The Tectonic Shift of Global Finance towards Sustainability… or is it Responsibility?
Decoding ESG, Impact Investing, and Greenwashing
In a world reminiscent of Charles Dickens’ Tale of Two Cities, we stand on the best of times with global ESG assets surpassing $30 trillion in 2022 [1] and impact investing celebrating its trillion-dollar milestone [2], yet in the shadow of a daunting $307 trillion of global debt, perhaps signaling the worst of times. Amid these tectonic shifts, buzzwords like impact and responsible investing [3], ESG, and greenwashing aren't just trendy jargon but pivotal cogs in the evolving machinery of modern finance. But as we navigate this brave new world, we must understand these terms not as mere nomenclature but as the heart of our financial future. After all, as Socrates wisely put it, “The beginning of wisdom is the definition of terms.”
Understanding ESG vs. Impact Investing
ESG refers to certain nonfinancial aspects of a company; namely, its environmental, social, and governance practices. As former head of sustainability research for Morningstar, Jon Hale highlighted in his insightful September 2022 Morningstar article, ESG serves either as a risk-assessment tool (a process) or as a product aimed at balancing returns with broader societal and environmental impacts. “ESG as process is about using ESG information and analysis to better understand investment risks and opportunities in a complex world. ESG as product refers to ESG funds, (often called “sustainable” funds) with the twin objectives of generating a competitive financial return and taking into consideration their broader impact on ESG issues.” [4]
While ESG investing and impact investing have similar roots in responsible investing (formerly known as socially responsible investing [5] or “SRI” in the 1980s and 1990s and now interchangeable with sustainable investing), they describe two different investment approaches. ESG investing is an investment approach that seeks to deliver competitive financial results while pursuing positive environmental, social, and corporate governance practices, or “people, planet, and profit” for short. Impact investing, on the other hand, is an investment approach that intends to generate positive social and environmental impact alongside a more conventional financial return. In other words, impact investments are actively managed to achieve specific (and measurable) beneficial outcomes. [6]
Still Confused?
Well, let’s dig a bit deeper. How is ESG investing different from impact investing? While ESG investing incorporates environmental, social, and governance factors into the investment process in order to manage risks and potentially enhance returns, impact investing typically seeks to achieve specific outcomes such as alleviating poverty or supporting renewable energy. ESG investors might favor firms with commendable worker policies or minimal carbon footprints, even if their products or services don’t directly yield measurable societal benefits. Impact investors, on the other hand, attempt to achieve measurable impact outcomes.
As the sustainable investment market grows and public awareness and concern about issues like climate change increase, so too does the risk of systemic abuses, especially greenwashing and impact washing by fund managers and companies. These entities mislead customers and investors by exaggerating the sustainability attributes of their investments and products. The positive shifts in public awareness are being offset by a growing cynicism and loss of credibility. Fortunately, on November 1, 2023, three key standards setters—the CFA Institute, Global Sustainable Investment Alliance (GSIA), and PRI—announced harmonized definitions for responsible investment approaches [7]. Although the definitions are limited in scope, there is hope that consistent and precise terminology will begin to address the problem of greenwashing and other abuses. However, these abuses are only the tip of the responsible investing abuse iceberg. Hidden ESG risks related to management, financial performance, regulatory issues, and transparency can all potentially shipwreck companies.
Risk management - Companies that fail to address ESG risks might face regulatory fines, reputational damage, or operational disruptions.
Financial performance - A growing body of research suggests that ESG-focused companies outperform non-ESG-focused companies over the long run.
Regulatory pressure - Regulators around the world are increasingly incorporating ESG factors into financial and corporate governance regulations.
Demand for transparency - With the rise of the internet and social media, companies are under constant scrutiny making it more difficult to hide or downplay negative environmental or social impacts, hence the increase in greenwashing tactics by some.
Why Does This Matter?
Back in 2006, the World Economic Forum highlighted a cautionary conclusion to its paper on responsible investing that stressed concerns about the impact market and achieving sustainable scale by embracing market fundamentals [8]. All of the cautionary fundamentals highlighted then are still valid today. In order to address the issue of greenwashing, enhancing impact market credibility, and capitalizing on opportunities for social and environmental impact, a number of these fundamentals should be embraced:
Standardization and reporting - Developing standardized frameworks for measuring and reporting impact is essential. Common metrics and reporting guidelines can help investors and stakeholders compare different investments and assess their actual impact.
Third-party verification - Independent verification of impact claims by reputable third parties can provide an additional layer of credibility. Certifications and audits can help investors and consumers trust that the impact being claimed is legitimate.
Regulation and enforcement - Governments and regulatory bodies can play a role in enforcing truthful and transparent communication about impact. Imposing penalties for greenwashing practices can discourage companies from making false claims.
Education and awareness - Increasing awareness among investors, consumers, and the general public about greenwashing tactics and how to identify credible impact initiatives can empower individuals to make better informed investment decisions.
What Can Be Done?
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Looking ahead, the role of sustainable investing will likely grow even more significant as both private investors and governments continue to prioritize climate action, social responsibility, and corporate accountability. Navigating this evolving landscape requires not only knowledge, but also a partner who understands the complexities and nuances of impact investing.
Footnotes
[1] Bloomberg, February 2024, https://www.bloomberg.com/company/press/global-esg-assets-predicted-to-hit-40-trillion-by-2030-despite-challenging-environment-forecasts-bloomberg-intelligence/.
[2] The Global Impact Investing Network (GIIN) estimates the size of the worldwide impact investing market to be $1.2 trillion. “The size of the impact investing market,” October 2022, https://thegiin.org/assets/2022-Market%20Sizing%20Report-Final.pdf.
[3] According to the United Nations Principles of Responsible Investing (PRI), responsible investing involves the consideration of environmental, social, and governance (ESG) criteria when making investment decisions and/or influencing companies (known as active ownership or stewardship) with respect to those same considerations, and typically complements traditional financial analysis and portfolio construction techniques. “What is responsible investing,” PRI, https://www.unpri.org/introductory-guides-to-responsible-investment/what-is-responsible-investment/4780.article.
[4] Jon Hale, “ESG as Process Versus ESG as Product,” Morningstar, Sep 23, 2022, https://www.morningstar.com/sustainable-investing/esg-process-versus-esg-product.
[5] In the 1990s, ESG’s precursor was called socially responsible investing. ESG analysis, came along in the early 2000s, more concerned with ‘value’ than ‘values’. Leslie Norton, “Morningstar’s Jon Hale Learned About Sustainable Investing Over 40 Years,” Morningstar, May 17, 2023, https://www.morningstar.com/sustainable-investing/what-morningstars-jon-hale-learned-about-sustainable-investing-over-40-years.
[6] “What are impact investments,” The GIIN, https://thegiin.org/impact-investing/need-to-know/#what-is-impact-investing.
[7] See definitions for screening, ESG integration, thematic investing, stewardship, and impact investing. PRI, “Definitions for responsible investing approaches,” https://www.unpri.org/investment-tools/definitions-for-responsible-investment-approaches/11874.article#Screening.
[8] Virtually any mature industry that has grown to scale and has attracted private capital has in place the following elements:
1. Common terminology 5. Investment rating services
2. Transparency 6. Fund comparison data
3. Adherence to standard accounting practices 7. Insurance
4. Regulation by third parties 8. Liquidity through secondary markets
“Blended Value Investing”, WEF, March 1, 2006, https://www.blendedvalue.org/blog-posts/blended-value-investing-an-initial-paper-from-the-world-economic-forum