What is Ethical Investing?
What is ethical investing?
The desire to invest ethically is not new. For example, in the 18th century, Methodists in the US avoided investing in companies involved in alcohol, tobacco, or gambling. Today, retail investors can access an increasing variety of ESG funds and investments (ESG stands for Environmental, Social and Governance), which reflects the ongoing desire of many of us to do good while investing to generate a financial return. Broadly speaking, ESG strategies aim to promote Environmental, Social or Governance factors, either by excluding certain sectors (such as tobacco, or oil and gas), or by investing to actively improve one or more of these factors. But what exactly is ESG, and does investing in a company or fund rated highly for ESG make us an ethical investor?
Let’s begin with a very simple problem. I’ve woken up with a cracking New Year hangover, and can vaguely remember my friend, John, convincing me to ride down the high street in a shopping trolley. I begin to wonder whether John is a good person. Drunken antics aside, I’m sure he is – he gives to charity, is patient with his children, lends me money…
Suppose I want to be a bit more systematic in my assessment. How ethical is John on the basis of environmental, social and governance issues? After pausing to wonder why anyone would ever want to ask the question in this way, I draft a list of criteria:
- Does he own a car, if so, what kind? How many miles does he drive?
- Does he use public transport when he can?
- How large is his house, and how is it heated?
- Does he make charitable contributions?
- What job does he do?
- Does he help friends in need?
- Does he vote?
- Does he participate in local government?
- Does he get involved in local causes?
We might also think about his motivations:
- Did he use his car less just because he knew I’d be checking?
- Does he help out at a local charity, but post pictures of himself doing so on social media?
The list can be as comprehensive as we like. Now that I’m quite into making lists, I score each of these factors out of five, and come up with a rating. This is awesome, as I can now compare John to other friends, and divide my friends into tiers ranging from saintly to incorrigible.
Unfortunately, this doesn’t help very much. Firstly, because my friends and I are unlikely to agree on how to weight these different factors. For example, John might impress me so much with his selfless charitable activities that I am unconcerned by his draughty, oil-heated mansion. This is a matter of judgement. Secondly, does any of this really tell me whether John is a good person? Should I be looking at what he does, or what motivates him, or how he thinks through ethical dilemmas? Can we even offset ethical and unethical behaviour in this way?
We will return to John after a brief introduction to ESG.
Companies are given ESG ratings in a similar, but vastly more complicated, way to John. Each of the three factors – Environmental, Social and Governance – are broken down into lower level factors, which are then measured by a variety of indicators. MSCI, one of the main rating agencies, breaks down the three main factors as follows (1):
Environmental: The Environmental factor is comprised of sub factors – Climate Change (which includes carbon emissions, product carbon footprint), Natural Capital (which includes water stress, biodiversity and land use, raw material sourcing), Pollution and Waste (which includes toxic emissions and electronic waste), and Environmental Opportunities (which includes clean tech, green building and renewable energy).
Social: The Social factor is broken down into Human Capital (labour management, health and safety), Product Liability (product safety and quality, chemical safety, privacy and data security), Stakeholder Opposition (controversial sourcing, community relations), Social Opportunities (access to communication, access to finance, access to healthcare).
Governance: The Governance factor is comprised of Corporate Governance (board, pay, ownership, accounting), and Corporate Behaviour (business ethics, tax transparency).
In other words, in assessing the performance of a company on Social criteria, MSCI look at Human Capital, and to do this, assess how labour is managed, and whether health and safety is good or bad. So, for each of these underlying issues, we need some way of measuring the strength or weakness of health and safety. The same goes for all the other factors.
In theory, if we break things down enough, we should have a list of measurable factors that add up to a number that tells us how a company is doing from an ESG perspective. Unfortunately, just as with John, rating agencies do not agree about what the underlying indicators should be, nor how they should be weighted. For example, is labour turnover, or the number of prosecutions brought by employees a better indicator of labour management, and how should either of these be weighted against emissions when everything is added up? The Economist (2) notes that ratings agencies agree on ratings barely 50% of the time. Tech companies frequently score well because of their low emissions, but score much lower for those concerned about data privacy, or the impact on teenagers' mental health. This is not something about which we are likely to agree. We have different views about what is most important, and our ratings reflect these.
The disagreement about emissions vs privacy illustrates the assumption with a ratings approach that good and bad behaviour can be netted off against one another. This isn’t something we take for granted in ordinary life. We don’t offset stealing with charitable contributions when assessing someone’s character. It is an open question whether we should assess companies on the basis of how they do in respect to a variety of factors, or whether a single example of malfeasance is sufficient for us to consider them unethical, regardless of how they do on other factors.
