What are the different types of responsible investing and how do they work?
What's the difference between ESG, SRI and impact investing?
A quick google into “how to invest responsibly” and you’ll quickly find that these investing terms are often used interchangeably.
But look closer, and you’ll find that ESG, SRI and impact investing actually mean quite different things.
1. ESG rates companies on environmental, social and governance criteria to find the “good” ones. There are, however, no standardised criteria, so it depends a lot on who’s deciding what counts as “good”.
2. SRI excludes companies from an investment that are involved in certain businesses, e.g. gambling, alcohol, or fossil fuel. It’s useful for single-issue investors.
3. Impact investing looks at the specific measurable impact of a company on a particular issue, e.g. climate change, gender lens investing, etc. Investors can see the measurable impact of their money alongside the financial returns.
Before we dive into the key differences between ESG, SRI and impact investing, it's good to understand why these are becoming increasingly popular in the investment world in the first place. What each investment typedoes have in common is their intention to look beyond merely financial returns, to the behaviour of the company you’ve invested in.
Sometimes called “responsible investing”, each type looks at the story behind the company — although, as we’re about to find out, that scrutiny can vary.
This type of responsible investing is becoming increasingly common, as millennials enter their prime earning years.
Millennials are commonly regarded as socially minded, a generation that differs because, rather than solely focusing on the financials of a potential investment, they look at the potential impact it might have on the world around them.
Sound like you? A 2019 Morgan Stanley study found that 90% of millennials want to tailor their investments to their values.
That's why, with $30 trillion of wealth in the process of being transferred from baby boomers to millennials, creating investment products that appeal to these new investors is on the to-do list of most financial institutions.
So, what are the options for an investing-curious ethically-minded millennial?
So, what does ESG actually stand for? To answer briefly: E = Environmental, S = Social, G = Governmental. Yes, what do "environmental", "social", and "governmental" stand for in this case?
To answer this question, let's consider a takeaway cup of coffee from Latte Lou’s.
The environmental element of ESG is fairly easy to imagine.
When it comes to producing coffee, there’s the environmental impact of growing and harvesting the coffee beans, the emissions that come from transporting the beans, plus the materials needed to produce a takeaway cup and plastic lid and the energy used to keep the shop open, amongst many, many other things.
The social component looks at how the company interacts with the world on a more human level — within the community it manufactures and sells in (often two very different sides of the world). It also applies to the staffing of the company.
So in the case of Latte Lou’s coffee, the S of an ESG filter will analyse how ethical the supply chain of coffee beans is - is the farmer fairly paid, are the harvesters provided with the right safety equipment? Then there’s employees at the coffee shop - are they given a decent benefits package, do they have the right to belong to a union? Finally, there’s the staff at Latte Lou’s headquarters — is hiring diverse, is career progression equitable?
Last, there’s the third element: governance. This refers to corporate governance — in other words, who the decision makers are and how they run the company. This could include things like whether the CEO is incentivised based purely on profit or on other targets such as reducing emissions, whether there are any lawsuits against the company and whether decision making within the company is transparent.
A method of analysing companies for potential investment using criteria regarding their behaviour in relation to the environment, society or the way the company is governed. ESG investing attempts to weed out companies that are not behaving responsibly, often through a scoring or ratings system. Investments might be ‘traffic-lit”, or given a total overall score that needs to reach a certain level in order to be included in the fund.
Here are a few examples of how this works.
Trillium Asset Management is the “oldest investment advisor exclusively focused on sustainable and responsible investing”, so has a strong history in ESG investing. Their criteria includes avoiding companies that have anything to do with coal mining, as well as those who make 5% or more of their revenues from nuclear power or weapons.
In contrast, Deutsche Bank scores companies out of 100, giving environmental factors 40% of the weighting, including the supply chain, products and operations; social factors 30%, including how the business interacts with the community and how staff are treated; and 30% to governance, including corporate ethics and publicised principles.
Clearly, there is no standardised ESG criteria — so what ‘behaving responsibly’ actually means depends very much on the person or company doing the rating.
While some will have stringent measures that a company must achieve, less committed parties might be less rigorous in their approach, in order to achieve a long list of potential investments while still being able to claim it as an ESG investment product. Likewise, some will regularly reassess whether a company remains ESG-compliant, while others will add a company to the green-lit list and perhaps never check again.
Despite this uncertainty, ESG investing is increasingly common, going from ‘niche to normal’ over the past few years. As of 2018, one in every four dollars was invested in accordance with a sustainable investment strategy. But as with anything popular, it has become somewhat of a buzzword.
Some companies have adopted it purely to appeal to this new generation of mindful investors, rather than wholeheartedly believing in the need to consider a company’s behaviour alongside their financial performance. Within large investment corporations it’s common to find that only a certain percentage of their investment products are ESG compliant, simply because many of their investors still don’t care about anything more than financial returns.
Even within ESG investing, while the behaviour of a company is considered, the main focus is still the return, AKA how much money you can make from your investment. And that’s immediately obvious when you look at how many companies are included in a typical ESG fund.
Just take a look at the S&P 500, which is made up of 500 of the largest companies in the US.
When you take away the companies that don't conform to S&P’s ESG requirements, 311 of them remain. And if you look at that list, it includes Amazon, Visa and Procter & Gamble - perhaps not the companies you’d expect to support if you were looking for an investment product that matched your values.
