There is so much of confusion around ESG, and it stems from a lot of terms being conflated with each other.
I like the way it has been framed by iShares, a family of exchange traded funds owned by BlackRock: Sustainable investing is about investing in progress, and recognizing that companies solving the world’s biggest challenges can be best positioned to grow.
The confusion arises when one sees that sustainable investing is a spectrum where various investment approaches are placed. Let’s navigate the jargon.
SRI
When one refers to Socially Responsible Investing, the focus is on exclusionary screening to ensure a portfolio reflected the values of an investor. It is also known as ethical investing, and seeks to avoid industries that negatively affect the environment and its people. SRI is customizable, just list products or industries that clash with your values and exclude them from your portfolio. Think tobacco and alcohol.
But investing strategies evolve over time as investors began to analyse other parameters such as the environment, workplace policies, product safety, and the global supply chain. These issues were frequently the topic of dialogue between responsibly minded investors and the companies they held.
That gave way to a broad based Sustainable and Responsible Investing (the acronym remains the same - SRI) and stands on the three pillars of ESG.
ESG
ESG investing involves strategies that take a company’s Environmental, Social and Governance factors into consideration. This is a broad umbrella that includes carbon emissions, energy efficiency, waste management, human rights, labour standards, audit committee structure, and board composition.
From a values-based perspective, the thesis behind sustainable investing is that directing capital toward companies that are dealing effectively with sustainability issues will enhance the transition to a more sustainable global economy. By doing so, investors concerned with sustainability may also achieve good performance on their investments because many companies that are effectively addressing the ESG issues facing their businesses tend to be promising long-term holdings.
To understand this in more detail, read ESG is not about sin stocks and How ESG is incorporated into company research.
Impact Investing
Impact investing refers to attempts to measure the positive environmental or social outcomes of a given investment. Impact investors are focused on targeting specific goals and the impact desired.
The Rhino Impact Bond is a case in point. It is the world's first financial instrument for species conservation and links conservation performance to financial performance. The fixed-income investment has a 5-year term and is aimed at growing the numbers of African black rhinos across five sites in Kenya and South Africa. It covers a total of 700 black rhinos that form about 12% of the world’s entire black rhino population.
The $50 million bond is based on an “outcome payments” model — a concept where investors receive financial returns only on the successful and measurable completion of the objective. Investors will pay an upfront cost for buying the bond and they will be paid back their capital and a coupon if the population of African black rhinos increases in five years. The yield on the bond will be subject to the growth of the rhino population.
So where do you fit in?
While I have given a broad view, these terms are fluid and mean different things to different people. When used interchangeably, the confusion persists. Hortense Bioy, Morningstar’s global director of sustainability research, shares some practical thoughts. For the sake of simplicity, she breaks it down to three approaches based on what investors believe in and want to do, and notes that these can overlap.
- Some individuals people just want to exclude stocks that don’t reflect their personal values. For instance, they may choose to steer clear of investments in weapons or tobacco or alcohol companies. These companies will be screened out from their investment shortlist. Investors who choose this approach, need to be aware that exclusions purely on the basis of ethical criteria may potentially affect their investment returns negatively.
- For a number of individuals, sustainable investing means ESG integration and using ESG factors to mitigate risk and potentially generate alpha. So, the objective here is not ethical but financial. An increasing number of asset managers are deep diving into this strategy, and it is expected to become the new normal. Eventually, every professional investor will integrate sustainability in their investment decisions.
- The third approach is thematic and impact; you, as an investor, want to make a difference. So alongside generating a good financial return, you also want to solve the world’s problems. For instance, you want to tackle climate change, finance energy transition, or improve people’s wellbeing. Impact investing is perhaps the most exciting but also the most challenging part of the sustainable investing space.