What's in a name? When it comes to sustainable finance, quite a lot

Welcome to the first in our Impact Investing 101 series. Here, we take a deeper dive into what we're really talking about when we talk about impact investing.

What do we mean when we talk about impact investing?

For that matter, what about green, thematic or ethical investing? Where do the acronyms ESG (environmental, social and governance) and SRI (socially responsible investing) fit in? And what, exactly, do the ‘responsible’ and ‘sustainable’ umbrellas capture?

All approaches aim to maximise financial returns while also targeting positive – or mitigating negative – real-world outcomes. Beyond that, consensus breaks down.

In the last decade, sustainable and responsible investing has entered the mainstream. At conferences, on websites and in annual reports, asset managers and owners proudly trumpet their commitment to it.

As the field has exploded, so too has the volume of jargon. Terms are used interchangeably and inconsistently. It’s one reason why there’s no global reporting framework, which has in turn hampered widespread adoption.

In short, the definitional deficit is a big problem.

At Util, we do impact. To understand why, it’s worth first examining the meanings and approaches of its four complementary siblings: screening, ESG integration, engagement and thematic investment. 

Negative screening

What: Integrated into investment analysis, negative screens filter out specific companies or industries that don’t comply with established environmental or social criteria. Tobacco, weapons, gambling, alcohol and pornography are common culprits.

Why: Sometimes referred to as the ‘do-no-harm’ approach, negative screening reduces negative environmental and social outcomes but doesn’t explicitly aim to advance positive ones. 

How: Screens exclude or underweight companies of certain countries, industries, or which underperform on specific ESG-related criteria. They’re established by the asset manager and informed by client specifications. For example, a climate-friendly pension scheme may negatively screen fossil fuel companies.

Pros: It’s a simple and effective way for investment firms to adhere to regulatory requirements and avoid reputational risk.

Cons: Screens are crude and can be subjective. What should be defined as ‘negative’? Who defines it? Where do you draw the line?

See also: Responsible investing, socially responsible investing (SRI)  

ESG integration

What: ESG factors are the environmental, social and governance practices of a company that have a material effect on its financial performance. ESG integration enhances traditional financial analysis by identifying risks and opportunities not captured by technical valuations.

Why: The primary objective of ESG integration is to improve financial performance. Positive effects on people and planet are an added bonus.

How: Broadly speaking, ESG investors focus on company operations. Exposures, self-reported disclosures, policies and governance will all inform a company’s ESG score. Investors can also engage with a company via stewardship to improve its operations. Unlike screening, ESG doesn’t necessarily preclude companies or industries because of undesirable outcomes.

Pros: It helps investors mitigate risk by capturing factors that may not be included in traditional financial analysis but which could negatively affect the share price and shareholders.

Cons: ESG integration tends to focus on how a company is run and generally overlooks its core product proposition. (British American Tobacco is included in the Dow Jones Sustainability Index, yet its raison d’être is a product that kills 8 million people a year.)

See also: Sustainable investing

Active ownership

What: Active ownership, or engagement, is the process of exercising shareholder rights. An asset manager will engage with a company to influence its corporate behaviour and actions, with the aim of steering investee companies towards better ESG-related outcomes.

Why: Engaging with companies – rather than just divesting – is a great way to encourage ‘good’ and discourage ‘bad’ corporate behaviour, thereby improving long-term value for shareholders.

How: Asset managers have a number of tools at their disposal to influence the behaviour of the companies in which they invest. These include shareholder resolutions and proxy voting (i.e. managed through a third party) at company AGMs, active monitoring and informal dialogues.

Pros: Active ownership can be very effective when shareholders work together, particularly on issues relating to internal governance.

Cons: Taken alone, it doesn’t do much to improve the sustainability of companies whose core product is harmful. What’s more, without the threat of divestment (which index investors usually can't fall back on), it’s not unheard of for companies to dismiss the opinions of their investors.

See also: Stewardship, corporate governance, engagement

Thematic investing 

What: Thematic investors hone in on a particular environmental, social or governance issue and build a product around it. For instance, a fund with an environmental tilt might invest in renewable energy and low-carbon companies.  

Why: Thematic products address social or environmental challenges by investing in sectors that offer a solution. They aim to make a positive impact while also generating financial returns. 

How: Thematic investing is a top-down investment approach with a focus on a broad macro theme. Companies in this space have the potential to deliver long-term financial as well as non-financial returns. For example, renewable energy companies will likely outperform fossil fuel companies in the transition to a low-carbon economy.

Pros: Unlike the first three styles, thematic investing is a positive investment story. In other words, you’re not just mitigating risk; you’re also supporting the shift to a new economy. That represents a huge investment opportunity.

Cons: Currently, the analytics available focus on more niche areas of the market, e.g. private companies and green bonds.It’s difficult to take a thematic investment approach to mainstream listed equities.

See also: Positive screening, green investing, ethical investing

Impact investing

That brings us to impact investing.

What: According to the Global ImpactInvesting Network (GIIN): “Impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.”

Why: Impact investing aims to achieve certain environmental or social goals by targeting companies aligned to, or working to meet, these objectives. It offers the potential for long-term financial returns via exposure to companies likely to outperform in a changing economy.

How: It may sound similar to thematic investing, but impact investing is more focused on companies than on themes. Unlike ESG integration, however, it doesn’t take into account a company’s internal operations as a metric of impact. Instead, it focuses on a company’s external outputs: any action that has a positive or negative effect on stakeholders. (At present, the most easily measurable of these is a company’s products and services.)

Pros: Like thematic investing, impact investing provides a way for investors to drive the shift towards – and tap into the opportunities yielded by – a new, more sustainable economy. But it goes one step further. Impact investors have access to a broader universe and can be more selective about the companies in which they invest, leading to long-term stakeholder value. 

Cons: Impact investing has its limits. In an ideal portfolio, it would be used in tandem with ESG integration and corporate engagement to maximise financial returns and drive better company behaviour.

The best responsible portfolio has five ingredients

The same could be said of any one of these approaches. They’re complementary - even interdependent. When combined, they have the potential to mitigate financial risk, minimise harm and deliver social, environmental and even financial value.

Unfortunately, asset managers and their clients frequently fall into the trap of seeing each as a distinct point on a spectrum, with negative screening at one end of the commitment continuum and impact at the other.  

We don’t visualise it that way. In our view, a brilliant responsible fund manager running a brilliant responsible portfolio would first screen out certain, indisputably harmful industries and look instead towards the sectors driving the shift towards a sustainable economy. He or she would layer ESG integration into the financial analysis process and engage, on consistent basis, with companies held in the portfolio. And, of course, select companies that create demonstrable social and environmental value.

(Using Util data.)

Sign up
Sign up to our Week in Impact newsletter to learn more about what's going on in the world of impact and stay up to date with our latest views, research, and feature releases.