The concept of responsible investing is not new but has witnessed tremendous growth in recent years, fuelled by the rising consciousness around climate change. Although responsible investments are not restricted to climate alone and operate across an array of sectors, they can be primarily categorized into two often-confused investment approaches – ESG investing and impact investing.
Despite being multi-trillion-dollar industries practiced for over a decade, the understanding of the distinctness between the two concepts of ESG investing and impact investing remains ambiguous to most. So, if you’re using the terms ESG and impact investing as substitutes, you’re not alone. This can be majorly attributed to the blurred boundaries of how the two categories of investments are defined, leading to industry stakeholders having less clarity, funds not being deployed efficiently, and activities like greenwashing becoming commonplace.
It is important for investors to understand that ESG is not a sub-set of impact investing, and their investments will not necessarily create a direct impact with it. In fact, it is the reverse that is true – impact investing is a sub-set of ESG investing. In order to comprehend this notion, the following are a few actualities about the two approaches.
Let’s start with the definitions of the two approaches. ESG investing refers to the infusion of funds in companies that meet ethical considerations of environmental, social, and governance standards. Impact investing, on the other hand, refers to funds allocated to businesses driving environmental or social change, thereby creating impact. Having understood this, we can say that ESG investments are based on the records of the past performance of any company in consideration, while impact investments are based on a company’s plans to generate impact in the future wherein the investor can decide what kind of impact they intend to invest in through the company.
ESG works as a framework that aids in the identification of non-financial risks that may influence an asset’s value. It helps stakeholders understand a company’s approach toward managing risks and opportunities around environmental and social issues based on past measures that have been taken during the normal course of business. It can be considered a scorecard for a company.
Impact investing seeks to address the future and requires sustainability goals to be identified and delivered by the investee company. The business should work toward changing the status quo of an environmental or social condition by offering solutions that aid in building a better future through business practices that create impact. This makes intentionality, to create meaningful and measurable impact, a key factor in impact investing. The performance of an impact fund is measured against the sustainable goals the company had identified to achieve, making the stakeholders responsible for direct and visible impact and diminishing the risk of greenwashing.
Furthermore, all impact investments comply with ESG standards, but not all ESG funding can be said to be impact investments. This can be comprehended by observing the due diligence processes for both types of funds. ESG assessments typically focus on business practices — whether the enterprise has appropriate internal policies and procedures favorable to attaining ESG standards. On the other hand, impact due diligence also needs to include extensive data and assessment on the impact outcomes of the actions and products of enterprises.
Undoubtedly, both categories of investments seek to offer positive solutions to environmental and social challenges, and both require capital infusions. Hence, it is necessary for conscious investors to understand the scope of both and invest in the approach that aligns with their goals. One emphasizes not supporting businesses harming the environment, while the other focuses on supporting businesses that are proactively working toward creating a change in the status quo.
For example, ESG funds will avert investments in companies that create non-biodegradable waste and harm the environment by not managing the waste it creates while an impact fund will invest in companies actively aiding in the reduction and management of waste.
With this clarity, investors must define their investment goals and direct their capital accordingly. While we need ESG investors to aid responsible businesses, we also need impact investors to achieve the UN’s Sustainable Development Goals.
Speaking practically, ESG investing should have been a reality today, with no business being allowed to operate without a working ESG policy. This would also have strengthened the position of the impact investing sector, with funds being channeled to the right resources. Understanding this notion will help investors allocate funds more efficiently and understand the kind of impact their investments are essentially creating, further augmenting the development toward achieving sustainable development goals and warranting great returns for investors, people, and the planet.
Arvind Agarwal is co-founder and CEO of C4D Partners, an impact fund manager. Views are personal.