ESG explained: why company behaviour matters to your investments

You’ve probably heard the term ESG, but do you know exactly what it means and how it can impact your investments? Our Head of Responsible Investment, Eva Cairns, explains more. 

ESG stands for Environmental, Social and Governance factors. It’s a way of looking at how companies operate, which can affect financial measures like profits and growth. ESG considers things like how a company looks after the environment, how it treats its employees and customers, and how well it’s run.

For investors, considering ESG factors is less about being 'ethical' and more about managing risk and supporting sustainable long-term growth and resilience. Companies that perform well on ESG issues are often seen as better positioned for the future, which is why ESG factors are now widely used by pension funds and investment managers when making investment decisions.

Individuals can have different views about ESG factors and how much they matter to them. But where risks and opportunities related to E, S and G metrics can impact financial investment outcomes, they should be considered as part of sound investment decision making - whether someone cares about ESG or not.

How ESG investing can make a difference

Environmental - some environmental risks, like climate change and loss of nature, can have significant effects on businesses. Changes to weather patterns may increase the chance of flooding, for example, or wildfires. Damage to nature and water stress might reduce the availability of key materials needed to make products. These impacts not only affect companies individually, but whole economies, communities and financial markets. They are, therefore, referred to as ‘systemic’ risks. 

Companies that consider their impact on the environment and how it can affect their business often tend to be those that use materials more efficiently, have less waste and commitments to reducing their carbon emissions. They may spend less on energy too, and they may have considered having a spread of suppliers to protect themselves against any disruption.

Social - social factors could include things like whether an employer treats its workers fairly, or if it pays a living wage. It could also cover whether a business checks conditions in the factories it gets supplies from, and whether its goods and services are safe. Diversity, equity and inclusion and how human rights are considered in the supply chain are also important social considerations. 

Those businesses that have thought about the risks and opportunities from social issues may be better placed to attract and keep workers. So, they’ll spend less on recruitment and be able to keep hold of the skills they need to run their business effectively. 

They may also gain a reputation for treating their suppliers fairly. That can help them build strong relationships with important suppliers, which can help them secure better trading terms, or even discounts, keeping their running costs low. Customers too are more likely to use businesses that they hear good things about.

If a business takes its social responsibilities seriously, it could face fewer financial risks from loss of business or even avoid fines for things like breaking health and safety rules. 

Governance - this includes how a business is run. It could cover what decisions it makes and how those decisions are made, and how it reports the way it does business. It can include things like behaving ethically and adhering to high values-driven standards, being open and honest, and having diverse people leading the business.

These can improve a business’ reputation, its compliance with laws and regulations and how well it performs, which can all improve its investment standing. Governance is a particularly important consideration when it comes to the use of AI to ensure there is transparency, accountability and oversight over how AI-driven decisions are made.

Opportunities and risks

ESG can create opportunities and help companies better manage risk.  This can mean that they perform well as a business, reducing costs, growing revenues and improving profitability, which can benefit their share value, and potentially make them better investments. 

Taking these factors into consideration can open up new opportunities. Because of this, and with growing customer interest in these areas, many companies now have ESG policies or rules that they follow in running their businesses. 

They may set themselves targets and then measure how well they’re doing in meeting those targets. For example, how much energy they’ve saved, whether less waste is going to landfill, or how diverse their workforce is. These measures, and a company’s overall ESG policy, can help show how well a business is dealing with ESG issues and form the basis of ratings that fund managers use when making decisions on where to invest.

Individual measures on the different elements of E, S, and G can be helpful to understand the risks and opportunities businesses face. They can also support tracking progress over time and feed into company engagement discussions.

ESG integration tools

Fund managers use a variety of tools to integrate ESG factors into investments.

ESG tilts - This means favouring companies that score better on ESG issues, and giving less weight to those that score worse, while still investing across the same broad stock market index. You’re not excluding sectors or companies altogether; instead, you are overweighting and underweighting based on ESG assessments alongside financial considerations. 

A stock market index is a selection of publicly listed company shares that are being bought and sold. Examples include the FTSE 100 index of the biggest 100 companies in the UK, or the MSCI World Index, which is a selection of companies from across the globe. An alternative approach is for a fund to track the performance of a tailored index which has the ‘tilts’ built in. 

Exclusions - Some pension companies or fund managers will also have rules about the type of companies they won’t invest in at all - known as exclusions. Examples could include companies in the tobacco industry, those that make controversial weapons, and coal extractors. 

To sum up…

ESG factors can impact a company’s financial standing. That’s why they are used by investors to understand how companies operate, how they manage ESG risks and how well they are positioned for the future. By looking beyond traditional financial figures alone and considering issues such as climate risk, fair treatment of people and good leadership, ESG helps investors better assess long-term risks and opportunities. Integrated into many investment approaches today, ESG is about supporting sustainable, resilient businesses that can deliver long-term value for savers.

You can find out more about how Scottish Widows integrates ESG factors into its investments by visiting our responsible investment page.