What's the difference between ESG & impact investing?

ESG (Environmental, Social, Governance) and impact investing; these terms are often used in tandem and, with interest levels reaching all-time highs in 2020, now regularly appear in the media and investment prospectuses.

ESG funds captured $51.1 billion of net new money from investors in 2020, the fifth consecutive annual record, according to a Morningstar Landscape Report. This was more than double the $21 billion investors funneled into ESG funds in 2019. Meanwhile, dedicated impact investing funds have grown exponentially in the past few years, jumping from $502 billion in assets under management in 2019 to $715 billion in 2020.

Both impact investing and ESG investing can provide competitive financial returns while supporting investments in a better society. However, there are some important distinctions to be made. Understanding these distinctions can help investors make better judgments, businesses position themselves more appropriately, and improve reporting and transparency.

What is ESG?

ESG focuses on three foundational pillars that are crucial to today’s corporate management and investors alike. Environmental issues can include energy use, pollution, climate risk, exposure to extreme weather, carbon management, and use of scarce resources. Social issues can include product safety, human rights, worker safety, customer data protection, and diversity & inclusion. Governance issues can include factors such as accounting standards compliance, succession planning, anti-competitive behavior, and a strong ESG management process.

ESG is used to mitigate risk related to environmental, social, and governance practices in order to protect and, by providing opportunities to adopt progressive practices, enhance value. This holistic view of a company can be used as a filter for investors seeking responsible, sustainable, or impact investment opportunities.

Investors use ESG to gain insights into the success and value of a company’s performance and policies outside of their balance sheet in order to mitigate risk and identify superior risk-adjusted returns. Ultimately, the primary focus of ESG investing is on increasing the bottom line through investments in responsible companies that are being managed well.

What sets impact investing apart?

Impact investing is defined as an investment strategy that seeks to positively address social or environmental challenges while generating financial returns. Ultimately, the goal of impact investing is to use money and investment capital to achieve positive social results; financial returns are secondary. Impact investors by definition integrate material ESG factors into investment processes and decision-making, but they also go beyond ESG in a number of ways.

In 2019, the GIIN published the Core Characteristics of Impact Investing, which included:

• Intentionality. An investor must intend to have a positive social or environmental impact through their investments.
• Return Expectations and Asset Classes. Impact investments are expected to generate a financial return on capital or, at minimum, a return of capital. This means competitive returns are not necessarily the purpose of the investment; impact investments target financial returns that range from below market to risk-adjusted market rate. These investments can be made across asset classes and can include cash equivalents, fixed income, venture capital, and private equity.
• Impact Measurement. A hallmark of impact investing is the commitment by the investor to measure and report the social and environmental performance and progress of underlying investments, ensuring transparency and accountability while informing the practice of impact investing and building the field.

In addition, the Bridgespan Group identified two more criteria that must be true for an investment itself for it to qualify as an impact investment:

• The impact must materially advance progress toward meaningful social and environmental goals, for example the 17 United National Sustainable Development Goals (SDGs), giving due consideration to all of the most important potential impact pathways for a given investment.
• The realized impact should be integral to the company’s business model.

Impact measurement & management

Just like ESG investors, impact investors are working toward building global consensus on how to measure, assess, and report impacts on people and the natural environment.

Initiatives like the Impact Management Project (IMP) are helping clarify the landscape of standards and provide guidance that can be used by investors for their impact management practice. Resources such as the Impact Management Platform help organizations learn how to act responsibly and mitigate negative impacts on the environment and society using tools like the three pillars of sustainable development (economic, environmental, and social, informally referred to as people, planet, and profits), the SDGs, and UNDP Practice Standards.

Impact investors also utilize impact measurement and management frameworks such as PwC’s Total Impact Measurement and Management (TIMM) framework. These frameworks seek to provide a holistic view of a company outside of financial reporting, including exposure to risk, potential opportunities, and the positive impacts on society.

TIMM’s framework measures impact using four primary categories:

• Social impact: Measures and values the consequences of business activities on society such as health, education, and community cohesion.
• Environmental impact: Looks at how the impact of business on natural capital, such as emissions to the air, land, and water, and the utilization of natural resources, is valued.
• Tax impact: Looks at how taxes on profits, people, production, and property, as well as environmental taxes, are included when valuing a company's contribution to public finances.
• Economic impact: Measures the effect of business activity on the economy in a given area, by measuring changes in economic growth (output or value-added) and associated changes in employment.

This paradigm evaluates a firm's positive or negative influence on society, taxation, economics, and the environment, allowing investors to compare strategies and investment options by assessing the whole impact of each organization. These frameworks exist apart from ESG frameworks such as the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI), despite the fact that they are both supported by organizations like the Principles for Responsible Investing (PRI).

The world needs both ESG & impact investing

Coming out of 2020, the world faces many systemic challenges such as the COVID-19 pandemic, Black Lives Matter movement, and rising annual global temperatures. Both ESG investing and impact investing can play critical roles to play in addressing these challenges.

ESG investors can drive stronger, more responsible business that take stakeholder considerations into account, businesses with diverse and inclusive teams, engaged employees, and reduced environmental footprints.

Meanwhile, there remains a sizeable investment gap required to meet the SDGs, a gap that can be significantly addressed through impact investing. With a focus on driving change over returns, impact investing ensures that mandates to end poverty, reduce inequalities, improve education, and protect the environment can become a reality.

ESG materiality assessments

With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.

An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.

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Ryan Nelson

Ryan Nelson is Conservice's SVP & General Manager, ESG. He has over 20 years in enterprise software and management consulting experience, including supply chain software implementation and process optimization for fortune 50 companies. Since 2009, Ryan has been focused on helping companies amplify their ESG impact with technology.

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