Why the world needs both ESG and impact investing (and how they’re different)

Socially responsible investing. Ethical investing. Environmental, social, and governance (ESG) criteria. Impact investing.

These terms now appear regularly in the media and in investment prospectuses, with interest levels reaching all-time highs in 2020. Investors plunged an estimated four times more cash into ESG investment funds in 2020 than they did in 2019. Meanwhile, dedicated impact investing funds have grown exponentially in the past few years, jumping from $502 billion in assets under management in 2019 to $715 billion in 2020.

While both impact investing and ESG investing can deliver compelling financial returns while helping to build a better world, there are some key differences. Understanding these differences can help impact investors not only make better investment decisions but also avoid the potential for “impact washing” by providing transparency and clarity about the nature of the impact being achieved by a given investment.

What is ESG investing?

ESG investing is an investment approach that incorporates environmental, social and governance factors into decisions throughout the investment life cycle. Using a variety of approaches, a rapidly growing number of funds now do this. Bain & Company helpfully distinguishes between those funds that are ESG “risk mitigators” and those that are ESG “opportunity seekers.” Risk mitigators use ESG considerations to a limited extent to assess and manage potential risks during diligence and ownership, while opportunity seekers proactively look for investment opportunities that support environmental, social or governance progress.

There is increasing evidence that an opportunity-seeking approach to ESG, in particular, leads to investments in businesses that are more successful over the long term. Businesses that are envisioning a net-zero future are proactively transitioning to a low-carbon footprint and reducing their energy costs. Businesses that are making their workplaces fully inclusive and supportive of employees are developing workforces that will be productive in the long run. And businesses whose boards have truly independent and diverse voices, particularly along racial and gender lines, will make better risk-management decisions and more efficiently allocate capital. Now, more than ever, the market has reason to believe that doing the right thing can also be the profitable thing.

What sets impact investing apart?

The Global Impact Investing Network defines “impact investments” as “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” Thus, as a start, impact investors by definition integrate material ESG factors into investment processes and decision-making. But they also go beyond ESG in a number of ways. Based on The Bridgespan Group’s experience conducting impact due diligence on over 400 potential investments, and building on our understanding of broader industry frameworks, we believe that a true impact investment meets three criteria that relate to the investor as well as two criteria that relate to the investment (i.e. the investee company).

What must be true of the investor? Drawing on the IFC’s Operating Principles for Impact Management, to which 112 impact investors have signed on, three criteria must be true of the investor for an investment to be a genuine impact investment:

• The investor intends the impact, articulating particular outcomes that will be pursued through the investment and specifying who will benefit from these outcomes.
• The investor contributes to the impact, articulating a credible narrative about how the investment will help achieve the intended outcomes.
• The investor’s contribution can be financial (e.g. flexible capital) or non-financial (e.g. portfolio support). The investor measures the impact, putting in place a system of measurement to link intent and contribution to actual improvements in social and environmental outcomes.

ABC World Asia is an example of an impact investing fund that fulfills these three criteria. ABC is a $405 million (US$300 million) fund that invests in businesses that aim to deliver meaningful and positive change in South Asia, Southeast Asia and China. Through its investments, ABC intends to address Asia’s biggest environmental and social challenges, focusing on five main investment themes: climate and water solutions, financial and digital inclusion, better healthcare and education, sustainable food and agriculture, and smart and livable cities. ABC contributes both capital and expertise to its investees, playing an active role during ownership. And ABC is committed to measuring its impact using evidence-based research and a measurement approach aligned with the Impact Management Project’s five dimensions of impact.

What must be true of the investment? In addition to those investor criteria, we contend that two more criteria need to be true of an investment itself for it to qualify as an impact investment:

• The impact must materially advance progress toward meaningful social and environmental goals — for example, the 17 UN Sustainable Development Goals (SDGs) — giving due consideration to all of the most important potential impact pathways for a given investment.
• The realized impact should be integral to the company’s business model.

It is important to rigorously test whether an investment will, in fact, advance progress, not by relying on instinct but rather through analyzing company data and available social science research. For example, an investment in an edtech platform focused on improving the math outcomes of underprivileged students would qualify in advancing progress toward SDG 4 (quality education) if the evidence shows that those student outcomes do improve. Meanwhile, a similar edtech platform focused mainly on affluent students would not advance progress toward these goals (as these students already have access to quality education), even if the evidence of improved performance were compelling.

Investments that might initially appear to have high impact may turn out otherwise when multiple pathways are considered. For example, bike-sharing companies contribute to SDG 13 (climate action) by reducing carbon emissions, but these benefits may be offset by negative outcomes on SDG 3 (good health and well-being), because commuters use the bikes in dense cities and get into more accidents.

The relationship between impact and business model, the last criterion, can take various forms. A company’s core products and services might have impact, or the company may have found a way of producing goods and delivering services that is cost-effective and better for the world, or the brand has become so associated with sustainability that it will lose its customer base if it pivots too sharply. The point is that the integration ensures the impact will remain central to the company’s strategy over the long term.

Contrast that with the looser coupling involved when companies make significant charitable donations to the communities in which they operate, or source sustainably despite the squeeze to their margins. These practices have a positive social or environmental impact, to be sure. However, any impact that isn’t core to a business can be fleeting: A tough year can put these commitments on the chopping block, for example, or a new investor with different values can steer a company in another direction.

Coming out of 2020, the world faces many systemic challenges. Both ESG investing and impact investing have critical roles to play in addressing these challenges, and we need to direct more capital toward both. We need more ESG opportunity seekers who can help build better businesses that take stakeholder considerations into account — businesses with diverse and inclusive teams, engaged employees, and reduced environmental footprints. Such funds are well placed to lead transformations of legacy businesses and can create remarkable benefits for society in so doing.

Meanwhile, the scale of the investment gap required to meet the UN SDGs demands continued growth in impact investing. We believe that greater industry alignment regarding what truly defines an impact investment will both help raise the bar for impact performance and provide investors with much-needed clarity on the effects associated with different investment opportunities.