ESG investing aims to create superior risk-adjusted returns by analysing a company’s environmental, social and governance factors alongside financial analysis. The basis for this is that non-financial issues often result in financial consequences, whether good or bad.
Creating a more complete company profile helps investors to judge where a businesses’ vulnerabilities and opportunities lie.
Although ESG factors are important in impact investing (much as fundamentals and valuations are), it is not the ESG profile that drives investment decisions.
ESG is typically concerned with a business’s operations (such as employee welfare, supply-chain transparency and the structure of the board), whereas impact investing is concerned with a company’s output. Does the company generate revenue from products/services which help to address the world’s environmental and social challenges?
A high ESG score can exist in almost any sector.
An oil exploration company with rigorous safety mechanisms, robust maintenance capex and strong employee welfare, is less likely to experience oil spills, accidents and the ensuing fines and reparations (not to mention environmental damage).
It would justifiably be ranked “best in class” from an ESG perspective and is likely to be a superior investment opportunity to its peers, due to the lower risks (and therefore higher certainty in forecasts).
However, it would be very difficult to define this business as a “positive impact” company as, regardless of its strong ESG credentials, its revenue is derived from the extraction of fossil fuels.
The role of engagement in impact investing
Engagement refers to the communication between suppliers and consumers of capital.
It enables investors to both understand (and in some cases shape) corporate strategy, and in the case of impact investing in particular, it can be a useful educational tool.
Engagement is critical and should be embedded in every stage of the investment process – from the initial investigation of an investment, to the impact measurement of a fund holding.
A robust and honest bilateral relationship with companies is the most effective way to gain clarity on the true intentionality of a business.
It also provides the necessary encouragement and support for them to deepen and broaden their measurement and disclosure of non-financial KPIs, which are relevant to the investor.
To further the effectiveness of impact investment and create broader top-down change, engagement should go beyond these bilateral relationships and include collaboration with industry peers, governmental organisations, academics and specialists.
Impact measurement is key
All impact investors have their own approach.
However, what is important for the success of impact investing (success defined here as the development of a sizeable proportion of global investments which have, at their core, the goal to generate a financial return by improving societal imbalances and nurturing the environment) is that high standards are maintained and that it is clear what is meant by “impact”.
Questions appear on the last page of this article.