What is ESG & Impact, Really?

A Brief History, Up To Today

Everyone is talking about ESG, which many may know stands for "Environmental, Social, and Governance."

What does that really mean, and how does it differ from other terms like "Impact Investing" and "Socially Responsible Investing?"

This guide will trace through the origins of these terms to convey a better sense of how all this fits together. You'll come away with a better understanding of how the thinking and terminology around ESG issues has changed over the centuries.

In the Beginning...

A medieval market. From wikimedia commons.

While news about ESG investing seems like a new thing, the interrelation between investing and moral values actually traces back to the origins of investing around the world.

During Medieval times, the Church ruled that no Christian should lend money at interest. This interpretation of the Bible derived from the scene where Jesus erupted in anger upon seeing moneylenders inside of the temple.

As a result, throughout the middle ages, anyone seeking a loan had to secure one from a non-Christian. The Jewish communities ended up operating most of the financial institutions throughout Europe.

Similar prohibitions against moneylending exist within Islamic Finance, still practiced today. Islamic finance has created several profit-sharing-based investing structures to work around these religious prohibitions.

Recent History

As the financial system developed its modern form during the Enlightenment, the antiquated Medieval religious prohibitions disappeared, and finance dissociated from morals. Throughout the industrial revolution, popular literature described finance and financiers as amoral and unscrupulous, such as the businessman Ebenezer Scrooge in Charles' Dickens' "A Christmas Carol."

A Christmas Carol by Charles Dickens. Wikimedia commons

c. 1970: Socially Responsible Investing

In the wake of the western cultural revolutions of the late 1960s and 1970s, many sought to bring back a moral sense to finance, and funds formed premised on avoiding "socially irresponsible" activities such as weapons manufacture, alcohol, gambling, nuclear energy, and tobacco. These industries were termed "sin stocks," and the act of avoiding them was "Socially Responsible Investing," abbreviated as "SRI."

During this time, many large endowments and pension funds would adopt guidelines for responsible investing. One of the most rigorous such guidelines is The Ethical Investor, which explicitly guides large endowments like Yale University.

c. 2010: ESG

As the internet and Big Data revolutions transformed finance in the early 2000s, quantitative analysts found that some non-financial information correlates with the risks and returns of stocks. A lot of this information served as an indicator for how well the company management operated ("governance"), and the risks that a company could minimize, such as avoiding penalties from environmental and social regulation. Over time, this general data-driven approach came to be known as "Environmental, Social, and Governance" analysis, or ESG.

Instead of looking at whole industries as "sin" industries, ESG analysis assesses each company. Most companies are strong in some areas and weaker in others. The granularity of company analysis leads itself to a variety of strategies, such as:

A few pioneering funds launched using more sophisticated strategies than simply avoiding sin stocks. Some ESG strategies include

  • Tilt Underweighting the companies that score poorly on ESG criteria and overweighting companies that score well
  • Best-in-Class Deciding upon a fund's sector allocations and then, within each sector, choosing only the best companies on ESG criteria.
  • Active Active managers using ESG scores and research as part of in-depth company research, helping paint a fuller picture of company strategy and positioning among investment analysts.

c. 2020: Impact Investing

ESG strategies demonstrated over time that choosing in good companies can prosperous. Yet as social and environmental crises return to the forefront of people's concerns, many investors are looking to have an impact beyond benefiting financially -- many investors are looking to contribute to positive impact. The ultimate goal of impact investing is to allow investors to have a personalized say in how their dollars contribute to positive developments in the world.

This approach requires a different approach to data than simply ESG analysis. Rather than using various indicators to assess the health of a company, of central importance to impact data is the traceability of investment input and real-world outcomes. Also, the data must be intuitive to the asset owners directly, as opposed to being designed for professional quants to parse within investment firms.

Asset Classes

Since ESG investing is so dependent on quality data, The ways in which ESG approaches vary by asset class are in many cases tied to what data can be made available.

