Kusi Hornberger and Neil Gregory
Kusi Hornberger is an Associate Partner with Dalberg Advisors. Neil Gregory is Chief Thought Leadership Officer for the IFC. Both are based in Washington, DC. The views expressed in this post are their own.

Why the rise of ESG and Impact Investing matters for inclusive businesses

15. Oct 2020

Environmental, Social and Governance (ESG) and Impact Investing strategies are booming right now. That’s good news for inclusive business because over time these trends could drive down the cost of capital for companies that make a social impact.

According to JP Morgan, ESG-related investing could reach $45 trillion by the end of 2020, and a recent report by IFC suggests impact investing could total as much as $2 trillion. Trends analysis from the Global Impact Investing Network (GIIN) suggests that impact investing AUM from the same set of investors grew by an annual growth rate (CAGR) of 17% over the last five years and continues to accelerate year on year.

Around the world, more people are seeking ways to deploy their money in ways that create financial return – across a spectrum of return expectations – while also responding to global challenges like climate change, disease and rising inequality: issues that have been exacerbated by business as usual and passive investment decisions. This trend has been accelerated as global interest rates remain low and impact investing strategies are starting to show they can generate superior profitability to alternatives.

Thanks to demand from Millennials and Generation Z, the investment landscape is starting to take a new shape. These generations are increasingly demanding investments that will make a difference in society. Inclusive businesses are well positioned to meet these demands through robust ESG standards and business models that include the most disadvantaged in society. However, the biggest opportunity for inclusive businesses is in the rise of impact investors and their comparatively larger focus on how to help solve the world’s biggest problems.

The ABCs of ESG and Impact Investing

ESG investing is the systematic incorporation of environmental, social and governance (ESG) factors where material to performance. As a more holistic analysis than traditional investing, ESG integration is often pursued as a means of improving investment performance. The specific ESG factors included may be selected according to materiality to financial performance of the portfolio and/or relevance to the asset owners.

ESG is used commonly in public markets strategies and can involve screening out investments that do not meet ESG criteria. ESG criteria allow for more stakeholder advocacy because they force companies to track and report how they are doing with regards to a range of topics, including issues like pollution and worker safety.

In contrast, impact investing at present is commonly applied in private markets strategies intentionally seeking investments that contribute measurable solutions to global challenges like the United Nations Sustainable Development Goals (SDGs).

Enough room for everyone

There is room for both ESG and impact investment strategies in the market, and investors may want to allocate funds to each in different proportions. Both can deliver superior financial performance, can be mutually reinforcing and make the world a better place, but they work in different ways, and there are some overlaps between the two strategies (see Figure 1).

For example, most Impact Investors will screen for, and manage, ESG risk as part of their investment practices. Indeed, the Operating Principles for Impact Management - adopted by over 100 investors globally - requires this. And ESG investing can generate meaningful positive impact when corporate leaders change their behavior because of those pressures, or when those pressures create a big enough influence on capital markets to lower the cost of capital for firms generating positive impacts.

Figure illustrating the differences between ESG and impact investment. The main points are repeated in the text.
Figure 1: Comparison of actions taken at each stage of typical investment process by ESG and impact investing strategies. Click here to enlarge

Despite these commonalities and the fact that many advisors lump ESG and impact strategies into a broader bucket of ‘sustainable’ investments, there are three requirements of investors to ensure their investments are impact investments and not ESG:

  1. selection of assets with intent for impact,
  2. a contribution to the impact of the investee firm, and
  3. objective measurement of that impact

How Impact Investing goes beyond “just” ESG

These practices, enshrined in the Operating Principles for Impact Management, are what ensure that investments make a real, positive impact, and help the market avoid ‘impact washing,’ in which investors claim they have had an impact by claiming credit for outcomes that would have happened anyway.

Here is why:

  • Intent: Impact investors believe that capital can be purposefully invested to solve the world’s most difficult and intractable problems, such as ending gender discrimination, combatting climate change, eliminating poverty, stopping systemic racism and thwarting rising inequality, and that, therefore, screening out companies based on practices that could potentially be harmful isn’t enough. We won’t solve these problems unless we allocate capital to create solutions to solve them. For example, AXA Investment Managers launched a $200 million Climate & Biodiversity fund in 2019 to deploy capital into credible solutions that address climate change and slow the loss of biodiversity.
  • Contribution: Similarly, it is not enough for investors to hold shares in companies that manage ESG risk well, and in companies that have positive impact. Rather, investors’ investments must make a meaningful difference on the impact that the companies have, either through financing their growth, or by influencing their behavior. For example, Actis evaluates its contribution to each of its investments on a scale of low, moderate or high based on an assessment of what would have happened in the absence of their investment. 
  • Measurement: Finally, we should not settle for good intentions and aspirations for contributing good. We should set realistic, evidence-based targets for what our investments can achieve, then monitor and evaluate actual achievements, using data and evidence to measure whether the investments we make cause material positive changes and avoid harm along the way. For example, Global Partnerships not only require their investees to report on a set of common impact indicators: They also run periodic in-depth impact studies, field visits or partner on external evaluations and assessments to more deeply understand and report on the impact of their investments on the populations served.

In reaction to the COVID19 public health and economic crises, investor interest in both ESG and Impact Investing strategies has accelerated.

How can inclusive businesses prepare themselves for an expansion of these forms of investing?

First, good Environmental, Social and Governance standards are the bedrock, with both ESG and impact investors laying great weight on them. Companies should make sure that they thoroughly consider these aspects and make their policies and efforts public.

Second, impact investing demands that companies have an impact on social problems. The best way to show this is to develop an explicit impact strategy that shows how business models affect change. This is even better when backed up by targeted and credible data collection.

We believe in the power of well managed impact investments to help solve the world’s problems. But ultimately, impact investors are only as impactful as the companies in their portfolios. It’s up to businesses with a social impact – inclusive businesses especially – to meet the rising demands of socially conscious investors and tackle the grave challenges at hand.