ESG funds come with various risk ratings so that investors can invest in funds that match their attitude to risk.

A common misconception is that performance must be sacrificed in an investor’s pursuit of ensuring their investments have a positive impact, or at least not a damaging one, to the planet and wider society.

However, an article produced by the Financial Times in 2020 actually found that roughly 60% of ESG funds delivered higher or equivalent returns compared to their more conventional peers when looking at the previous decade.

Whilst past performance is no guide to future returns, this demonstrates that performance isn’t necessarily hampered as a result of considering ESG factors. Indeed, one could argue that companies that embrace these values will do better in the modern world.

Additionally, given the larger interest in ESG investing demonstrated by the CFA’s survey, it could be that the consideration of ESG factors becomes the norm for investment strategies.

How does it differ from other Ethical investing strategies?

There are other ethical investment strategies that are similar to ESG investing, such as Socially Responsible Investing (SRI) and Impact investing.

SRI is a more tailored approach that aims to align an investor’s values with their specific investment choices. As an example, an ESG strategy may be to be comfortable investing in a company with a strong governance structure, but it may still have a negative impact in other areas. An SRI strategy would completely remove investments in companies that were not aligned to an investor’s values.

Impact Investing is much more focused on real world impact as opposed to portfolio returns. Investors would choose assets or companies that are directly trying to positively impact society. For example, a company actively trying to solve the global warming issue.

Essentially, the main difference depends on how bespoke an investor wishes their portfolio to be.

What are some key issues that relate to ESG Investing?

ESG funds are at risk of ‘Greenwashing’ whereby a company may imply they’re much more environmentally responsible than they are.

Companies may do this by promising to reduce their carbon footprint by a certain amount, by a certain date, which could prompt investment. However, if there is nothing binding the company to this statement, then they could simply change their mind or not even actively try to achieve it.

There are ways you can avoid ‘Greenwashing’ such as to look beyond a name of the fund and complete additional research by reading the fund factsheet or key investor information document where a fund’s aim and how it hopes to achieve this aim is stated.

To conclude, ESG investing is a good way for clients to put their money to work by investing in a fund that incorporates environmentally and socially responsible companies. If you are interested in ESG investing or any type of investing, please do not hesitate to contact the CBW financial planning team and we will be happy to help.

Do listen to our most recent Financial Planning podcast, with Jack Turner, Investment Manager from 7IM, talking to Lewis O’Sullivan about ESG Investments here.