Defining ESG & The Spectrum of Responsible Investing (Part 2)Written by
Definitions matter. A lack of clear expectations for what a strategy can and cannot achieve sets it up for failure. As the Environmental, Social, and Corporate Governance framework gained popularity, so did its risk of becoming a catch-all buzzword.
ESG is often used interchangeably with terms like SRI (Socially Responsible Investing) and Impact Investing, and while all three strategies fall under the larger theme of Responsible Investing, they each target different outcomes that vary with individual investor’s preferences, definitions, and expectations for sustainability. Clearly distinguishing each strategy will allow us to better zero-in on ESG and why we believe it matters to anyone looking to deploy capital or build a business for the long-run.
What is Responsible Investing
Responsible Investing, broadly speaking, is any investment strategy that aims to promote the long-term health and stability of the market as a whole. What makes Responsible or Sustainable investing so difficult to define is that terms like “Responsible” and “Sustainable” are inherently vague: one investor’s view of what is a responsible business practice will almost certainly vary from another’s. As such, as investors, it is imperative that we establish clear delineations between the different investment strategies to ensure we are targeting our desired outcome. We will discuss the three most prominent strategies that investors are using to deploy capital responsibly today:
Socially Responsible Investing: SRI employs ethical or moral criteria to negatively screen out investments that do not align with an investor’s principles. Typically SRI evaluates companies based on how they make money; if a company’s goods or services present an ethical issue to a given investor, it will become restricted from investment. Restricted investments vary based on the investor, but typical examples include alcohol, tobacco, or firearms. Additional nuance is presented within large corporations that derive their revenue from multiple brands or products. To adequately screen for material ethical misalignment, companies typically need to derive more than a certain percentage threshold (typically 5%) from the restricted criteria. Of the three strategies, SRI has been around the longest, first emerging in the 1960’s with the rise of shareholder activism, such as challenging Dow Chemical’s production of Napalm or Nelson Mandela’s plea to divest from companies that supported the apartheid in South Africa. The first SRI Mutual fund, Pax World Fund, was established in 1971.
Impact Investing: While SRI seeks to avoid negative exposure, Impact investing aims to achieve positive outcomes, typically targeting specific social or environmental objectives, and differs from philanthropy by simultaneously targeting positive financial returns. One of the largest challenges facing Impact investing is defining what constitutes positive impact. Organizations like the Global Impact Investing Network (GIIN) and the Principles for Responsible Investing (PRI) have established frameworks for measuring material impact and setting standards for impact objectives such as the UN’s Sustainable Development Goals (SDG). Typically impact is achieved through either pure play companies, meaning companies whose activities are directly aligned with impact themes such as improving health care, financial empowerment, environmental sustainability, education, food scarcity, or through a company’s positive externalities, such as promoting gender equity within an organization. Either way, on top of defining and measuring these metrics, impact investors have the added difficulty of maintaining the double bottom line of positive social or environmental outcomes and profit.
Environmental, Social, Corporate Governance: Simply put, ESG is a framework for evaluating risks that are not adequately captured on a company’s financial reporting, namely exposure to environmental, social, and governance issues that pose material impacts to a company’s performance. ESG’s core tenet is that traditional accounting standards do not represent the entire picture of a company’s financial health. As such ESG provides an essential framework to define and measure metrics that will determine a company’s long-term viability. ESG does not explicitly exclude companies from investment due to where they derive their revenue, rather it provides an objective way to score companies whose financial future may be jeopardized by gaps in governance or a lack of regard for the environments in which they operate. Unlike impact investing, ESG does not explicitly target specific outcomes; rather, it recognizes that if companies fail to foster sustainable business practices, they risk long-term financial underperformance. While a company that pursues SDGs aims to achieve positive outcomes, investing in it from an ESG perspective would evaluate those sustainable practices as promoting positive financial performance. Another distinction that the ESG makes is that it takes into account companies’ improvement across environmental, social, and governance factors over time. Thus, while an impact investor might avoid holding a petrochemical producer; an ESG investor might evaluate the entire Oil & Gas sector, and invest in the company that has made the most significant investment in renewables, which would preserve its business viability as society moves towards decarbonization.
- Responsible Investing refers to the broader umbrella of capital allocation strategies that, while unified in their goal of achieving long-term sustainability, differ in their practical approach to capital allocation.
- Socially Responsible Investing uses exclusionary screens to filter out investments that might violate a specific investor’s moral or ethical criteria.
- Impact Investing targets both financial returns and specific sustainability related outcomes such as emissions, education, or healthcare.
- ESG Investing evaluates non-balance sheet risk that is still material to long-term financial sustainability.
Our Goal: Investing In and For the Future
Over the past two articles, we have discussed the history of ESG, why it matters, and how it differs from other Responsible Investing strategies. Understanding how ESG differs from Impact Investing and Socially Responsible Investing allows us to more intentionally target the desired outcome of our capital allocation strategies. By providing this context, we hope to set the stage for LPs, VCs, and founders alike to have fruitful conversations about financial sustainability and how adopting the ESG framework provides a path towards it. Reaching widespread financial sustainability requires a coordinated effort, and we at Geodesic welcome everyone in our community to join us in our goal to invest both in and for the future.