This piece was originally published in ImpactAlpha.
Between the COVID-19 pandemic, the escalating climate crisis, and the movement for racial justice, there has been a growing recognition that social and environmental sustainability must be embedded in both business and investment decisions.
Yet confusion persists about the differences among investment approaches that claim to incorporate environmental, social, and governance (or “ESG”) considerations and those that seek to make a positive “impact,” leading to accusations of greenwashing and impact-washing. Understanding this distinction—and how to combine best practices from the worlds of ESG and impact—will be critical to move both markets forward.
At its most basic, “sustainable and responsible investing” involves the consideration of a company’s ESG operations in the investment decision-making process, including factors such as a company’s carbon footprint, workplace diversity, or board composition. Meanwhile, “impact investing” focuses on measuring and managing the contribution of investees to particular impact outcomes, such as expanding access to healthcare or more affordable housing.
In practice, however, the distinctions are not as simple as looking at what a company is doing inside its walls, versus what it is doing outside. Yet thanks to a significant amount of market progress in recent years, the nuanced differences in ESG and impact strategies are becoming easier to navigate, thanks in large part to the work of the Impact Management Project (IMP) and its partners.
The ABC’s of ESG and impact
The IMP’s ‘ABC’ framework has helped to classify different approaches based on whether they seek to: A) Avoid harm (e.g., by mitigating emissions); B) Benefit stakeholders (e.g., by focusing on companies that provide workers with better pay or benefits); or C) Contribute to solutions (e.g., by investing in a wind farm), with most ESG strategies falling in the ‘A’ or ‘B’ categories and most impact investment strategies falling in the ‘C’ category.
What’s often missed in the ABC framework, however, is the notion that the categories usually build on each other. For example, an investor may first develop an ‘A’ approach via a negative screening strategy, and then layer on ‘B’ with ESG integration, and finally add ‘C’ via an impact fund. As a result of this improved clarity, the market segmentation is now giving way to a confluence and cross-fertilization of best practices between “ESG” and “impact” approaches.
In a sign of things to come, we are now beginning to see sustainable and responsible investing standards move towards reporting on “outcomes,” whereas impact management standards are encouraging impact investors to incorporate ESG risks and performance issues into their investment processes.
For example, the Operating Principles for Impact Management (“OPIM” or the “Impact Principles”) were launched in April 2019 by the International Finance Corporation (IFC) and 60 founding signatories to “provide a framework for investors to ensure that impact considerations are purposefully integrated throughout the investment life cycle.” The guidance for Principle 5 specifically asks signatories to “identify and avoid, and if avoidance is not possible, mitigate and manage ESG risks” and also “monitor investees’ ESG risk and performance, and where appropriate, engage with the investee to address gaps and unexpected events.”
In other words, impact investors are expected to avoid and/or mitigate ESG risks (e.g., paying a living wage to all workers, promoting diversity and inclusion in the workforce, providing a safe working environment, etc.) as part of their impact management processes – an important step toward the maximization of net positive impact.
In a recent Tideline report on verifying investor alignment with the Operating Principles, “Making the Mark,” we discovered an interesting contrast in how signatories implemented an ESG risk identification process that was aligned with industry standards. We found that some mainstream asset managers who were first-time impact investors benefitted from their experience implementing ESG performance and risk management processes for many if not all of their portfolio companies. Meanwhile, some of the “pureplay” impact investors were new to some of the more nuanced aspects of ESG risk and performance management and were still in the early stages of developing robust systems for minimizing negative impacts and proactively addressing ESG risks.
There remains much that mainstream asset managers and dedicated impact investors can and should learn from each other.
What’s next for ESG and impact investing
The convergence is essential for the financial community to move beyond simply tallying a discrete set of metrics and toward driving real positive outcomes and helping build a more sustainable and inclusive society. Investors fluent in ESG and impact understand that measuring the “right” ESG risks for any given investment strategy and context is an important part of understanding where the most investable impact opportunities might be in a particular sector. For example, an investor in recycling that is seeking to contribute to the circular economy may want data and evidence that the facilities in which they invest also have strong records of worker safety and job quality.
To generate a holistic picture for each investment, shared standards and best practices will be key, as will the degree of transparency into the quality of an investor’s ESG and impact management practices.
Independent verification can play an important role in continuing to drive convergence and the adoption of best practices across ESG and impact management disciplines.
By marrying convergence with accountability, independent verification will increase market trust among key stakeholders (e.g., investors, allocators, companies, policymakers and regulators) and move us closer to a future where impact—total net impact—is managed with at least the same rigor as financial risk and return.
Christina Leijonhufvud is the CEO of BlueMark, Tideline’s new verification business. She manages all aspects of business strategy, new product development, and external relations, and has directly led over 20 impact verification assignments across investor types and asset classes.