The strength of impact investing lies in the clarity of the goal: to invest in well-run businesses seeking to solve global problems. Many Environmental, Social and Governance (ESG) investment strategies position themselves as having the same ambition.
Here, Tribe Impact Capital’s Chief Impact Officer Amy Clarke and Chief Investment Officer Fred Kooij outline the merits and limitations of ESG as a risk framework.
Like impact strategies, ESG strategies have an innate insight at their core, favouring management teams which are thinking beyond the next quarter’s earnings and considering the possible operational risks that could arise from their business’ position and interaction with the wider world.
In a purely monetarist, free-market system, ESG considerations would have limited appeal, governments would be unlikely to hold businesses to account for their poor polluting, working or management practices and so investors would be unlikely to take notice.
ESG as a shared language
Since no company operates in such a theoretical vacuum, ESG has become a powerful framework for businesses to consider their operational risks using a shared language, which has been developed with investors. It provides shareholders and lenders into a business with a more detailed gauge of the business’ awareness and treatment of certain risks.
A reliance on ESG data in isolation, however, has significant limitations. The biggest “risk” being assertions of “sustainability”, “responsibility” or “impact” obtained from a single ESG data source of publicly available information. Even Investopedia makes the mistake of assuming that funds with high ESG scores are automatically impact funds.. They are not.
Genuine sustainability and impact requires detailed engagement with a business’ products and services, along with its history. Data needs to be acquired from multiple sources and specialists. An impact strategy can’t be passive, it requires active and considered management along with a detailed understanding of an industry in order to understand the potential challenges.
The limits of ESG
Over the last few years we have seen examples of businesses that would never be recognised as responsible or sustainable, due to certain business practices identified in the impact due diligence process, appearing in active and passively managed funds under an ESG banner across sectors. From the financial sector – a bank getting exemplary scores for governance yet investing billions of dollars into Tar Sands exploration businesses for example, to within the clothing retail sector – where large gaps in data and scrutiny on both the environmental and social impact of production were overlooked.
Problems then arise in both hoped-for impact and financial returns. This misrepresentation is misleading to investors and opens them up to the exact risks they were seeking to protect themselves against with a sustainable investment strategy. It is therefore critical investors don’t fall into the trap of taking too much comfort from ESG data’s protective blanket and failing to interrogate a business’ strategy in a more holistic manner.
Whilst the goal is clear, the data isn’t always. As impact investors, we’re searching for businesses whose products and services are working towards positive change, and at Tribe we use the UN SDGs as our framework to help us towards that goal. Unlike ESG, impact isn’t silent on what a company does. Without a solid understanding of the intentionality, there’s no measure that a business will maintain its commitment of working with this mission in mind.