ISR and ESG: Two Complementary but Different Approaches
Socially Responsible Investing (ISR) and Environmental, Social, and Governance (ESG) criteria are often confused. However, while they are related, they have fundamental differences that influence investment strategies. Let’s explore these distinctions to better understand their impact on sustainable finance.
ISR: A Committed and Selective Approach
Socially Responsible Investing (ISR) is a proactive approach that integrates non-financial criteria into asset selection. Its dual objective is to generate financial performance while creating a positive impact on society and the environment.
ISR follows several investment strategies:
- Exclusion Method: This involves avoiding companies involved in sectors deemed harmful, such as weapons, tobacco, gambling, or fossil fuels. For instance, many ISR funds exclude companies generating more than 5% of their revenue from these industries.
- Best-in-Class Approach: Instead of excluding entire sectors, this method selects the most environmentally and socially responsible companies within each industry. For example, an ISR fund might invest in an oil company actively reducing its carbon footprint rather than avoiding the sector entirely.
- Impact Investing: This strategy funds projects that generate direct social or environmental benefits, such as renewable energy companies or initiatives promoting social inclusion.
- Shareholder Engagement: Investors influence corporate decisions by voting in general assemblies and engaging in discussions with executives to encourage responsible practices.
This approach reflects an investment choice aligned with ethical convictions and specific values, prioritizing a rigorous selection of financial assets.
ESG: A Risk Management and Analysis Tool
ESG criteria, on the other hand, are indicators used to assess a company’s non-financial performance. Unlike ISR, which is based on a committed approach, ESG is primarily a risk management tool that helps investors evaluate opportunities and risks associated with environmental, social, and governance factors.
ESG is now essential in asset management, as companies are assessed based on three key pillars:
- Environmental: This includes carbon emissions management, energy efficiency, biodiversity conservation, and natural resource consumption. For example, a high-carbon-emitting company could receive a lower ESG rating if it fails to implement reduction strategies.
- Social: This covers working conditions, labor rights, workplace diversity, and stakeholder relations. A company with exemplary practices in pay equity and employee well-being will receive a higher ESG score.
- Governance: This refers to board structure, financial transparency, executive compensation, and anti-corruption policies. Poor governance can negatively impact long-term performance and increase the risk of corporate scandals.
Investors use these criteria to identify financial risks linked to sustainability issues. However, ESG does not necessarily imply ethical commitment or sector exclusion. A company with a high ESG rating may still operate in controversial industries. ESG is more about risk assessment than moral investment. At OUTSCALE, we understand these challenges and offer innovative solutions for asset managers with evolving ESG regulations and frameworks, our solutions help professionals streamline SFDR (Sustainable Finance Disclosure Regulation) reporting and save time in managing compliance.
ISR vs ESG: Which Approach to Choose?
The choice between ISR and ESG depends on an investor’s goals:
- ISR funds cater to investors looking to align their portfolio with their values and maximize positive impact.
- ESG approaches are widely used by financial institutions to assess corporate resilience to sustainability risks.
Increasingly, ISR strategies integrate ESG criteria to balance impact and performance. However, methodologies vary, and ESG ratings are not always directly comparable. For example, a company might receive a high ESG score from one rating agency and a lower score from another due to differences in evaluation criteria.
Transparency is becoming a major issue. Regulations like SFDR in Europe now require asset managers to clearly disclose whether their investments follow ESG or ISR principles. These regulations aim to combat greenwashing, where some funds claim to be responsible without a consistent approach.
Towards More Responsible Finance
ISR and ESG are two pillars of sustainable finance, but they follow different logics: ISR emphasizes commitment and exclusion, while ESG focuses on risk analysis. Investors must understand these nuances to build strategies that align with their objectives.
With growing climate and social concerns, both ISR and ESG will continue to evolve. Increasing regulatory and transparency demands are pushing companies and investors to redefine their strategies to meet 21st-century challenges.
In an upcoming article, we will explore European regulations on ISR in greater depth
