ESG versus impact investing – two sides of the same coin?

December 2024 | FEATURE | FINANCE & INVESTMENT

Financier Worldwide Magazine

December 2024 Issue

Companies today are devoting considerable time and resources to environmental, social and governance (ESG) issues. The burgeoning growth of the ESG space can be attributed, in part, to rising public awareness of environmental and social issues over the last decade. Climate change protests, natural disasters and social justice movements have shed light on the urgent need for sustainable practices.

Given this increased push toward sustainability, companies are being required to produce detailed reports, ratings and analyses that provide insights into their environmental impact, social initiatives and governance practices – which is then made available to investors and other stakeholders.

Investors themselves are increasingly cognisant of the impact their investment choices can have on the world. This has translated into a greater demand for investment options that align with personal values and contribute positively to environmental sustainability and social equity.

Indeed, according to Precedence Research, the size of the global ESG investing market surpassed $25.13 trillion in 2023 and is estimated to increase from $29.86 trillion in 2024 to approximately $167.49 trillion by 2034. It is projected to grow at a compound annual growth rate of 18.82 percent from 2024 to 2034.

Tricky terminology

But the investment industry overflows with terminology and nomenclature which can be confusing. ‘ESG investing’ and ‘impact investing’, for example, are frequently interchanged and often conflated phrases. Adding to the confusion are ‘socially responsible investing’ and ‘sustainable investing’. Despite their prevalence, differences in the meanings of these phrases can be overlooked – differences which investors should take into account when considering which option better suits their objectives.

ESG investing criteria are used to direct capital into existing companies in an effort to improve their social and environmental footprint. By contrast, impact investing means directing capital into enterprises or funds that were created with the goal of having a positive impact.

“An ethical investment strategy, like any investment strategy, is a risky venture. But it does, perhaps, present more trade offs than traditional approaches.”

Impact investing optimises for a set of desired outcomes, rather than just maximising one. It goes beyond ESG screening and seeks to proactively place capital where it can generate restorative returns for people and planet, plus a financial return to investors.

According to the Global Impact Investing Network (GIIN), impact investing offers an effective alternative to philanthropy and can be deployed in both emerging and developed markets. Investments are expected to make a return, but these will vary depending on an investor’s goals. Its investing principles focus specifically on intentionality, return expectation, the range of return expectation and asset classes, and impact measurement, according to GIIN.

Impact investing offers a number of advantages to investors, not least democratisation – anyone can become an impact investor. There is no need for an affiliation with a particular programme or company. This may allow for more freedom and independent investment decisions.

Impact investing gives investors the opportunity to put money into meaningful projects, empowering individuals to use their financial leverage to improve people’s lives and the health of the planet in a way that resonates with them on a personal level. Individuals exert more control over which companies and industries receive funding.

Given these advantages, demand is increasing. Impact investing has progressed beyond small-scale investments delivering below-market-rate returns. It is becoming clear that impact investing can deliver healthy financial returns at scale.

It does, however, require rigorous research – without which, funds can be mismanaged and investors may lose out.

ESG investing can provide diversification to an investment portfolio. Its guidelines are more established than impact investing and can produce returns on par with traditional investing.

But ESG investments often have higher-than-average expense ratios, which can lead to underperformance. In addition, some corporations or stock traders may not want to associate with investors focused on sustainability sectors.

It can also be a challenge for ESG investors to narrow their focus from a variety of important issues, such as climate change or diversity, equity and inclusion, among many others. By having too broad of a focus across several issues, investors risk underserving all.

Clarification

An ethical investment strategy, like any investment strategy, is a risky venture. But it does, perhaps, present more trade offs than traditional approaches.

To avoid confusion and disappointment, terms and labels within the ethical investment space should be clarified. While developments in ESG and impact investing feed into one another, greater classification and understanding of the differences between the two will help investors make better decisions based on their values, goals and risk appetite.

Richard Summerfield