By ESG Analyst Chloe Stoneburgh
It is well-accepted that the collaboration of finance and sustainability will be an essential intersection for the transition to a greener economy. The growing demand for the integration of ethical considerations into the investment process has led to a proliferation of social finance approaches (Investopedia). Yet, as the mainstream movements toward sustainable integration gain transaction, individuals are left confused about the different solutions on the market, which can lead to delays in or misplaced action despite an eagerness to adopt new practices.
Often, terms like environmental, social, and governance (ESG), socially responsible investing (SRI), and impact investing are used interchangeably, despite fundamental differences. So, what are the key differences that distinguish each type of social finance? Read more below to understand the definitions, priorities, benefits, and criticisms of each approach.
ESG (Environmental, Social, Governance)
What is it?
ESG refers to a wide array of environmental, social, and governance criteria to measure the non-financial performance of a company. ESG meets the growing demand for the integration of material information regarding sustainability by providing an approach to including these factors in decision-making. Since it was first popularized in 2005, ESG has become widely used to evaluate a company’s impact beyond the balance sheet by investors and other stakeholders (S&P).
What does it consider?
ESG uses three overarching categories to measure a company’s impact on society. The categories are defined by the S&P Global as such:
1. Environment – Considers the company’s impact on the physical environment, including utilization of natural resources directly and through the supply chain.
2. Social – Deals with matters related to employee satisfaction, health and well-being, human rights issues, and contributions to the greater community.
3. Governance – Pertains to factors of decision-making including policymaking and rights distribution as determined by the board of directors, managers, shareholders, and stakeholders.
How is it useful?
ESG evaluation is a useful tool to supplement traditional financial analysis by including the identification of risks and opportunities. It can be a beneficial tool for companies to become aware of how they operate in a greater context, beyond financial returns. A well-thought-out ESG strategy can add organizational value helping with customer relations, market growth, cost reduction, increased employee engagement, and improved risk management (BDC).
What are the criticisms?
Just because companies are engaging with the concept of ESG, it does not mean they are necessarily positively contributing to their environment. In the current state of ESG reporting, it is easy for companies to appear to engage with these values without any actionable changes. In part, ESG has become a way to reduce the regulatory and reputational risks that would come from the lack of such policies (Institutional Investor). In this way, greenwashing has become more prominent than ever. Further, ESG funds – those that consider these factors within their investing strategies – are being criticized for not executing adequately on financial or ESG performance leaving investors confused about the value proposition of social finance (Harvard Business Review).
Socially Responsible Investing (SRI)
What is it?
Socially responsible investing filters investments based on specific ethical considerations. Socially responsible investors will actively avoid companies whose businesses go against their moral values, despite impacts to financial returns (Forbes).
What does it consider?
This type of portfolio bases decision-making on the principle behind an organization, valuing if it is within its moral requirements (Investopedia). Some common examples of what an investor may look to eliminate from their portfolio include firearms manufacturing, alcohol and tobacco products, environmental damage, gambling, or human rights violations.
How is it useful?
Socially responsible investing is good if you have clear boundaries on your morals and values that you need your portfolio to abide by. Having this kind of investment approach allows you to stick to your core values while still having an active portfolio. Socially responsible investing allows capital to be transferred to companies with sound ethical choices, supporting companies that will contribute positively to the greater community.
What are the criticisms?
The primary criticism of socially responsible investing is despite excluding certain industries, the portfolio might not necessarily align with your required values. For example, just because you are excluding all fossil fuels from your portfolio, the rest of the organizations may not be engaging with responsible carbon emissions within their operations (Forbes). In this way, it can be difficult to ensure that the companies you are investing in align with all your values throughout all elements of their business procedures.
Impact Investing
What is it?
As a subset of SRI, the primary consideration of an impact investing portfolio is producing measurable social good (Investopedia). Impact investing is concerned with supporting businesses and organizations that will have a positive impact on society.
What does it consider?
These types of investments are made with the intention to provide a tangible positive social and environmental impact while still providing financial return (GIIN). Impact investments consider return expectations and impact measurement within their portfolios. The level of impact measurement will vary between portfolios but is often related to establishing, setting metrics, monitoring, and reporting on social and environmental objectives. Some common sectors addressed by impact investment include sustainable agriculture, renewable energy, and affordable services, along with any other difficult-to-solve social issues (GIIN).
How is it useful?
Impact investing takes the step beyond doing less bad, towards doing more good. Impact investors look beyond mitigating social and environmental damage and prioritize having an active positive impact. In this way, impact investing is the best solution for investors who intend to have a positive impact on the communities their investments are operating in.
What are the criticisms?
As investors have seen the rise of impact investing, along with it has come a simultaneous rise in greenwashing. Many “impact” initiatives can fail to deliver the impact value as promised by their business plan while sustaining positive financial returns (Legacy Group). In this way, although the intention of impact investing is there, without streamlined mechanisms and increased transparency for non-financial reporting, it can be difficult to truly grasp the impact of an organization or portfolio.
The rise in interest in social finance demonstrates a great first step towards the transition to a greener economy. However, the lack of distinction between each of these forms of investing could present a danger to the progress of these approaches. Using each of these approaches interchangeably can easily result in the perception of an organization doing more good than it deserves recognition for. As ESG approaches grow in popularity, it could become dangerous to the progress of the sustainability movement to overly applaud companies for simply doing less bad. Going forward, we need to continue to push companies to look beyond reducing the harm they are causing and encourage organizations to reflect upon what positive social impact they could bring to the communities they operate in.