Demystifying Common Misconceptions Around Impact and ESG Investing
November 07, 2022
By Patanjali Sonawane
To help investors and individuals make informed decisions and understand the differences between impact and ESG investing, Lourenco Miranda, Managing Director of ESG and Sustainability Solutions at EisnerAmper, clarifies and answers four of the most misinterpreted and misunderstood questions about both topics.
There has been a lot of confusion in the industry about the terminologies of "impact investing" and "ESG investing." Can you explain the differences between the two and why it is important to differentiate between them?
Think about a company in which you want to invest. This company is exposed to many different risks that would potentially impact the ability of that company to achieve its business objectives in the short, medium and long terms. Also, the business of this company is either to provide services, sell products or both, and the result of its operations will have a potential impact on the environment and society.
For example, a product that is produced consumes energy, raw materials, water, labor and so forth. So, in the process of producing that product, the company has an impact, either positive or negative, on the environment and society. The product can consume more energy, more water, will pollute more, etc. So, we can say that a company, any company, has two sides of the same coin. My analogy here is that impact investing and ESG investing represent both sides.
On the one hand, there is ESG investing, which is concerned with how environmental, social and governance aspects or risk factors will affect a company’s business and cash flows, and how you integrate ESG into the decision-making process of your company with the ability to generate future cash flows’ sustainably. The SEC is asking public companies to disclose and be transparent about how they are identifying and managing their climate-related risks. Whenever I'm investing in a company, I need to have and understand all the above aspects.
On the flip side of the coin, you have impact investing. Impact investing entails expecting a return on investment, while also having a similar, if not more significant, impact on the environment and society. You, as an investor, are concerned about financial results as well as positive impacts on the environment and society. You expect that your capital will be used for the good of the environment and people.
An impact investor needs to understand the level of greenhouse gas (“GHG”) emissions of the company, the plan of that company to decarbonize its operations and to be aligned with one of these international agreements, such as the Paris Accord and its commitments. As an impact investor, I'm not only interested in financial performance, I also need to understand the impact. It's important that the impact is measured, assessed, and that all these targets the companies are putting together are also credible, reachable and disclosed.
How you reach those targets is called the pathway—measures taken by companies to fulfil their declared ESG goals that are also disclosed and publicly available for investors to understand.
When talking about impact investing, what are the different strategies that an impact investor could use to build their portfolio?
The most common strategy for impact investing is portfolio alignment.
You pick a benchmark like the Paris Agreement or the Net-Zero Banking Alliance. Build your portfolio in such a way that you are targeting companies that are aligned with these different types of international agreements. Start setting your portfolio based on the number one and probably most-accessible indicator: GHG emissions.
One needs to understand the GHG emissions of their portfolio to make sure that they are aligned with international agreements and decarbonization strategies. For example, say I am investing in a portfolio that contains many equities. First, I'm going to make sure my strategy is aligned with the Paris Accord and that it is aligned with the decarbonization pathways. In a few years from now, this portfolio will decarbonize and have a reduction in GHG emissions, which aligns with my strategy.
If I'm investing in those companies, over time they will be incentivised to reduce their carbon footprints. They are going to have a better and more positive impact on the environment.
The big question now is how one can ensure that all these companies’ efforts to improve and reduce their carbon footprint for all services and products are going to happen in the future as well as have a positive impact on the environment and society.
So that's a step that makes impact investing a little more interesting. You must start to understand not only the risks and opportunities that this company is facing but also how this company is producing its goods and offering its services. You must understand the life cycle of these products and services and the company’s sustainable business model to reduce their carbon footprint.
Impact investing is changing the way that companies are producing their goods, offering their services and structuring their businesses. One benefit of impact investing is that you have a direct influence on the circular economy.
Most importantly, how you improve the sustainability of your product-line value chain is where Scope 3 of the SEC Proposed Rules for Climate-Related Disclosures starts to play a significant role, because you have to understand it from cradle to grave. You must know how much one product or service contributes to GHG emissions throughout its life. That's why lifecycle assessment is extremely important for impact investing.
Does that depend on the type of asset? For instance, how does that differ between a private equity investor and an equity investor in a mutual fund?
Suppose there is a public company and investors are buying the shares of this company or have proxy investors and proxy voters who have a direct impact on that company. They have voting rights and can put people on the board. Shareholders and proxy voters can impact the boards of public companies, influencing how the company implements these strategies, how they introduce this concept in their companies, and how they force changes in their organizations.
For private equity, the fund general manager can exert a direct influence over the portfolio company's decisions. They can influence this company to identify opportunities to improve their sustainability performance while improving their financial returns.
Finally, depending on the industry, and not a particular type of asset, you are going to have a different way of measuring and assessing the impact on setting your strategies.
Why should companies start assessing the impacts they generate? How can they do it?
MIRANDA:Whenever I put myself in the shoes of an investor, I have multiple choices of where I'm going to invest my capital. I'm going to choose companies that are better at managing their business and the risks that will impact it; companies that will be sure that what they are doing is exactly what they are disclosing; companies that are transparent in the way they identify and manage risks; and concurrently they can identify opportunities to mitigate those risks.
So, as an investor, I need to understand and know all the climate-related risks companies and funds are facing and the opportunities to mitigate those risks so that they can generate those sustainable cash flows. Ultimately, assessing the impact will make individuals and investors comfortable enough to put their capital into their companies.
How to do it
Companies must calculate and estimate the GHG emissions (including Scopes 1, 2 and 3) for all their products and services and create a baseline so they understand the impact of the emissions they produce. They must understand the life-cycle impact of their products and services so that they can create plans to make those products and services more sustainable, having clear decarbonization paths and sustainability strategies in place.
This brings us to the second step, which is creating the targets and strategies for reaching those targets. Develop sustainability strategies or pathways for your products or services to achieve those targets.
Funding: Set a goal and find ways to fund it. Banks have financial products that fund such transitions and give better rates that allow you to have more access to finance. Private equity funds have the capital to invest in such companies to change their business models and make them more sustainable.
In a less-risky way, that's a win-win situation for everyone.