What is ESG investing and what does it mean for investors?

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Environmental, social and governance (ESG) challenges are amongst the biggest risks that the world faces and will have a direct impact on companies and pension schemes investing in them.

ESG issues are non-financial in nature but present financially material risks. Climate change heads a list of many issues posing material risks to investors. ESG integration and active ownership are now fundamental components of effective investor decision making.

Read on to learn about ESG investing, or visit our XPSArena hub to gain more insight on ESG investment strategies, how they differ from sustainability as a whole, and what benefits they present for investors.

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What is meant by ESG investing?

ESG stands for Environmental, Social & Governance. In terms of investment strategy, ESG integration involves investment managers considering ESG factors when analysing an investment, and understanding the exposure to key sources of risk and possible impact on long-term prospects for the investment.

As a minimum, we expect all investment managers to be integrating ESG into all decision making. This does not necessarily mean selling a company because of an ESG issue but simply recognising that issue as a risk when considering whether to buy or sell the company or asset.

ESG investing is often misinterpreted as “ethical” or “exclusionary” investing, which is to simply exclude companies on the basis the company is harmful to the environment, or supports what some people perceive to be harmful activities such as smoking or gambling. But that is not what ESG investing is really about.

Whilst these concepts are closely related, they are not the same. We think of “ESG” as “ESG integration”, or responsible investment. As above this simply refers to the practice of analysing ESG risks and assessing the potential impact of material financial factors within the investment decision making process.

Sustainability is about investing in a way which supports the needs of the present, without compromising the ability of future generations to meet their needs. Within investments, this means seeking out companies that positively contribute to the environment and society and avoiding those that negatively contribute. This can be in a range of ways, but will typically include exclusions on the worst offending sectors or companies, or selecting investments that contribute to deliver the so called “UN Sustainable Development Goals” (SDGs) - a set of 17 goals which were developed to essentially illustrate what “good” looks like across a range of environmental and social issues.  

All investors are exposed to ESG and climate-related risk, whether their investment strategies are active or passive, growth or matching, or have long or short time horizons, as they are some of the biggest risks the world faces. Risks relating to ESG issues are becoming more prevalent and impactful – for example climate change is causing increasingly severe and frequent weather events which are causing financial damage to companies, and human and worker rights are increasingly important and cause real issues for companies that don’t act in the right ways.

ESG investing ensures that the investor gets the full picture of the risks associated with a given investment.

Where Trustees consider ESG issues such as climate change to be financially material, they should be talking these factors into account. There has been a lot of research which has concluded that considering ESG factors is part of investors fiduciary duty to ensure positive outcomes for their beneficiaries.

As ESG continues to become more prevalent, and there is increased awareness, not taking appropriate action in relation to ESG risks could lead to reputational damage for the underlying company and the investor.

There continues to be an increase in regulations for companies to adhere to in relation to ESG factors, and it’s important to ensure that companies / schemes remain up to date to ensure they don’t fall behind and become non-compliant.

Stewardship is all about being a proactive owner of your investments. This often takes the form of voting (relevant for shareholders) and engagement – i.e. the investor in a company engaging with the management team. Stewardship is important for the following reasons:

Ensure alignment of interests between the investor and the company management (for example over things like executive pay)

Sharing of information, using engagement for the investor to learn more about the company and its operations so that it can identify the full range of risks within the investment that may not otherwise have been apparent.

Overall ESG investing is about improving risk management and supporting long-term value creation. Well run companies perform better over the long term.

Applying an ESG lens can help investors to understand the risks of areas that directly affect business performance, such as impact on nature, poor management of natural resources, poor treatment of workers which can damage productivity over the long term.

Investing in ESG positive companies directly contributes to things like employee welfare and relationship building in terms of community, stakeholders, and suppliers.

Many pension scheme sponsors will have sustainability strategies and may want to ensure the pension scheme reflects those ideas. Many pension scheme members will have strong views on the way their pension is invested, and they may not want to be financing companies with bad environmental records or which are harmful to society.

There is a great deal of regulation around ESG so pension scheme trustees must have policies in place to consider ESG and climate change.

Explore our  ESG insights and briefings to learn more, our contact us if you’d like further information about our ESG Investing strategies.

XPS Investment Limited is authorised and regulated by the Financial Conduct Authority for investment and general insurance business (FCA Register No. 528774).