Unpicking the jargon of responsible investing

George Robinson, Business Development Manager for VALA Capital, wrote the following article to help explain the difference between ESG and Sustainable investing.  

Investors are increasingly interested in investing responsibly, by including non-financial factors in their investment decisions. But the rapid rise of responsible investing has led to the emergence of some terminology that is used inconsistently. With no settled definitions, things can quickly get confusing for individuals who are trying to navigate the responsible investment sector for the first time.

Below, we set out how Vala interprets the difference between ‘ESG investing’ and ‘sustainable investing’ – two important and distinct terms that are sometimes blurred together.

ESG (Environmental, Social and Governance) investments are those where the investor’s criteria include an analysis of a company’s non-financial policies and performance.

ESG funds will only allocate capital to companies that measure various ESG metrics and can demonstrate that they meet or exceed the fund’s ESG benchmarks. Some funds may simply exclude investments scoring particularly low on ESG performance (negative screening) while others may look to optimise for ESG scoring as well as financial metrics (positive screening). ESG investors are not necessarily aiming to make a major positive impact on the world. Instead, they hope to invest in businesses putting best practices in place for their stakeholders, community and environment, and avoid investing in businesses that are causing excessive harms through, for example, significant carbon emissions or unjust labour practices.

ESG investing does not have to result in lower returns. Indeed, research has shown that companies with a strong focus on managing ESG issues are often more profitable in the long-term, as well as more resilient to short-term crises.

Many ESG funds invest in large, listed companies that use an ESG reporting framework to monitor their non-financial performance. There are currently a number of organisations overseeing ESG frameworks, including the Sustainability Accounting Standards Board, the Global Reporting Initiative and the International Standards Organisation. However, there is also widespread recognition that ESG reporting standards need to converge, and it seems likely that the next few years will see some aggregation.

Sustainable investing involves allocating capital to companies with potential to generate a financial return for investors at the same time as making a positive and measurable contribution to addressing the world’s sustainability challenges. For these companies, the bigger they grow, the more the environment and society stand to benefit.

Of course, ‘sustainability’ is itself a term with many different definitions, which can encompass everything from cutting climate emissions to improving access to education. At Vala, our own sustainable investment strategy covers three broad themes – technology for planetary health, responsible consumerism and fairer access to social goods.

We monitor both the financial and non-financial performance of our investee companies. However, when investing in start-ups and early-stage companies, the major ESG reporting frameworks are not usually the right measurement tool. Complying with the requirements of bodies like the Sustainability Accounting Standards Board is simply too onerous for small companies. As an alternative, we work with the founders of our portfolio companies to agree some headline sustainability metrics that can be measured and reported on alongside financial performance, once the company is revenue-generating. As the companies grow larger, the sophistication of their ESG measurement can begin to increase.

Start-ups and early-stage companies that are tackling sustainability challenges often have huge addressable markets, driven by regulatory pressures and consumer demand for more ethical products and services. As such, just as with ESG funds, selecting sustainable investments need not lead to lower financial returns.

In summary, the difference between ‘ESG’ and ‘sustainable’ investments can generally be understood as the difference between ‘aiming to minimise harm’ and ‘aiming to make a positive difference’. If you want to understand the distinction in more detail, it is well worth listening to Jake Wombwell Povey and Max Middleton’s appearance on the EIS Navigator podcast.