ESG Investing vs. Impact Investing: What is the Difference?
Learn more about how your investments can drive positive social and environmental change.
By Asiyah Choudry
Updated: February 14, 2023
Originally published: October 28, 2021
As global awareness of climate issues develops, sustainable investing is increasingly viewed as a potential driver of social change. As a result, sustainable and responsible investment strategies like ESG investing and impact investing have grown in prominence over the past decade, incentivizing businesses to be more socially and environmentally conscious. According to a 2021 report from Morgan Stanley, 99% of millennials are interested in sustainable investing (an increase of four percentage points compared to 2019). But for the average investor looking to make their portfolio more sustainable, it may not be immediately clear how ESG investing and impact investing differ.
Both impact investing and ESG investing have advantages and disadvantages. You may find that you prefer one over the other depending on your goals.
Let’s examine the differences between the two approaches.
What is ESG investing?
ESG investing is an investment strategy that evaluates companies based on environmental, social, and governance risk factors alongside traditional financial metrics. According to Morningstar, in 2021, investors funneled a record-breaking $70 billion into ESG funds. That’s an increase of nearly $20 billion compared to 2020. And the number of ESG funds available to US investors continues to increase. Thus, it is evident that ESG funds are rapidly growing in popularity — but how are stocks and bonds screened for inclusion?
Some examples of the factors used to evaluate an investment for inclusion in an ESG fund include:
- Environmental factors such as carbon emissions, pollution, or climate change policies,
- Social factors such as human rights, workplace policies, or employee compensation,
- Governance factors such as financial transparency, executive compensation, or the board of directors.
If a firm has a low ESG risk profile, this may indicate future financial success. But if a firm has a high ESG risk profile, this suggests that poor environmental, social, or governance performance may negatively affect financial performance in the long run. Although financial professionals may use ESG ratings to guide an investment strategy, ESG ratings are less meaningful for individual investors.
Here are three important limitations of ESG investing.
(1) ESG ratings from different rating institutions vary
There is significant ambiguity associated with ESG ratings. No standard method for applying ESG criteria exists in the US. As a result, rating companies may arrive at different conclusions regarding the ESG risk profile of an organization. For example, Sustainalytics gave Amazon a high ESG risk rating, whereas Refinitiv rates Amazon as excellent on ESG performance.
(2) An ESG label does not guarantee positive climate impact
It is also important to note that ESG is not synonymous with climate friendly. ESG funds may include stakes in oil and gas companies. Analysis conducted by GreenPortfolio in 2022 shows that 80% of funds with “green” or “ESG” in the name still contained fossil fuels! As just one example, the SDPR S&P 500 ESG ETF, which includes “sustainable” firms from the S&P 500, has holdings in ExxonMobil — one of the largest oil producers (and fossil fuel expanders) in the US.
(3) Upcoming oversight may alter the ESG landscape
In response to growing investor demand for ESG, the Securities and Exchange Commission (SEC) prioritized regulating ESG funds and climate risk disclosure in 2021 and launched a Climate and ESG Task Force under the Division of Enforcement. The goal of the task force is to “proactively identify ESG-related misconduct,” including misrepresentations of climate-related financial risks. More recently, the SEC proposed rule changes to increase the transparency of ESG investments. While the SEC has yet to finalize any new regulations, it seems that increased oversight of ESG is on the horizon.
In the meantime, proceed with caution when it comes to ESG funds — while an ESG label is a starting point, thoroughly investigate any ESG fund you plan to invest in for greenwashing.
What is impact investing?
Impact investing seeks to create a positive social or environmental impact, in addition to a financial return. From 2019 to 2020, the impact investment market grew from $505 billion to $636 billion. A recent report by the Global Impact Investment Network (GIIN) estimates that, by the end of 2021, the impact investment market topped $1 trillion. This growing popularity has sparked the emergence of crowdfunding platforms like Raise Green, which has made impact investing more accessible to the average investor.
A distinguishing characteristic of impact investing is the broad range of investor return expectations. The foundation of impact investments is the creation of a positive impact, sometimes at the expense of profit. According to the GIIN, while most investors pursue competitive, market-rate returns, roughly 33% of investors are willing to target returns below the market rate to stay aligned with the non-financial objectives of their investments.
Impact investment currently faces many of the same challenges as ESG investing. These include the definition and measurement of the word “impact,” over which there is currently no regulatory oversight in the US. As the market grows, there will be an increased need to standardize this definition to avoid impact washing.
To provide investors with clarity, the GIIN has identified four core characteristics of impact investing:
- Intentionality: Impact investors aim to solve complex problems to create positive environmental or social outcomes.
- Evidence-based decision-making: To effectively create environmental or social benefits, investments need to be rooted in an evidence-based need. High-quality data is also an essential part of evaluating the performance of an investment against its targeted impact.
- Managing performance of investment: Impact investments are oriented around the intention to create a positive impact. Therefore, effective management is needed to move towards impact creation. This entails risk disclosure and measuring and reporting impacts.
- Advancement of the impact investment industry: This includes sharing lessons learned, using industry-standard language and conventions, and retroactively evaluating impact management practices.
How do ESG and impact investments perform?
The majority of investors care about their bottom line first. A study conducted by the University of California found that the median internal rate of return for impact funds is 6.4% — only slightly lower than traditional funds, which have a median internal rate of return of 7.4%.
Similarly, an examination of 1,000 studies of ESG and financial performance found an overall positive relationship that became more pronounced over time. There is also some evidence to suggest that low-risk ESG funds are more resilient in periods of uncertainty. For example, in the first year of the pandemic, ESG funds outperformed the S&P 500.
Align your investments with your values
ESG is a starting place for developing a better understanding of an organization’s environmental, social, and governance practices, but ESG labels can be misleading. Impact investing allows you to create measurable positive, social, or environmental change. Since both lack stringent oversight, it is important to do your due diligence to ensure that your investments are creating positive change.
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