What is ESG in Investing?

Investors are increasingly considering environmental, social and governance (ESG) factors when making investment decisions. Here’s what you need to know.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek professional advice.

The world today isn’t short of challenges. From climate change to an increasing and ageing global population – humanity has its work cut out to create solutions to the many complex problems of the 21st century. So, it’s perhaps no surprise that investors are increasingly thinking about how environmental, social and governance factors could affect their investments – and how their investments could impact people and the planet.

Responsible investing

Responsible investing involves incorporating ESG factors into investment decisions and analysis, as well as engaging with company management and voting at shareholder meetings. ESG refers to a range of non-financial factors that can influence a company’s operations and value, for example:

  • Environmental factors can include a company’s carbon footprint, water usage and waste efficiency or its impact on biodiversity
  • Social factors can relate to a company’s workforce, stakeholders and culture, human rights issues or diversity and inclusion
  • Governance factors can include board composition, shareholder structure, management incentives and accounting quality.

Analysis of these non-financial factors can identify both risks and growth opportunities. The aim of responsible investing is to manage and mitigate ESG factors which could materially impact long-term company and investment returns.

Responsible investing may also involve applying filters and screening to potential investments. This may be to exclude a specific industry sector considered to have a negative environmental or social impact (negative screening), or to favour investments considered to have higher ESG quality (positive screening).

Sustainable investing

Sustainable investing also incorporates ESG factors in investment decisions, but has an additional aim to make a positive environmental or social contribution. It’s a broad term that covers a number of different strategies and approaches.

For example, some sustainable funds invest in assets that are providing sustainable solutions, such as renewable energy or new technologies. Others invest in assets that are not yet sustainable but have the potential to transform. Some funds have specific, measurable social or environmental impact objectives, while others aim to support sustainable development goals more broadly.

Why ESG-related terminology can be challenging

Terms such as ESG, responsible investing and sustainable investing can be challenging, as there are currently no universal definitions or market consensus around how to approach them. The way one manager assesses a company’s ESG quality may be different to another, which can lead to different interpretations and investment outcomes. Similarly, managers may diverge in how they define and measure the environmental and social impact of investments. Regulations, standards and industry guidance in this area currently vary widely across jurisdictions, and are likely to evolve further in the future.

What this could mean for you

If you’re considering investing in a fund that incorporates ESG factors or sustainability objectives, it’s vital you understand the manager’s specific approach to ensure it aligns with your expectations and goals. You can do this by reading the fund’s Key Investor Information Document (KIID), factsheet and any other supporting documents. If you’re not sure about anything, please seek professional advice.

To help give investors more information about sustainable investing options in the UK, the Financial Conduct Authority (FCA) has developed four sustainability labels for investment funds. You may start to see these from 31 July 2024 – visit the FCA website to find out more.

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Smart Investor is an execution-only service that can help you strengthen your trading capability by providing you with the latest research and market information to inform your decisions. We do not provide personal investment advice or a view on whether investments are suitable for you in light of your personal circumstances and objectives. This means you are solely responsible for the decisions you make.

This article is not designed to be taken as expert advice, investment advice or a recommendation and any reference to specific companies is therefore not an opinion as to their present or future value or broader ESG credentials. Reliance upon any of the information in this article is at the sole discretion of the reader. Some of the views and issues discussed in this article may derive from third-party research or data which is relied upon and may not have been validated. Such research and data are made available as additional information for the reader where appropriate.

There is currently no globally accepted framework or definition (legal, regulatory or otherwise) of, nor market consensus as to what constitutes, an ‘ESG’, ‘green’, ‘sustainable’, ‘climate-friendly’ or an equivalent company, investment, strategy or consideration or what precise attributes are required to be eligible to be categorised by such terms. This means there are different ways to evaluate a company or an investment and so different values may be placed on certain ESG credentials as well as adverse ESG-related impacts of companies and ESG controversies where these are considered.

The evolving nature of ESG considerations, models and methodologies means it can be challenging to definitively and universally classify a company or investment under an ESG label and there may be areas where such companies and investments could improve or where adverse ESG-related impacts or ESG controversies exist. The evolving nature of sustainable finance related regulations and the development of jurisdiction-specific regulatory criteria also means that there is likely to be a degree of divergence as to the interpretation of such terms in the market. We expect industry guidance, market practice, and regulations in this field to continue to evolve.

Any references to ‘sustainable’, ‘sustainable investment’, ‘ESG’, ‘ESG data’ or other similar terms or related exclusions in this article are not to any jurisdiction-specific regulatory definition or other interpretation of these terms unless specified otherwise.

The third party manager’s assessment of a company, based on the company’s level of involvement in a particular industry or their own ESG criteria, may differ from that of other funds or an investor’s assessment of such company. As a result, the companies deemed eligible by the third party manager may not reflect the beliefs and values of any particular investor and may fall below certain ESG-related standards or result in negative ESG impacts.

The evaluation of companies in respect of their ESG credentials and characteristics is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the fund’s strategy will depend on the third party manager's proper identification and analysis of ESG data. Importantly, ESG data may not be audited or otherwise reviewed by an independent third party and we do not guarantee the information is accurate, complete, and up-to-date.

The ESG data, models and methodologies used, and the judgements, estimates or assumptions made, are rapidly evolving and this may directly or indirectly affect the metrics and data contained herein. While we seek to identify and select third party fund managers based on ESG considerations, we can accept no responsibility for the execution of a third party manager’s ESG or sustainability strategy or for the sustainability profile of the third party manager’s funds.