Finally, when assessing John, his motivations came naturally to mind. If John is merely going through the motions of being a good person for social cachet, we can’t rely on him if circumstances change. In a zombie apocalypse John might just be the sort of guy to steal my food and tell the zombies where I am. People genuinely motivated by a desire to do good are (hopefully) more reliable. That said, all bets are off in an apocalypse. Similarly, we want to invest in companies that are trying to do the right thing. Motivations matter because it is hard to work out what the right thing is. We think that lowering emissions will be better for the environment, but there are all sorts of other, unforeseen, consequences. One recent piece of research suggests that investment in developing countries is declining as investors focus on ESG factors (3). Developing countries have poor ESG profiles, despite very low emission levels overall. These are also economies that benefit enormously from investment, and will suffer disproportionately if it is withdrawn. Directing investment preferentially to companies and countries with high ESG ratings can have unethical consequences.
When companies and investment managers are faced with a list of factors against which they are assessed, it’s much easier to manage the data than it is to focus on the bigger issues and adopt a genuinely ethical approach. Ethical investment managers won’t exaggerate the ESG credentials of their investments or their funds, and will be honest about the trade-offs and difficulties they face.
The current approach to ESG involves coming up with factors that aim to make a company’s impact measurable. This isn’t what ethics is. Mostly, we want people to do the right thing, all things considered. We have general rules like ‘don’t lie’, but acknowledge that this rule is fuzzy and must be disregarded sometimes. We all know that even the golden rule to treat others as you would want to be treated needs to be approached with caution, especially by those with esoteric preferences (philosophers often insert a tedious example about masochism here, but I’ll spare you). We must not only treat others as we want to be treated, but also understand other people’s perspectives so that we can judge how they want to be treated. The same applies to investors and companies. Ethical investors and ethical business people try to do the right thing.
ESG criteria don’t tell us what the right thing to do is because ethics is about deliberation.
Ethics as a process
Suppose that we’re an investor who wants to be more ESG. Consequently, we’ve excluded arms manufacturers from our portfolios. One morning we wake up and wonder why on earth we did that. Why don’t we want to invest in arms manufacturers? Because they make products that kill people. Killing people is wrong, and we don’t want to be associated with it. However, it isn’t always wrong to kill people – killing in self-defence is usually morally permitted. So that isn’t really the issue. The issue is that arms manufacturers make products that can be used in ways we disagree with.
Is the problem therefore with the companies, or with their customers? Or even what types of weapons they manufacture? If we’re committed pacifists our answer will be clear. If we aren’t, it’s more complicated. So, we must try to focus in on what our real concerns are.
After that, we have to specify all our options.
- Don’t invest in defence companies.
- Treat the sector in the same way as any other and focus on profits.
- Invest subject to certain requirements, such as the types of products, who they sell to, how many of their products find their way to the black market, the ethical stance (or not) of management.
- Invest and use activism to change the industry.
The focus is on specifying all the options and spelling them out in detail. It is at this stage that we need good data, some of which are exactly the sorts of things that the ratings agencies can tell us.
Then we try to anticipate what can go wrong with each of those options. We need to solicit as many opinions as possible in order to feel informed. This may include experts, other investors, or friends and family. For example, does walking away from a bad company or sector make me an ethical investor? If ethical investors exit the arms industry, then the only investors remaining will be ones who do not share my concerns. Is this a more, or less, positive outcome? Just because we wash our hands of a problem doesn’t mean we acted ethically.
The war in Ukraine illustrates this very well. A number of investors exclude arms manufacturers from their portfolios. In the light of the support for Ukraine’s resistance, this looked naive. It turns out that many people do support arms manufacturers, but only if they’re selling to the right people. This lands us in ethical hot water. Why, out of all the ongoing conflicts, was it Ukraine that changed our minds?
Once we’ve decided what to do, we act. The process of deliberation, and our final decision are limited by the time and resources we have available. We will never get things totally right. But ethics is about thinking systematically about difficult issues. Importantly, systematic thinking doesn’t necessarily lead to an easily implementable investment strategy. We might end up investing in one arms manufacturer and taking an activist stance – turning up at AGMs to vote and protest. Other companies we may exclude entirely, while investing passively in others. Sometimes we might want to take an activist stance, but lack the time and resources.
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Doing the hard thing
Taking ESG seriously actually means doing something very difficult. It involves taking a step back and thinking about what it means for us to be a good investor. What do we want to achieve with our money, how do we want to achieve it, and what resources do we have to dedicate to investment?
This is a very similar thing to deciding whether a person is good. Most of us wouldn’t automatically expect that a ratings agency could do this for us. Of course, data is vital. And the rating agencies fulfil a necessary function. We need their data to understand what companies and investment managers are doing, and to form our judgements. However, our view of what an ethical investment strategy and an ethical company are may differ, which means that we need different data to each other, or will use the same data in different ways. Behaving ethically is a process and isn’t something we can outsource to rating agencies, or anyone else. Most of us are very busy and don’t have time to develop a fully informed investment strategy, so it is perfectly legitimate to take shortcuts and invest in ESG funds, or just exclude specific sectors from our portfolios. This is an acceptable way of expressing our preferences, but we should do so knowing that none of this necessarily makes us an ethical investor.
 What is an MSCI ESG Rating?
 The signal and the noise. Measurement of ESG data needs a big overhaul
 ESG deprives emerging and frontier markets of investment
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Cover image: Canva.