With COP26 in full swing, the Environmental, Social and Governance (ESG) theme sweeping the investment community could not be more topical.

For those keen to help the environment their pensions and investments can be invested to further their objectives.

With £2.6 trillion in UK pensions alone, the effect on company behaviour could be huge.

As society and investors take an increasing interest in environmental and social issues, the investment management industry has, in recent years, responded with a plethora of new ESG products.

However, despite the increasing interest in the area we still see a lot of confusion around the topic.

There is little standardisation or regulation of the terms being used and ESG rating of products. This makes life difficult for investors who must undertake more due diligence to ensure the products meet their requirements.

Historically, investors used to screen out investments from their portfolio using negative criteria to avoid investing in companies involved in certain “sin” industries, such as nuclear power, weapons manufacture, alcohol, gambling, tobacco, etc.

Increasingly, positive criteria under the ESG banner are now being used where investors favour investments involved in ESG activities that benefit society and the environment.

For example, investors will seek to invest in companies that have a positive impact on the environment through their products and services, such as renewable energy, environmental protection, and conservation of biodiversity and natural resources.

Investors also seek companies that respect and support the human rights of those affected by its business, particularly those firms upholding the highest standards of business conduct.

They seek to invest in companies that offer products and services that provide access to some of the world’s most basic rights, such as water, sanitation, education, healthcare, food, shelter, and energy, in an attempt to enhance livelihoods and society.

“Good” governance should always have been a factor taken into consideration when making an investment. Under the governance heading, consideration is given to issues such as board independence, excessive remuneration, and audit issues.

While some investors will only invest where all of these criteria are met, others realise it is a grey area and are prepared to invest in a wider range of investments and engage with companies to encourage them to become more ESG positive.

However, there is a danger of “greenwashing”, where products may claim to be ESG friendly but when you scratch below the surface investors might find their requirements are not being met and not enough is being done to drive companies to be more ESG positive.

Investors also need to consider the implications of adopting an ESG investment strategy. In theory, for any given asset allocation, portfolio risk is generally increased for an ESG portfolio since adopting the ESG criteria above results in less portfolio diversification.

Certain industry groups are typically excluded, including more established industries that expanded in the past when social standards were less strict. Because of this, ESG portfolios also typically have a bias towards smaller and medium-sized companies and less mature industries which increases the risk.

However, in recent years investors have often been rewarded for the additional risk with better investment returns. Portfolio performance has been higher as the increased risk has been compensated with higher returns over the longer term.

We are also of the view that ESG investment is becoming a much broader theme in society and that this may also lead to the outperformance of companies that meet the ESG criteria.

Investors should also be aware that ESG portfolios are typically more expensive as there are additional screening costs involved.

Trading costs are higher for smaller companies and, to date, there has been less competition between fund managers to drive down prices in this area.

However, we are beginning to see more ESG Index funds being launched, which will foster greater competition and help to lower costs.