UK Ethical and ESG Investing Explained

What ethical and ESG investing means

Ethical investing is the application of moral or values-based criteria to fund selection. ESG investing applies environmental, social, and governance metrics, often quantitative, to assess investment risk and impact. The two overlap but are not identical: an ESG fund is not necessarily ethical to every investor, and an ethical fund is not necessarily ESG-rated.

The UK SDR regime

The Financial Conduct Authority introduced Sustainability Disclosure Requirements in 2023 to regulate how UK retail funds describe their sustainability characteristics. Four investment labels exist: Sustainability Focus, Sustainability Improvers, Sustainability Impact, and Sustainability Mixed Goals. Funds using these labels must meet specific criteria and produce ongoing reporting.

The anti-greenwashing rule

From 31 May 2024 the FCA's anti-greenwashing rule has applied to all financial promotions of products and services in the UK. Sustainability-related claims must be fair, clear, and not misleading. This rule applies even to funds that do not use the SDR labels.

How ESG funds are constructed

ESG funds use three broad construction methods. Exclusion screens remove sectors (such as tobacco, controversial weapons, thermal coal). Positive screens overweight companies with strong ESG metrics. Impact strategies invest in companies whose products or services produce a measurable positive outcome (such as renewable energy generation).

ESG ratings disagree

Different rating agencies use different methodologies, weights, and data sources. The same company can score in the top decile with one rating provider and below average with another. Investors using a single rating as a screen should be aware that ESG outcomes are sensitive to methodology choice.

Performance and cost

The performance of ESG funds versus broad-market equivalents varies by period and sector exposure. ESG funds with energy underweights have outperformed in some periods (when oil and gas underperformed) and underperformed in others. ESG fund OCFs are typically slightly higher than passive broad-market trackers but lower than active funds.

Inside an ISA or pension

ESG funds can be held inside any standard UK wrapper (ISA, SIPP, GIA) with no tax difference. Many workplace pensions now offer one or more ESG-themed default or self-select options.

Pension scheme stewardship and ESG defaults

Workplace pension schemes are required to consider financially material ESG factors in their investment strategies under the Occupational Pension Schemes (Investment) Regulations 2005 (as amended). The Department for Work and Pensions and The Pensions Regulator have published guidance setting out the expected approach: trustees must produce a Statement of Investment Principles addressing ESG considerations, and an annual Implementation Statement showing how the principles have been applied in practice.

Many workplace pension defaults now include ESG-themed funds or apply ESG screens to the underlying portfolio. The Pensions Climate Risk Industry Group and similar industry initiatives have driven adoption of climate risk reporting frameworks, including the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). Schemes with at least GBP 1 billion of assets have been required to publish TCFD-aligned reports from October 2021 under regulations made under the Pension Schemes Act 2021.

For retail investors choosing within workplace pension self-select options, ESG-labelled funds are typically available alongside the standard default. The Independent Governance Committee or trustee board oversees the fund range and its alignment with member needs; complaints about fund choice can be raised through the scheme's internal dispute resolution and ultimately to The Pensions Ombudsman at pensions-ombudsman.org.uk.

How ESG funds construct their portfolios

ESG funds use three broad construction methods alone or in combination. Exclusion screens remove sectors or activities considered unacceptable: tobacco, controversial weapons (cluster munitions, anti-personnel mines, biological and chemical weapons), thermal coal production, fossil fuel reserves above specified thresholds, gambling, adult entertainment, and similar categories. Exclusion lists vary by fund; the strictest funds exclude all fossil fuel-related activity, while broader funds exclude only the most controversial activities.

Positive screening overweights companies with strong ESG metrics relative to benchmark. The metrics typically used include carbon emissions intensity, social factors (workforce diversity, supply chain labour standards, community relations), and governance factors (board independence, executive pay alignment, anti-corruption policies). The fund's quantitative scoring methodology determines which companies are overweight or underweight relative to a benchmark such as the MSCI ACWI or FTSE All-World.