So going back to the coffee beans used in Latte Lou’s coffee, if the company used beans from a supplier known to use child labour, they absolutely wouldn’t make the cut. But the beans don’t need to be Fairtrade. As long as they don’t raise any major ethical issues the company may well fulfil the ESG criteria, but it will depend on who’s put together the criteria and what they’re looking for.
But what about a coffee company inventing a whole new way of farming coffee, which used less water, less land, and resulted in a larger harvest (and more money) for the farmer?
Impact investing begins where ESG ends.
If ESG investing is about weeding out the bad guys, impact investing is about seeking out the good guys. It examines the impact that a company has on the world, investing only in those that have a positive impact, in whatever social or environmental area that impact investor is focused on.
An investment that aims to address a social or environmental problem in a measurable way while generating financial returns.
Every company in the world has an impact, regardless of size, industry or location. And those impacts can be felt everywhere. Back to Latte Lou’s...
If the company cuts down rainforest to plant an intensively farmed coffee plantation? A negative impact.
Provides employment opportunities to a community affected by drought? A positive impact.
Transport coffee beans across a continent by road? Negative.
Employs and trains people post-incarceration to work in the coffee shop? Positive.
There’s a lot that goes into that one cup of coffee.
While ESG investments rate companies based on their interaction with the environment, society and corporate governance, leaving a relatively long list of investment opportunities, impact investing only includes those companies working proactively to address a very particular problem or issue. The result is a much smaller list of potential investments, with many household names notably absent.
But as you’ve already seen, the term ‘impact investing’ is relatively wide, because of how many places impact can be felt. At Cooler Future, we’re focusing on climate impact investing, which we've discussed in more detail here. But let’s look briefly at what that means for Latte Lou’s.
In order for Latte Lou’s to be a viable investment for Cooler Future to invest in, the company will need to demonstrate that they are doing something quantifiable to reduce their carbon footprint.
When it comes to coffee, there are several emissions-heavy areas that need addressing. These include the emissions related to shipping it from where it’s grown to where it’s consumed, the energy-hungry roasting machines to turn the green beans into something drinkable, and the energy used to keep the coffee shop in business, including lighting, air conditioning, coffee machines and probably several laptops plugged in by customers.
So, if Latte Lou’s was to be a viable candidate for climate impact investment, these things would have to be addressed. And that involves more than just appointing a ‘Head of Sustainability’.
It would require, for instance, a five year plan demonstrating how emissions are going to be tackled at every stage of the business. This would have to include careful analysis of the current levels of emissions, together with quantified targets set over the course of those five years.
Crucially, this would not be about one splashy headline change, like “Latte Lou’s makes customers pedal in-store bikes while drinking coffee to power their shops”. It’s about a serious commitment to address emissions at every stage, together with clear targets that need to be hit in order to qualify. It’s about ongoing assessment, with regular reviews reaffirming a company’s suitability for impact investment.
In short, successful climate impact investing is the antithesis of greenwashing.
A phrase used to describe a company making efforts to appear environmentally conscious, often for marketing purposes, but without a proper commitment to addressing its carbon footprint.
So if ESG investing involves somewhat inexact criteria and impact investing is measurable and specific, what does socially responsible investing involve?
SRI, standing for Socially Responsible Investing, is a somewhat simpler concept, although one that is becoming less popular in favour of more general ESG investing.
An SRI investment can address just one issue. This is easy to navigate, if you’re, for instance, a member of PETA and want to ensure that none of your investments are in companies that perform animal testing.
Other SRI products will allow you to specify the issues that you want to avoid - animal testing, weapons manufacturing and fossil fuel production, for instance - so they can exclude those companies from your investment portfolio.
SRI investing also covers the more niche religion-based investing requirements, such as Sharia-compliant investments. These are investments that comply with Sharia law and Muslim principles, such as avoiding companies that have anything to do with weapon manufacturing, alcohol or pork products.
The binary exclusionary nature of SRI investments is simpler than ESG’s ratings system, and therefore allows for less ‘grey area’ in which companies are included. Because of this, it’s generally seen as less reward-focused than ESG investments, although investors will still expect to see some kind of return.
An investment selected on the basis of ethical guidelines, such as only those with no links to animal testing, tobacco products or gambling.
Whichever responsible investment approach you take, one thing is becoming increasingly clear: the days of focusing solely on financial return are drawing to a close. As governments begin to legislate emissions reduction targets and the behaviour of companies during a crisis draws more attention than ever before, the successful companies are the ones already behaving in a way that recognises their impact on the environment and on society. There’s (almost) no place for baddies in today’s world.
That was made clear when ESG stocks maintained their value in recent tumultuous financial times, when 59% of U.S. ESG funds were doing better than the S&P 500 Index, while in Europe, 60% of ESG funds beat the MSCI Europe Index. After all, investments that don’t include fossil fuel companies can’t be affected by the oil price crash, while those that don’t include airlines won’t be impacted by the global reduction in air travel.
So, does this mean the end of buy-low!-sell-high!-Wolf-of-Wall-Street-money-at-all-costs investing? Perhaps not imminently, but as the profile of the ‘typical investor’ evolves away from Gordon Gecko-alikes and towards Ashton Kutcher-aspirers, that time may well be coming.