What is sustainable investing?
Diving into ESG, Impact Investing, SRI, and more.
By: Julianna Eng & Mary Kate Henderson (Lookthrough Research)
Micheile Henderson via Unsplash
According to Morningstar, reports show that $20.9 billion flowed into sustainable funds in the first half of 2020, almost equivalent to 2019’s total. The inevitable intersection of sustainability and finance is becoming harder for investors to ignore. Full of mysterious acronyms and terms that sound too similar to differentiate, the sustainable finance space can seem daunting for many. However with the right guidance, it is possible to leverage the rapid growth in this field and use sustainable investing practices to make a positive difference on society and your wallet
The whole sector can be classified under one umbrella term: sustainable investing. Sustainable investing, simply put, is investing to make the world a better place. But what does that exactly mean, and more importantly — how?
Although sustainable investing leaves room for interpretation, it can largely be divided into four subsections: ESG Investing, Impact Investing, Socially Responsible Investing, and Green Finance.
ESG Investing
ESG Investing is an investment practice that uses environmental, social, and governance considerations to mitigate risks and identify opportunities in companies.
After an ESG rating or analysis is conducted, an investor can use this information to make a decision to target an ESG framework or impact strategy. Depending on a firm’s ESG policy, they may have specific ESG risks they will avoid (like alcohol/tobacco companies) or certain ESG standards that investments need to meet. There is not a universally accepted set of ESG standards which has caused the emergence of several popular frameworks.
The “E” Factor
The “E” in ESG stands for environment and represents the environmental policies of a company. Environmental risks vary depending on the product and operational factors of a company, which include factors like climate change risk, pollution and waste, or natural resource depletion. Holding firms accountable for their environmental impact will represent indirect costs that negative environmental practices result in. Environmental considerations can help mitigate negative externalities that a company may impose on third parties. Some popular frameworks that help measure the environmental impact of a company include Task Force on Climate-related Financial Disclosures (TCFD) and Carbon Disclosure Project (CDP).
Zbynek Burival via Unsplash
The “S” Factor
The “S” in ESG stands for social and represents the social elements of a company. Socially conscious investing takes into account the social factors of a company measured through their labor practices and distinct product risks.
Common screens found in operations can include diversity and inclusion practices or gender diversity board requirements. Additionally, socially conscious investing can come in the form of cybersecurity, data privacy, and safety — is a company doing enough to protect its customers? Community impact and philanthropy are also metrics of the “S” factor. Companies that give back to their communities and use their influence for a positive impact can be flagged as socially conscious.
The “G” Factor
The “G” in ESG stands for governance and represents how the governance of a company contributes to its success. Governance conscious investing assesses the operational risks of a company, including board composition, anti-corruption policies, regulatory compliance, and stakeholder advocacy. Typically, if a company has a committee focused on sustainability or ESG principles, its initiatives and goals tend to be environmentally and socially conscious. Additionally, proxy checking is a method to see if a company is passing resolutions that hurt or help their environment or social strategy.
Impact Investing
Impact investing is a niche yet an emerging burrow within sustainable finance. It can be commonly confused with venture philanthropy, socially responsible investing, corporate social responsibility, and social entrepreneurship. Although intimately connected, impact investing is differentiated as investing that generates environmental and social impact alongside a financial return.
The Global Impact Investing Network estimates that this market is valued at $715 billion (as of 2020) and will continue to grow substantially in the coming years.
Triple Bottom Line Accounting
Impact investing is commonly referenced with the triple bottom line, an accounting framework measured by three Ps: people, planet, and profit.
Impact Measurement
Because of the focus on positive impact, a core principle of impact investing includes being able to measure and report the impact of investments which ensures accountability and transparency. Typically this is done through frameworks such as the UN Sustainable Development Goals and the Impact Reporting and Investment Standards, although there are many approaches to finding the right framework.
Catalytic Capital Model
The MacArthur Foundation defines catalytic capital as “investments that accept disproportionate risk and/or concessionary returns relative to a conventional investment in order to generate positive impact and enable third-party investment that otherwise would not be possible”.
In practice, this comes in the form of riskier investments, like energy access in developing countries or micromortages. Catalytic capital is critical in scaling impact and generating momentum for sectors that need it the most.
Larm Rmah via Unsplash
Socially responsible investing (SRI)
Socially responsible investing is broader than the previous two sustainable investing methods and captures a larger part of the market share. It can be reduced down to two methods:
- Investing in companies that have a positive social impact
- Not investing in companies that have a negative social impact (companies that profit from poor labor standards or environmental devastation)
The latter is a larger component of SRI. Negatives screens usually refer to companies that engage in “sin stocks”, such as weapons, tobacco, and gambling. Additionally, negative screens can include ethical concerns. For example, if a supply chain exhibits human or animal rights concerns, a socially responsible firm’s negative screen would exclude it from their profile.
Green/Climate Finance
Green/Climate finance is any structured financial activity that’s been created to ensure a better environmental outcome. Climate finance is used for investing in climate change mitigation and adaptation efforts.
Feri and Tasos via Unsplash
CleanTech
Clean technology, or cleantech, refers to companies and technologies that aim to improve environmental sustainability. Companies that aim to reduce or optimize the use and effect of natural resource use are considered cleantech. Examples of clean technology are solar energy, efficient supply chain solutions, and emission control.
Green Bonds
Following the Green Bond Principles from the International Capital Market Association, green bonds, or climate bonds, are fixed-income financial instruments that generate positive environmental and/or climate benefits. The capital invested in green bonds is used to fund projects that aim to mitigate climate change impacts.
Conclusion
There is no better time to immerse yourself into the sustainable finance landscape. Investing for intentional positive impact is a rapidly growing trend within the financial services industry and is increasingly becoming mainstream due to the positive environmental, social, and financial benefits. Although it can seem intimidating at first glance, investing with sustainability in mind can be straightforward and effective if you understand how the subsections work individually and collectively. Whether your interest lies with risk mitigation or tangible social impact, sustainable finance should have strong place in everybody’s portfolio.
