ESG stands for ‘environmental, social and governance’ and comes from the practice of incorporating non-financial factors in investment decisions and active ownership, otherwise known as ESG integration or responsible investment.
However, has come to mean many different things to different people. Most commonly it is misunderstood as an approach concerned with restricting investment in so-called ‘sin’ sectors on the one hand. On the other hand it is often mixed up as a strategy that seeks to achieve an intentional and measurable environmental and/or social impact. We’ve captured some key principles here to help you distinguish ESG integration with exclusionary, thematic or impact focused approaches.
ESG integration is an investment input
As an investment input, ESG integration is primarily concerned with assessing and managing financial risks and opportunities. For example, an oil and gas company facing increasing carbon taxes on it’s greenhouse gas emissions could be an environmental factor that could materially impact its profitability, and therefore your assessment of that company as an investment opportunity.
Alex Edmans – Professor of Finance at London Business School – describes ESG integration as both ‘very important and nothing special’ (Edmans, 2022). He’s right. It’s very important because an ESG factor could be material to the financial performance of assets you invest in. You should understand how these factors could impact your investment performance. On the other hand it is nothing special; as a driver of value ESG should not be treated with more prominence than other drivers of value in your investment process.
ESG integration does not ‘exclude’
ESG is often mixed up with values based investment, also known as ethical investment. This normally deploys ‘negative screening’ to exclude from the investable universe companies and assets that do not align with investors’ values or globally accepted norms. For example, a fund seeking to comply with Sharia principles would automatically exclude investment in assets that make money from alcohol, pornography and pork products, irrespective of financial considerations.
ESG integration does not mean pursuing a sustainability objective
Investing in line with a sustainability objective is classed as sustainable investment and is the key differentiator of a sustainable investment fund when compared to others. The objective could include:
- Ensuring majority of underlying assets align with credible sustainability criteria, for example activities defined by the EU Green Taxonomy and the UK Taxonomy
- Investing in assets with the potential to improve their sustainability profile and performance, most often achieved through stewardship and investor activism
- Investing in a broad sustainability theme, for example renewable energy
ESG integration is not about generating a positive environmental and/or social impact
Marketing such as ‘make a positive change’ or ‘impact through investing’ are commonly associated with ESG. This is incorrect, as ESG integration alone is about financial risk management. This is actually impact investing, which is defined by The Global Impact Investing Network (‘GIIN’) as investments made with the intention to generate positive, measurable social and/or environmental impact alongside a financial return.
In summary, intention is the distinguishing feature
The key thing to differentiate ESG integration with other approaches, such as values based investing, sustainable strategies and impact investing is ‘intention’. ESG integration is an investment input like any other and used alone is concerned with managing investment risks and opportunities. On the other hand, ‘ethical’, ‘sustainable’ and ‘impact’ investment approaches all seek some sort of outcome, whether that’s excluding assets on ethical grounds, alignment with a sustainability theme or to to contribute solutions to social and/or environmental issues.