1 minute read 

• Ethical investing is about making investments that reflect your personal values. In most cases, this means avoiding harmful industries and seeking positive activities to invest in
• ESG investing aims to assess the financial risks and opportunities of companies’ approach to environmental, social, and governance issues   
• ESG ratings can be inconsistent, and some ESG funds face greenwashing accusations
• Ethical and ESG investing are gaining popularity, especially among young investors who want their money to drive positive change
• SIX’s ethical profiles do the hard work for you by highlighting the big ethical issues in a company or ETF and giving you the facts to make your own choices

5 minute read 

Investing can sometimes feel like navigating a maze, especially when so many buzzwords are thrown around without explanation. 

‘Ethical investing’ and ‘ESG investing’ are two of them. They’re also often confused. While they might sound interchangeable, these investment styles are different so they produce different results.

This blog is here to demystify the difference between ethical and ESG investing, so you can confidently choose the approach that works best for you.

This one’s a bit more personal: It’s about putting your money where your values are. 

A good place to start is to think about what types of industries and companies you’re comfortable investing in, and which ones you definitely want to avoid. For example, many ethical investors avoid fossil fuels, weapons and tobacco companies. 

The flip side of avoiding harmful industries is seeking out those that make a positive contribution to society, such as healthcare, renewable energy and social housing. This style of positive investing took off in the 1960s, with union-linked pension funds in the USA investing in social housing. 

Now research suggests that 88% of Australians expect their investments (including super) to be invested responsibly and ethically.

Over 80% of Millennials and Gen Z, particularly women, want their money to be invested in line with their values, more than other generations.

If you’re selecting your own investments, then you can make your own judgment calls about what’s in or out. However, many people rely on professional investment managers to select their investments, like in your super fund or an ETF. 

When professional investment managers have rules for what they avoid as an unethical investment, this is called ‘negative screening’. On the flip side, their rules for what they will actively seek out as an ethical investment is called ‘positive screening’.

The most common way negative and positive screening is done is to use ‘revenue thresholds’. That is, they see how much revenue a company earns from positive and negative activities. 

For example, some funds might have zero tolerance for exposure to fossil fuels and remove a company if it earns any revenue from coal mining. Likewise, if a company earns any revenue from renewable energy some funds will include it. 

Where it can become tricky is if a fund allows a ‘tolerance’ for a minimum amount of “negative” activity. For example, an ethical fund might think it’s ok if a company earns ‘just’ 5% of revenue from coal mining or gambling or alcohol. So it’s important to check what rules ethical fund managers apply to ensure they match your expectations. 

Check out this blog for a breakdown of ethical ETFs on the ASX

Some activist investors go further by pressuring other investors to avoid harmful industries and sell out of or ‘divest’ from them. In the 18th century, religious investors wanted to avoid investing in slavery, chemical production and tanning which can harm people - and encouraged others to follow. In the 1960s, activist investors coordinated a campaign to divest from companies operating in South Africa to pressure them to leave the country and force the Government to end apartheid. These movements were replicated for tobacco, weapons and gambling whose harms were by then well established. 

The 2010s saw the fossil fuel divestment movement try to stigmatise fossil fuel companies for their impact on the climate. This movement lobbied institutions and pension funds to dump their fossil fuel investments. To date, over 1600 investors managing US $40 trillion+ have divested from fossil fuels.  

It’s important to remember that ethical investing isn’t about charity or throwing your money away. Ethical investing has actually been shown to perform as well as traditional investing. It's about aiming to earn a decent return on your money while investing in activities that match your values.

In the early 2000s, parts of the finance industry began recognising that non-financial factors should be included in the valuation of a company. They believed companies that treat workers better and care for the planet can make more money than those that don’t. Companies like Unilever, which reported cost reductions from sourcing more sustainable products, were the poster children of the movement. The logical conclusion was that companies performing poorly on these issues carried a greater risk of financial loss. ESG offered a ‘win-win-win’ for the environment, society and business. 

This led to today’s multitudes of ESG (Environmental, Social and Governance) analysis, reporting, accounting, and rating frameworks. ESG analysis has expanded to include environmental issues like carbon pollution and biodiversity, social issues like a company’s gender pay gap and racial diversity, and governance issues such as board accountability and risk management. 

However, ESG rating agencies have been criticised for using opaque scoring methods when analysing companies. These methods make it difficult to compare the ESG ratings offered by different companies and have misled investors about the change that ESG creates in the real world. Why? Because while ESG ratings are sold as the measure of a company’s impact on the world, they actually measure the potential impact of the world on the company (and its shareholders). 

This means that if a company has a big impact on the planet or society, for example through its greenhouse gas emissions, an ESG analyst may decide that is not financially relevant to the company and therefore won’t consider this in calculating the company’s rating. 

The man who coined the term ‘Triple Bottom Line’ in 1998 (a similar concept to ESG) has since said the concept deviated from its original purpose to fully cost broader economic and social impacts of business and ‘transform capitalism’. Others have argued that companies need to go further by reporting context-based sustainability information so investors know if a company is operating within local ecological and social limits. 

Another factor to consider is that ESG ratings usually compare companies to their industry peers. A fossil fuel company can score an A or a D in comparison to its peers, but at the end of the day, it’s still selling a product that is causing catastrophic climate change, which many people find unacceptable. 

Unsurprisingly, some companies offering ESG funds have been accused, and in some cases found guilty, of greenwashing. Some countries, including Australia and the EU, are cracking down on this by making it mandatory for companies to report if they violate certain social and environmental limits when doing business. This is a big step forward. 

Despite the criticism of ESG, some investors are making genuine attempts to incorporate ESG into their investment decisions. With consumers demanding their money is invested ethically, it’s unlikely to go away anytime soon. In fact, money continues to flow into both ESG and ethical funds in Australia and Europe in particular.

In short, ethical investing is about aligning your money with your values, and ESG investing is about managing financial risks and opportunities in your investments. Both are valid approaches to investing. 

Plus, with these terms used interchangeably by companies and investment funds, SIX’s ethical profiles help you align your values with your investments by doing the hard work for you! 

To read SIX’s ethical profiles, create an account today!