Impact strategies invest in companies whose products or services produce a measurable positive outcome. Examples include renewable energy generation, electric vehicle manufacturing, water and sanitation infrastructure, affordable housing, and pharmaceuticals addressing diseases prevalent in developing countries. Impact funds typically report on the real-world impact of their investments using metrics aligned with the UN Sustainable Development Goals.

The ESG ratings disagreement problem

Different rating agencies use different methodologies, weights, and data sources. The same company can score in the top decile with one provider and below average with another. A study by MIT and Zurich researchers documented average correlations of only around 0.6 between major ESG rating providers (MSCI ESG, Sustainalytics, Bloomberg ESG, S&P Global, and others), compared with correlations above 0.99 between credit rating agencies on company default risk.

The disagreement arises from three sources. First, providers measure different things: some emphasise climate risk, others workforce diversity, others corporate governance. Second, providers weight the same factors differently in their composite scores. Third, providers use different data sources and validation processes, with varying levels of company self-reporting and third-party verification.

For retail investors using ESG ratings as a screening tool, the disagreement implies any single rating should be treated as one data point rather than a definitive judgment. The FCA expects fund disclosures to identify which ratings or methodologies underpin a fund's sustainability claims, allowing investors to understand the basis of the claim.

Performance evidence and academic studies

The performance of ESG funds versus broad-market equivalents varies by period, methodology, and sector exposure. ESG funds with energy sector underweights have outperformed in periods when oil and gas underperformed (such as 2020, when COVID-19 demand collapse pushed energy down) and underperformed when energy outperformed (such as 2022, when the Russian invasion of Ukraine drove energy prices up).

Academic studies present mixed conclusions. A 2020 meta-study by NYU Stern reviewed over 1,000 academic papers and found that 58 percent reported positive performance from ESG approaches, 13 percent found neutral results, and 8 percent found negative; the remainder were inconclusive. Multiple Morningstar reports comparing UK and European ESG fund universes against broad benchmarks have similarly found mixed long-run performance.

The takeaway for retail investors is that ESG investing does not require sacrificing returns over long periods, but ESG funds will not consistently outperform broader market alternatives in all periods. The decision to use ESG criteria typically combines investment performance views with non-financial preferences about how the investor's money should be deployed.

The SDR labels in detail

The four FCA SDR labels are defined in the Sustainability Disclosure Requirements Policy Statement PS23/16. Sustainability Focus funds invest in assets that are environmentally or socially sustainable as the primary objective. At least 70 percent of the fund's assets must meet a credible standard of sustainability or align with a specified sustainability theme. The standard or theme must be evidence-based and reflect a robust methodology.

Sustainability Improvers funds invest in assets that are not yet sustainable but have credible plans to become so. The fund must engage with investee companies to drive the improvement, and the fund's methodology must include specific stewardship and improvement metrics. The strategy is sometimes characterised as transition investing: backing companies in carbon-intensive sectors that are credibly transitioning to lower-carbon business models.

Sustainability Impact funds invest to achieve a positive, measurable contribution to specific sustainability outcomes. The contribution must be measurable through specified KPIs. The strategy is often associated with thematic investments in renewable energy, social housing, healthcare access in developing countries, and similar areas where the impact can be quantified.

Sustainability Mixed Goals funds allocate across multiple strategies (typically combining Focus, Improvers, and Impact assets). The fund must disclose its mix and how it manages the combination. Mixed Goals funds suit investors who want diversified sustainable exposure rather than a single thematic position.

The anti-greenwashing rule in practice

From 31 May 2024 the FCA's anti-greenwashing rule has applied to all financial promotions of products and services in the UK. The rule requires sustainability-related claims to be: clearly defined, evidence-based, complete (not omitting material information), and consistent with the actual sustainability characteristics of the product. The rule applies whether or not the firm uses the SDR labels.

Common failure modes the FCA has flagged include: claims that a fund 'considers ESG factors' without specifying what consideration means; claims of carbon neutrality without disclosing the underlying methodology or offsetting reliance; claims about sustainability that apply to only a small portion of the fund's holdings; and statements that imply the fund will produce specific real-world impact without underlying measurement.

