The world of values-based investing is awash with industry jargon. The most common mistake I hear is the conflation of ESG (Environmental, Social, and Governance) and impact investing. While the two fields share some similarities and could be considered to belong to the same family, at best they are cousins.
ESG investors typically invest in large, publicly-traded businesses (e.g. shoe manufacturers, cosmetics brands, tech companies, etc.). Unlike traditional investors, ESG investors consider the financial risks of investing in companies with poor environmental, social, or governance practices. For instance, a company with irresponsible waste management practices is at more risk of being sued.
But many different approaches to ESG investing exist. Here are the basics you should know. They are ordered from most simple to most onerous and potentially impactful:
ESG Exclusions: Eliminating certain types of companies or entire industries from one’s investable universe. This approach is common with religious institutions that have moral objections to certain industries (e.g. weapons, alcohol, pornography, etc.)
ESG Screening: Using quantitative screens to either search for (positive screens) or exclude (negative screens) companies that possess various ESG attributes.
ESG Integration: A much more onerous approach than ESG screening that involves infusing both quantitative and qualitative ESG analysis throughout the entire investment process.
Shareholder Engagement: Engaging corporate executives to encourage or pressure them to adopt more socially or environmentally beneficial policies.
While ESG investing happens among institutional investors buying publicly traded stocks and bonds for the purpose of reducing their financial risks. Impact investors on the other hand aim to make investments that have a positive impact on people and our planet.
Impact investing has two defining criteria, 1) that the impact be intentional and 2) that it be measurable.
In order to make an intentional positive impact, one must have a theory for how their investment will accomplish this. In impact investing, we call this a Theory of Change (TOC) and it should be clearly documented.
For instance, I may decide to invest in small and growing businesses in Africa because I believe this act will allow these businesses to grow faster, create more jobs, raise incomes, stimulate the economy, and ultimately improve livelihoods.
Once I detail my theory I need to measure whether the actual outcomes match what my theory predicted. This is much harder than it seems. I need to collect data cost-effectively, ensure its accuracy, and assess causality.
In other words, are livelihoods actually improving and are they improving specifically because of my investments? And even if I can prove all of that, I will then continually work to improve my approach so I can make an even bigger positive impact.
ESG investing is complex and highly sophisticated but the motives of its investors, the markets in which it happens, and its methods differ wildly from what you’ll find in impact investing. So as I say, at best, ESG and impact investing are cousins.