ESG and Socially Responsible Investments
The Financial Conduct Authority (FCA) has recently warned of the risks of environmental, social and governance (ESG) benchmarks and will be scrutinising how they are constructed and labelled. But what do we mean by ESG and how does it link in to socially responsible investments (SRI)? This article is relevant to the CII’s R01, R02, AF4, R06, and AF5 exams.
Environmental, social and governance (ESG) factors
There has been a great deal of media coverage of ESG factors in recent times. These are the factors that are believed to influence how ethical and sustainable an investment actually is.
The correct terminology is, in fact, ‘material factors’ and it is these factors that are deemed likely to affect the operating performance or financial condition of a firm. For example:
- carbon emissions and energy efficiency;
- working conditions and product safety;
- business ethics and anti-bribery policies.
Pros and Cons
Some would argue that companies who score highly for ESG are likely to be progressive in their thinking and successful in the fields in which they operate. There is some evidence to suggest that SRI funds have performed as well, if not better than non-SRI funds of late.
However, not everyone agrees. Potential disadvantages of taking an ethical approach to investing include:
- narrowing the investor’s choice of firms to invest in;
- reducing access to dividend income by excluding high-yielding companies in unacceptable sectors;
- increased volatility as larger companies may be excluded leaving only small and medium size companies;
- potentially higher charges as many ethical funds are actively managed.
Incorporating ESG into a socially responsible approach to investments
While there are a number of approaches to SRI, the most well-known include:
|Includes firms that score highly on ESG factors.
|Excludes firms whose output is harmful or unethical.
|Excludes firms that score poorly on ESG factors.
|Best in class
|Companies who would normally be excluded due to their sector, may be included if they score more highly on ESG factors than others.
|Shades of green
|‘Shades’ refers to how ‘green a firm is – the darker the shade, the more likely that they’ll score higher on ESG factors and will qualify for inclusion
|The investment manager assesses a firm’s ESG material factors as part of their holistic analysis of the firm before determining whether to include them in an investment portfolio
|Aims to create a positive environmental or social impact.
|Aims to tackle the ESG issues of today by investing in solutions to them.
The FCA has concerns that some benchmark administrators have not accurately described the economic reality that their benchmarks measure. They believe that the subjective nature of ESG factors, and how ESG data and ratings are incorporated into benchmark methodologies, give rise to an increased risk of poor disclosures in ESG benchmark statements. They conclude that the quality of these benchmarks may not, therefore, align with the expectations of both their users and the end investors.
Concern is growing that without any official definitions, there is the possibility that the make-up of ESG or sustainable funds will not match the desires of end investors. There are currently no rules in the UK on what qualifies as an ESG or sustainable fund.
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Information in this article is correct as at 26 September 2022.