Enforcement of the rule is part of routine FCA supervisory activity. The FCA can use its full range of supervisory tools including private warning, public censure, financial penalty, and (in severe cases) variation or removal of permission. Firms typically conduct internal reviews of marketing materials, fund factsheets, and customer-facing communications to identify and remediate potential breaches.

Stewardship and engagement

Many ESG funds use stewardship (voting at shareholder meetings, engagement with company management on sustainability issues) as a substantive part of their strategy. The UK Stewardship Code 2020, administered by the Financial Reporting Council, sets the standards for institutional investor stewardship; signatories report annually on their stewardship activities.

For retail ESG investors, the stewardship dimension matters because divestment alone has limited real-world impact: shares change hands but the underlying company is unaffected. Stewardship through voting and engagement can drive change in investee companies. Funds that are signatories to the Stewardship Code and produce detailed stewardship reports give investors visibility into the engagement activity.

The international equivalent is the UN Principles for Responsible Investment (PRI), to which over 5,000 institutional investors globally are signatories. PRI signatories report annually on their integration of ESG factors and stewardship activities.

Tax wrapper interaction

ESG funds can be held inside any standard UK wrapper (ISA, SIPP, GIA) with no tax difference from non-ESG funds. The tax treatment depends on the wrapper, not the fund's sustainability characteristics. Dividends and capital gains inside an ISA or SIPP are tax-free; outside a wrapper, dividends above the GBP 500 dividend allowance are taxed at 8.75, 33.75, or 39.35 percent and gains above the GBP 3,000 annual exempt amount are taxed at 18 or 24 percent for individuals on shares.

Cost comparison with broad-market funds

ESG fund OCFs are typically higher than equivalent broad-market index trackers but lower than active funds. A global ESG-screened index ETF typically charges 0.15 to 0.30 percent OCF, compared with 0.06 to 0.15 percent for the equivalent unscreened global tracker. Active ESG funds charge 0.50 to 1.50 percent OCF, similar to active non-ESG funds.

Over a 30 year horizon, the OCF difference between a 0.10 percent unscreened tracker and a 0.25 percent ESG tracker compounds to roughly 4 percent of final wealth, all else equal. The difference is typically small enough that investors prioritising ESG considerations can accept it as the cost of expressing their preferences through the portfolio. The cost gap to active ESG funds is much larger and may not be justified by the marginal return after fees.

Disclaimer

This article provides general information about ESG and ethical investing in the UK and is not personal financial advice. Investments can fall in value. ESG criteria are subjective; investors should review the specific methodology of any fund considered.

Frequently asked questions

What are the four FCA SDR labels?

Sustainability Focus, Sustainability Improvers, Sustainability Impact, and Sustainability Mixed Goals. Each has specific criteria around asset allocation and sustainability objectives.

Do ESG funds perform worse than non-ESG funds?

Evidence is mixed. Some periods show outperformance, others underperformance, depending on sector exposure and methodology.

Are ESG ratings reliable?

ESG ratings are useful as one input but differ significantly between providers. Investors should not rely on a single rating in isolation.

Does an ethical fund avoid all controversial sectors?

Not necessarily. Each ethical or ESG fund publishes its own exclusion criteria; some are stricter than others.

Can a pension be invested ethically?

Yes. Most workplace pension default options now include ESG-themed funds, and self-select members can typically choose ESG funds from the platform's range.

Frequently asked questions

What are the four FCA SDR labels?

Sustainability Focus, Sustainability Improvers, Sustainability Impact, and Sustainability Mixed Goals. Each has specific criteria around asset allocation and sustainability objectives.

Do ESG funds perform worse than non-ESG funds?

Evidence is mixed. Some periods show outperformance, others underperformance, depending on sector exposure and methodology.

Are ESG ratings reliable?

ESG ratings are useful as one input but differ significantly between providers. Investors should not rely on a single rating in isolation.

Does an ethical fund avoid all controversial sectors?

Not necessarily. Each ethical or ESG fund publishes its own exclusion criteria; some are stricter than others.

Can a pension be invested ethically?

Yes. Most workplace pension default options now include ESG-themed funds, and self-select members can typically choose ESG funds from the platform's range.