What is the difference between impact investing and ESG?
While ESG investing operates as a framework to assess material risks and opportunities for firms, impact investing is an investment strategy that seeks to first and foremost create a specific, measurable social or environmental benefit.
SRI versus ESG
The most common types of sustainable investing are socially responsible investing (SRI), which excludes companies based on certain criteria, and ESG, a more broad-based approach focused on protecting a portfolio from operational or reputational risk.
The key difference between sustainable finance and impact investing is that sustainable finance tends to be more focused on ESG integration and risk management, while impact investing is focused on generating positive impact and creating change.
Often, it means filtering out certain types of companies and sectors – usually 'sin stocks' like tobacco products and companies involved in animal testing. The significant difference between ESG and ethical investment is that the latter focuses more on subjective, moral judgements than performance considerations.
Investors not only want to know in what way they are having an impact, they also want to be able to compare parties with each other. And there is one more reason for the increasing demand for impact investing: the good feeling it gives investors who consciously choose to invest this way.
Impact investing is defined as the deployment of funds into investments that generate a measurable and beneficial social or environmental impact alongside a financial return on investment. An innovative way of boosting the private sector's contribution to sustainable development can be achieved with impact investing.
Retail investors do care a lot about the ESG-related activities of the firms they invest in, but only to the extent that they impact firm performance, independent of ESG performance.
Investors increasingly believe companies that perform well on ESG are less risky, better positioned for the long term and better prepared for uncertainty. Companies that realign to the stakeholder capitalism agenda may have a competitive advantage over those that try to return to business as usual.
By considering ESG factors, investors get a more holistic view of the companies they back, which advocates say can help mitigate risk while identifying opportunities.
Impact investing is more focused and deliberate in seeking investments with a specific social or environmental outcome. In contrast, ESG investing considers a company's ESG factors and traditional financial metrics. This is one of the main differences between ESG and Impact investing.
Is there a difference between ESG and sustainability?
The key difference between ESG and sustainability is that ESG is a specific tool used to measure the performance of a company, while sustainability is a broad principle that encompasses a range of responsible business practices.
The same report introduced the three pillars or principles of environmental, social and economic sustainability, also known as ESG (Environmental, Social, Governance).
Companies with a low ESG score are thought to have the worst environmental, social, and governance impacts. Undesirable ESG scores have also been linked to rising poverty levels in the communities where the firm operates, as well as poor employee mental health.
Pros | Cons |
---|---|
Can help investors diversify their portfolio | ESG funds may carry higher than average expense ratios |
May reduce portfolio risk | ESG investing is still a fairly new concept and there isn't a ton of reporting on performance |
There are a number of risks and challenges associated with impact investing. One of the key risks is that impact investments may not generate the intended social or environmental impact. Another risk is that financial returns may be lower than anticipated.
However, there are also some cons to ESG investing. First, ESG funds may carry higher-than-average expense ratios. This is because ESG investing requires more research and due diligence, which can be costly. Second, ESG investing can be subjective.
Fundamentally, there is a principal-agent problem in ESG investing. This is because investors – be it institutional or retail – delegate investment decisions to portfolio managers who are supposed to be superior not only in picking stocks that will outperform the market but also at assessing firms' ESG credentials.
In general, impact investing is an umbrella term and can be used as a broad synonym for ESG investing and socially responsible investing. ESG investing describes investments that are made with environmental, social, and corporate governance (ESG) criteria as an explicit focus of the investment.
By definition, impact investing means doing something different. Traditional investors focus on financial returns; impact investors must make an intentional 'contribution' to measurable social and environmental outcomes.
The past few years have seen the rise of impact investing as a reaction against the one-dimensional search for the highest return through – sometimes highly complex or solely arbitrage – investment propositions. Impact investing seeks to add value to society.
Why is ESG criticized?
One of the biggest criticisms of ESG is that it perpetuates what it was partly designed to stop – greenwashing.
89 percent of investors consider ESG issues in some form as part of their investment approach, according to a 2022 study by asset management firm Capital Group.
According to a study by MSCI, companies with high ESG ratings had better financial performance than those with lower ESG ratings, with a 35% higher return on equity and a 20% higher valuation.
IS IT JUST MILLENNIALS DOING IT? No, the vast majority of money in ESG investments comes from huge investors like pension funds, insurance companies, endowments at universities and foundations and other big institutional investors.
Overall, the survey found that 85% of investors think ESG leads to “better returns, resilient portfolios and enhanced fundamental analysis.” Among executives surveyed, 84% said ESG helps them “shape a more robust corporate strategy,” according to Adeline Diab, BI's director of ESG strategy and research.