Environmental, social and governance (ESG) and sustainable investing – let’s clear up the confusion
Gareth Trainor | September 3, 2019
Two areas of investment are gaining momentum: ESG and sustainable investing. One brings new regulatory responsibilities affecting trustees, while both give employers topical subjects which they can use to encourage their employees to engage with their pensions. But the associated terminology – think responsible, socially responsible investing (SRI), ethical, impact, green – is confusing and could be discouraging. Gareth Trainor, Head of Investment Solutions, aims to clear up the confusion.
New policy directives and an increasing focus on identifying risk and opportunities in investments have pushed environmental, social and governance (ESG) investment, into the mainstream. Most recently, the Department for Work and Pensions outlined ESG requirements which they expect trustees to implement by 1 October this year.
But the rise of ESG comes alongside growing interest and innovation in sustainable investing (funds such as ethical and impact). This has led to lots of choice – and topical subjects that employers can use to engage employees in their pensions – but also multiple and confusing terminologies. In fact, research shows that lack of understanding is a key barrier to people investing responsibly, even when they’re keen to do so.
In a special two-part feature, I try to clear up some of the confusion. In part one, I look at the differences between ESG and sustainable investing. In part two, I consider what’s driving growth in these areas of investment and why they’re a compelling way to help engage employees with their pensions.
What’s the difference between ESG and sustainable investing?
Responsible, ESG, sustainable, ethical, SRI, impact, green – these terms are used inconsistently with different meanings from investment manager to manager; a problem reflected across providers and the media. There’s growing recognition that this is creating confusion for investors. Earlier this year, the Investment Association (IA) launched the first industry-wide consultation on sustainability and responsible investment. One focus is to agree industry-endorsed standard definitions to help investors navigate these areas.
Terminology and definitions will continue to evolve. In the meantime, I’m keen to help clear up some of the confusion, especially when it comes to the significant difference between ESG – an overarching process for risk assessment used across investments – versus funds using asset allocation to achieve specific values-based outcomes.
ESG or responsible investment
At Standard Life we talk about ESG as ‘responsible investment’. This is in line with the United Nations-backed Principles for responsible investment (the PRI), which defines responsible investment as an approach that aims to incorporate environmental, social and governance (ESG) factors into investment decisions to better manage risk and generate sustainable, long-term returns.
ESG is an overarching investment process increasingly being used across funds in general, not just ‘ethical sector’ funds, as it can highlight problems which can be missed by more conventional risk analysis. Investment managers use it to assess the financial health and risks of a company based on the actions they take (or don’t take) around environmental, social or governance factors. This could include identifying:
- disconnects between financial performance and employee remuneration
- poor management of supply chains or natural resources
- the impact of production activities on local communities and climate change
ESG analysis can help to spot issues on the horizon, so investment managers can work with companies to fix or even avoid these. Or, in the case of active managers, move money out of companies that are resistant to change.
If an investment manager understands a company’s management of ESG factors – and therefore any associated risks the company may face – they can better value what they’re investing in. In turn, this can help them achieve better risk-adjusted returns for investors. Remember, your employees’ pensions are invested to help them grow. That means the value of your employees’ investments could go down as well as up and they may get back less than was paid in.
Sustainable investing which is about values-based outcomes
At Standard Life, we use the term ‘sustainable investing’ to cover investment styles such as ethical, socially responsible, green and other environmental and social thematic funds, faith-based and impact funds. They’re funds that tend to reflect themes or specific ethical requirements and allow people to match their investments to their values. Themes and requirements may include:
- avoiding companies that produce tobacco or weapons, or that test on animals
- investing according to certain religious values
- seeking out investment in companies with a positive environmental target, such as renewable energy
The big difference
ESG is an overarching investment process. It’s about financial assessment and risk management across all funds – so it’s relevant to all investors (not just ‘ethical’ investors). However, if an investor wants to invest in line with their wider view of the world, then they may consider a fund that uses asset allocation to target a specific outcome.
On one hand you have a fundamental process for risk assessment; on the other hand you have individual funds accommodating or promoting specific outcomes in addition to financial returns.
You could think about it this way. Do you want to consider:
- an investment manager who embeds a robust ESG approach in their investment processes across all funds to help manage risk and return?
- an individual fund or range of funds that target a specific values-based theme or outcome?
This infographic helps explain these two distinct areas of investing.
Find out more in part two
In new responsibilities for pension trustees – new opportunities for employers we look at what’s driving growth in ESG and sustainable investing and why these topics are a compelling way to help engage employees with their pensions.
Please remember that the value of all investments can go down as well as up, and could be worth less than originally invested.
If you’re unsure about any of these descriptions, you might want to speak to a financial adviser though there’s likely to be a cost for this.