A Primer on ESG & Impact Investing
At Junxion, we believe transparency drives trust. When we have shared definitions, it’s much easier to work together toward shared goals and values. So here’s a primer on a particular part of this world: ESG and impact investing.
Senior Consultant in our Canadian team, Shayla has a wealth of experience in social finance, impact evaluation, and B Corp certification.
Newcomers to all this work are quickly confused by all the jargon and its ever-shifting definitions. Even veterans of sustainability and social responsibility can struggle to put their experience to work in ‘ESG,’ ‘impact investing,’ or ‘social purpose.’ So no wonder we’re seeing pushback against these valuable approaches to making business a force for good.
Let’s Start With The Basics
What is ESG?
ESG comes from the investment world. It is shorthand for environmental, social, and governance factors that may affect the value of an investment. ESG is a framework investment professionals use to assess and screen potential investments for material risks, in order to maximise returns from their portfolios.
What is materiality?
A key concept of ESG screening is materiality. Single materiality—or ‘outside-in materiality’—consists of identifying and assessing the risks to a company’s bottom line of various ESG factors. For example, if there are poor labour conditions in a company’s factory, this could lead to strikes, which could in turn affect revenue. This is an ESG risk. Double materiality adds the ‘inside-out’ perspective and looks at how business operations affect society and the environment. For example, might those poor working conditions be harming employees? (Interesting that ESG tends to be about risk assessment…More on that shortly.)
Are ESG and sustainability the same?
To many people, ESG equates ‘ethical investment’—investing in green or sustainable assets. This is problematic. For investment professionals, ESG simply indicates that ESG criteria are one input to an investment decision.
There are many follow-up questions that need to be answered to determine whether an asset is truly sustainable, such as which ESG methodology was used, whether E, S, or G was prioritised, and how much this ESG screening affected the overall investment decision.
A sound ESG investment may present minimal material risks, but still not achieve real sustainability.
Some ESG funds have been making unsubstantiated claims about their ability to measure corporate sustainability performance. In May 2022, Deutsche Bank’s offices in Berlin were raided following whistleblower claims that the asset manager inflated its ESG credentials. In February 2022, the financial data provider Morningstar removed 1,200 funds from its European sustainable investment list after a review. And the European Commission and the SEC in the USA are cracking down on ESG overclaiming. (Hmm…A different type of risk?)
Ratings & Benchmarks
What are ESG ratings? And what’s their purpose?
ESG ratings are produced by rating agencies such as Moody’s and Sustainalytics. They go through publicly available information and give companies a rating based on ESG best practices. For example, does the company have anti-corruption training in place? Are there employee representatives on the company’s board of directors?
The ultimate aim is to make companies engage in less harmful practices. By giving investment managers more information about harmful practices (risks), riskier stocks should receive less investment, which should in turn incentivise companies to improve conditions (reducing their risks).
An ESG index fund is one that rates investment opportunities based on the severity of ESG risks. Blackrock has an ESG fund for example, which is a portfolio of low-risk ESG stocks. ESG ratings are visible to investment managers who will use them as one of the factors in determining their portfolio selection.
How can ESG ratings be different for the same company?
Rating companies have different algorithms, information sources and methodologies (e.g. single vs. double materiality, absolute best vs. best in class) so can end up with different ratings for the same company. They can also prioritize different elements of ESG for the overall score. For example, some ratings companies give social factors a larger weight than governance or the environment.
Rating companies usually rate public companies since there is more disclosure available. Privately owned enterprises aren’t obliged to disclose as much information. That said, ESG still very much applies to those companies; it’s just there are fewer public ratings available.
Investors typically look at a range of ESG ratings, before coming to their conclusions about which potential investments may carry more potential…and more risk.
How Does this Relate to Impact Investing?
What is impact investing?
Whereas ESG is often concerned with reducing risk, impact investing is more concerned with promoting net positive impact.
Net positive is going beyond mitigating negative sustainability impacts and creating positive impacts on society and the environment that would not otherwise have occurred. This ‘additionality’ is key to the concept of impact.
As with ESG, there is no legal regulation yet for the classification of an ‘impact fund.’ Frameworks like the Impact Management Project (IMP) and Common Approach are trying to set standards around what impact really looks like and how we qualify and communicate impact in the investment world. The aim of this is to make investment choices as comparable as possible.
One of the things IMP is pushing is to measure impact according to ABC, where A = Act to Avoid Harm, B = Benefit Stakeholders, and C = Contribute to solutions. In our view, investing is only impact investing when all of A, B and C are fulfilled. In contrast, ESG investments might only deliver on A.
What is an impact fund?
An Impact fund recognises organizations that have a net positive impact on society, the environment, or corporate governance. The Triodos Pioneer Impact Fund, for example, contains ‘a range of small and medium-sized stock market listed companies that are delivering pioneering solutions to sustainability challenges.’ Companies in this fund include solar companies and water management systems.
Where Is All This Heading?
What are the benefits of ESG?
For decades, environmental, social, and governance issues were not factored into business decisions or investing criteria. So ESG is valuable because it assesses the non-financial risks embedded in a company’s operations. As a movement, ESG calls for greater transparency from companies about their activities and their impacts.
Greater transparency leads to more accountability and when we can hold companies to account, we can expect positive action. As ESG expands, we should see fewer harmful business practices and more ethical and environmentally-conscious behaviour.
How can ESG be improved?
- Single materiality must be scrapped in favour of double materiality. Companies must expand their view from material impacts on their bottom lines to material impacts in the real world—on people and planet.
- While double materiality is a fundamental requirement to consider a company’s sustainability performance, true sustainability would compare the company’s performance to a scientific or societal threshold such as staying within 1.5 degrees of global heating or paying all employees a living wage. This is known as context-based materiality.
- Governments have to get serious about regulating disclosure. Disclosure of ESG data is still optional—so there’s a lack of comprehensive data about a firms’ impacts. This makes it much harder to judge and rank companies since ratings companies and investors have to rely on self-disclosure. Frameworks like TCFD and the GRI are making good progress—but there’s much more to do.
- The ESG measurement industry must get more consistent, stringent, and standardized. Rating companies are not audited themselves, which means there is no universal standard about what is an appropriate rating. This risks corrosion of the credibility of ESG.
- It’s key that ESG funds and ratings companies have really detailed information about how they approach ESG. It’s still a murky field and a lot more education is needed, both within investment companies, and for amateur investors. More transparency will drive more trust, and more trust will drive more uptake of ESG ratings and screens—and impact investing.
Where Does Junxion Fit In?
Junxion helps companies become more attractive to ESG and impact investors. Our double materiality assessments help companies to prioritize and reduce their most important risks. Our ESG & sustainability strategy work helps companies define meaningful goals and design a path to achieve them. And our impact measurement and reporting services help companies select and track the right metrics to ensure they’re optimizing their capacity to achieve their missions—while engaging stakeholders, including investors, along the way.
We also work with impact investors to make more impactful investment decisions, developing impact evaluation frameworks and implementation plans. We are also currently supporting an ESG risk rating agency in the development of an impact evaluation framework and plan to measure the impact of their work.
Earn returns for your investors. Deliver value to your stakeholders. And build a more resilient, future-proof business. If that sounds valuable to you, we should talk.