Terminology

The terms Impact Investing and Environmental, Social and Governance (ESG) have become increasingly important for asset owners and investment managers broadly. The terms are often used interchangeably, which muddies the waters as they are actually two different concepts.

ESG is the practice of considering how the operations of a business have an impact on the environmental, social dynamics and the overall governance of the business. The core focus of this is how the business is run, and less about ‘what’ the business does. So a mining company could score very well on ESG if it is applying best in class environmental practices (not using slag ponds for waste, eliminating toxic water discharge, etc.), social practices (worker safety and training, community engagement, etc.), as well as governance (diverse board members and executives, etc.)

By contrast, Impact Investments are more focused on what the business generates as outputs or services. So the mining company above would not be considered an impact investment as the production of the minerals isn’t inherently benefiting social or environmental outcomes. A better example would be a business that looks to reuse or recycle electronics, which in turn reduces electronic waste that is polluting landfills and often is dumped overseas in countries with lower environmental standards. It’s possible to quantify the impact of this business through the diversion of waste, and if they can reuse or recycle electronics, it also minimizes the mining that is needed.

Returns

In some cases, the term “impact investing” conveys a sense that an investing activity can and should exist, even if target returns are below market-rate returns for investments with similar risk. In other cases, “impact investing” conveys market-rate returns, with an unusually high social or environmental benefit. There is data to support both arguments of market rate impact investments and below-market rate, often referred to as impact first investments.

ESG typically is not applied to below-market rate investments, and the assumption is that ESG investments should generate market rate returns. There have been thousands of studies on the subject, with roughly 90% determining that incorporating ESG factors into investing has neutral to positive impacts on returns. 1

Across either ESG or Impact Investing, our experience at Impact Delta is that thoughtful application of either approach can generate returns equal to, if not greater than, comparable investments that don’t incorporate these factors.

Current Market Landscape

What has been the catalyst for the increasing focus on ESG and Impact Investing? Most analysts point to a) increasing urgency around climate change; b) changing social norms and expectations around gender equality; c) ongoing economic inequality, and growing political will to address it; d) an interest in reputation management by investors; and e) changing preferences associated with millennials seeking to do good and growing in influence. The 17 UN Sustainable Development Goals (SDGs) are a widely accepted framework for what “doing good” might entail.

With the entry of more GPs launching funds and businesses around ESG and Impact Investing, activity from other parts of the ecosystem has also accelerated. Global auditing firms, such as KPMG and EY, have recently established impact auditing practices, and impact investing market associations and information-sharing forums have grown in scope. Examples include the Global Impact Investing Network (GIIN), and the Impact Management Project (IMP). In September 2019, former Financial Times journalist Sarah Gordon became the first CEO of a newly created U.K.-based entity named the Impact Investing Institute. More recently, the IFRS and SEC have indicated that non-financial ESG data is under consideration for mandatory disclosure to investors.

ESG and Impact Measurement

Consumers increasingly vote with their buying power, and are increasingly asking for impact claims to be verified by independent third-parties. Impact investing benefits from impact measurement and management approaches that involve third-party solutions. Frameworks developed by the GIIN – such as the IRIS impact metrics catalog is a good place to start, while other resources are available through the Impact Management Project, as well as the IFC’s Operating Principles. ESG metrics are typically even more diverse than impact investing. This reflects the nuances of the range of industries and factors that could be measured along environmental, social and governance considerations.

Impact Delta works with clients to ensure that the impact measurement and management solutions we suggest, or help implement, result in the most robustly documented impact results the market can offer. We have seen the emergence of frameworks and measurement solutions that are becoming de facto standards across various different industries. For more information, please contact us.

1 – Gunnar Friede, Timo Busch & Alexander Bassen (2015) ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance & Investment, 5:4, 210-233, DOI: 10.1080/20430795.2015.1118917