Public Equity

Because public equity consists of relatively large companies that are obligated to perform many public disclosures, ESG data and investment methodologies are the most developed within this asset class. A wealth of data exists for data scientists and analysts to parse.

Public equity is a secondary market where, after a company issues stock at the beginning (Initial Public Offering - IPO), subsequent stock trading is redistributing money among investors, not directly helping the company operations.

The implication of the secondary market are that attributing investor impact becomes difficult within public equities. Any single investor can do very little to affect a company positively or negatively.

On the other hand, though, when the market changes its value of a company,

  • The price of the stock is directly a reflection of how investors, and by extension society at large, see the value of the company
  • Executive compensation, and employee stock options, give people within a company personal incentives to increase the stock price.
  • Strong and stable stock prices affect the ability of companies to raise additional financing that does directly affect operating capital, such as raising debt.

So even though any individual investor does not directly affect the stock price of a company, the aggregate perception of investors does substantially affect company operations.

So when the majority of investors use ESG factors as part of their company analysis, these environmental and social factors become baked into the way that stocks are priced.

When companies see that their stock price depends on their environmental, social, and governance performance, then companies will have strong incentives to measure and manage their ESG impact.

Private Equity

Private equity is one of the most direct ways for investors to contribute to impact. Traditional of impact private equity funds include financing clean water wells in rural Africa, or microfinance to small businesses in Bangladesh. Increasingly, venture capital firms are investing in sustainable-economy technology businesses, such as meatless meat and electric cars.

Measuring impact and assessing ESG are both very straightforwards and extremely difficult within private equity. On the one had, the investors will come to know the companies intimately, giving analysts a keen sense of company strategy and how that fits into the sustainable economy. On the other hand, this information is typically not shared outside of the company and their private equity investors. So from the outside looking-in, there's not much to see -- which makes it hard to take a quantitative ESG strategy and report on quantitatively comparable investment impacts.

There are many global initiatives to improve the transparency and impact reporting of this asset class, since it does have such potential for investors to create impact. One of the most notable areas is the IFC Impact Principles, which has a lot of signatories which you can read more about here.

Public Debt

Public debt contains a diversity of notable asset subclasses, such as Mortgage Backed Securities, Municipal Bonds, Corporate Bonds, and Community Investment Funds. Within these asset classes are immense opportunities for impact. For example, projects for affordable housing, municipal water treatment, large-scale wind/solar, and sustainable transportation would have large portions of public debt financing.

The investment funds that focus on these asset classes take an active management approach, where analysts become familiar with each individual issuance.

A large part of this process is hands-on. For example, if a municipal water treatment plant seeks to issue a green bond, the investors evaluating that bond at the primary issuance will sift through hundreds of pages of documents (over 500 pages is common) and call the city representatives for any questions. This complex, hands-on process requires investor expertise but also provides opportunities to create impact -- in the dialogues between the investors and the bond issuers.

The Main Challenges of ESG

The top two challenges with ESG today are

a) understanding what funds and investments are truly doing good ESG work, versus jumping on a bandwagon

b) Fitting the appropriate ESG strategy to your situation, both in terms of your values and your asset class allocation

A wise man once said, "ESG is not one thing, it's a dozen things. And the sooner people understand that the better decisions they can make."

As more and more fund managers and individual investors talk about ESG, understanding all the different approaches and rating systems, each with different intents, becomes harder and harder. Professional Investors and experts have generated a substantial amount of jargon that will only increase, while individual investors get left behind.

For a) evaluating fund managers, it's best to seek out the opinions of independent experts, who don't have cards on the table. This can be difficult, because many rating agencies are beholden to the asset managers and issuers they are rating, who are also their customers. And some (several) rating agencies even offer their own funds!

For b), a simple 3-step question you can think about approaches is:

  1. If you're looking to avoid 'sin' companies, you're looking for socially responsible investing
  2. If you're convinced that companies that are better citizens will achieve better returns or lower risk, put your money in ESG strategies
  3. If you're looking to leave a positive legacy on the world through your investments, seek Impact Investments