‘ESG’, ‘green’, ‘responsible’ and ‘ethical’ are all terms which tend to get used interchangeably in the field of sustainable investing, which also encompasses the approaches of impact investing and philanthropy. Environmental, Social and Governance investing (ESG) is probably one of the most well-used, yet 2021 research from Invesco showed that only 14% of investors understood what it meant.
This is set to change, with the Financial Conduct Authority recently outlining proposals for new rules around the naming and marketing of sustainable investment products, expected in early 2023. This will bring a more formalised framework to sustainable investing, that should be more straightforward for investors and financial advisers alike.
Variety of approaches
With the advent of sustainable investing we are seeing a paradigm shift where in addition to financial returns, investors are looking to the values and ethics of companies when deciding on their investment strategies.
Sustainable investing incorporates a values-based approach to investing, with a sliding scale from a focus on financial returns at one end, through to making a positive impact at the other. For the uninitiated, it has been a confusing universe to navigate, with a number of different approaches, each with differing characteristics.
Ethical investing – is as it says on the tin, this involves an investor using their ethical principles to decide on their investments. This is a values-based approach.
Socially responsible investing (SRI) can be seen as a values and risk-based approach. Forms of SRI investing include negative and positive screening, along with engaging with companies as an investor to influence their future. Examples of such engagement could include encouraging a company to reduce its carbon footprint or aligning directors’ compensation to achieving environmental goals for example.
Negative/positive screening – negative screening involves narrowing the investment universe by excluding companies that are not deemed socially responsible. Typical exclusions include tobacco, alcohol or armaments. Positive screening is the opposite – it screens favourably on areas that create external benefits, such as wind farms and solar panels.
ESG –Environmental, Social and Governance investing is more concerned with the risks of each of the three pillars. There is currently no standardised ESG criteria, so the definition depends very much on the person or company doing the rating.
Questions of classification
Many large corporations do not fit neatly into one box or another, however, which can be a barrier to investor engagement and understanding. For example, should we classify BP, which is a multinational oil and gas company yet also one of the biggest players in the European renewable energy market, as a sustainable investment?
The role of portfolio management is still important in the sustainable investing arena. There is currently no right or wrong way to build a sustainable portfolio and the approach taken will depend on an investor’s beliefs.
Impact investing – the pursuit of profitability and purpose
Impact investing is an investment philosophy which seeks to generate specific beneficial social or environmental effects in addition to financial returns.
It is becoming increasingly relevant in light of all the global problems facing us, from climate change and inequality to social division and the energy crisis.
The future looks bright for impact investing which, once regarded as niche investing, has now become mainstream. The traditional sources of capital, from government aid and philanthropy, are no longer enough to effect change, given the scale of the global challenges and as wealth transfers between generations, the momentum behind impact investing is likely to grow, while shifting in new directions.
Philanthropy – positive impact is first and foremost
At the end of the spectrum of sustainable investments is philanthropy, where making a positive impact is prioritised over a financial return. This can be seen as the inverse of traditional investing where the trade-off between risk and return is the sole focus. Philanthropy can be divided into venture philanthropy, or investment in businesses with social aims, and traditional philanthropy – a donation to causes that does not generate any financial return but expects a social return on a social investment.
Suitable structures for philanthropy include charitable foundations, donor-advised funds (a fund established under an umbrella charity that administers the fund on behalf of the donor) and not-for-profit businesses. Philanthropists recognise the need to use the right vehicle to support their goals, applying the same discipline as they would in the corporate world.
They also need to measure and demonstrate impact. Despite increasing amounts of data available, the measures used in the corporate world are not easily applied to philanthropic activity. Instead, more fluid metrics that combine short-term goals with longer-term aims are often more appropriate.
The sustainable investment arena is growing and becoming increasingly nuanced. The good news for the individual investor is that whatever your values and beliefs, it should be possible to identify an approach and solution to suit you and increasing regulation in this area should help both investors and advisers to make better-informed decisions.
Nick Astley is an Investment Manager and Richard Gillham is a Financial Planner at Progeny.
Featured Photo by Jason Blackeye on Unsplash
