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Sustainable, responsible or ethical – what’s the difference?

There is a lot of confusion when the subject of ‘responsible’ investing comes up. The term is often used as an alternative to ‘ethical’ investing, though these aren’t necessarily the same thing. To add to the confusion, so-called ‘impact’ or ‘social benefit’ investing are different again. This article aims to shed some light.

Responsible investing involves ESG

Responsible investing is a broad church of investment processes that have one important feature in common: when they make the usual investment decisions – stock picking, etc. – a ‘responsible investor’ explicitly takes account of environmental, social and governance factors (ESG).

  • An example of E might be: is the business involved in an industry that creates a lot of pollution and thus might be the target of changes in government regulations or tax regimes?
  • An example of S might be: does the business have a poor workplace health and safety record, which could result in it having low staff morale which can adversely affect customer service?
  • An example of G might be: does the business have a poorly articulated process for selecting Board members and thus may struggle to implement strategy successfully.

ESG considerations are in addition to the usual financial and macroeconomic drivers that analysts look at. Adherents believe that these sorts of factors have an effect on how a company will perform over time for its shareholders and debt investors. Responsible investors also believe that focussing investments on positive ESG-rated companies is good for business because it helps to enhance the world in which the company operates.

This is why responsible investing is often called ‘sustainable’ investing – the idea that a company with strong ESG ratings will be a more robust business that not only contributes towards sustaining the environment and the health of society, but is therefore a sustainable business. It’s not just about surviving the economic cycle, but the trends in society that are addressing issues like: more honesty and positive ethics in business; cleaner air and abundant water for everyone; and a better partnership between labour and capital than the acrimonious relationships of the past.

Use of ESG rankings

The responsible investment universe is occupied by a wide field of individual styles and approaches. For instance, you can have equity managers who favour growth stocks and those who favour value stocks, and there are many different ways that ESG ratings on companies are taken into account.

The most common is to attach a higher risk factor to the return projections for the lower ESG ranked companies. Under this approach, the manager will still invest in a poor ESG rated company, but only if the share price is low enough to provide a higher expected return for the risk. (If it’s a corporate bond being looked at, a wider credit spread would be needed to compensate for risk.)

Another approach is to use ESG rankings to bias the degree of overweight or underweight position the fund will take in a company. High ESG ratings enable a larger overweight to a company with positive financials and short term return prospects than low ESG ratings.

Yet another is to use ESG ratings as a screen – excluding the bottom X% of ESG rated companies in a sector, for instance. This is where the issue of fossil fuel divestment comes in. Some managers believe strongly enough that this particular ‘E’ factor warrants exiting these investments. Mostly this isn’t because of a ‘moral crusade’, but a view that governments around the world are likely to move towards policies encouraging less use of fossil fuels and that this will result in the assets of these companies falling in economic value over time.

Whichever of these approaches a manager may take, most of them also use ESG research as a tool to guide their engagement with the companies they invest in. For example, they hold shares in company B that has a poor ‘S’ rating because of poor compliance with workplace health and safety requirements. Rather than selling their shares, they will meet the management and discuss the negative impact of this on the company’s performance, encouraging them to lift their game. If you don’t own shares you can’t engage in this way.

What are ‘ethical’ investors?

Among those who use ESG as a screening device may be found the majority of ethical investors. Ethical investors usually screen out certain companies because they’re involved in activities with negative ‘S’ characteristics (eg they’re involved in gambling or illicit drug supply) and explicitly favouring of certain types of businesses regarded as being positive for society. Some ethical investors also screen out on ‘Environmental’ grounds as well, though not all use ‘E’ factors in that way.

Ethical investing is a minority group within the responsible investment universe. It’s an approach that doesn’t translate well into the public offer managed funds space. There’s a place for it and some fund managers are achieving some success with ethical offerings. However, the question of ‘whose ethics do you use?’ tends to get in the way of them being broadly accepted. Even among ethical investors, the list of excluded and preferred activities varies.

Ethical approaches are common when all the funds being managed are ‘in-house’ in some sense. This can range from an individual’s SMSF through private family office funds to self-contained institutions like church denominations where the synod or assembly agrees the ethical principles to be adopted.

Impact investing is different again

Impact investing is about making decisions that, while sound financially, also have direct, measurable and meaningful social outcomes. Normally it requires government involvement as it’s usually government that wants the cheapest option for delivering social policy outcomes and is prepared to pay the income on an impact investment if the programme is successful. For example, if a programme to help rehabilitate prisoners is successful then that will save governments money from not having to return those people to jail. If the programme is funded by private investors, then their return comes from government payments that reward the success of the programme.

A personal comment

My former employer was one of the first Australian signatories to the United Nations Principles of Responsible Investment (UNPRI). They thus committed to incorporating ESG into their processes. They are one of the largest fund managers in Australia. My current employer is not one of the largest, but requires the church’s investments to be in accord with a set of ethical principles that reflect the values of the members of the denomination. In both cases, the funds these organisations manage deliver strong, competitive returns to investors. It doesn’t prove the case by any means, but in my experience, being a responsible investor in no way detracts from investment performance.

 

Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing. He also serves as an Independent Member of the GESB Investment Committee. This article is general education and does not consider any personal circumstances.

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