The world of finance is evolving faster than ever, it’s exciting, but it can also be confusing. As investors become increasingly focussed on the impacts of environmental and social issues, we’re seeing new terms flood the sector: ESG, Impact Investing, Socially Responsible Investing (SRI), Sustainable and Ethical Investing.
These issues are more important than ever as we begin the hard work of rebuilding the economy amid covid19, and while the threat of climate change continues to grow.
The definitions below are designed to help investors understand the growing suite of options available, so you can put your money to work for better returns and a better world.
This is Part 2 of the Future of Investing series, stay tuned.
These approaches to investing are all focussed on assessing a company’s non-financial factors. They’re all in the same universe, but each has some unique qualities.
Your money has power, hopefully these explanations will help you direct it for maximum impact.
Analysing risk by looking beyond just the financial data
All investors use a selection of financial data and economic indicators to analyse a company. But ESG investors go further, they also analyse Environmental, Social and Governance (ESG) factors when assessing a company’s potential for success.
It’s a way of analysing investment risks, while maximising opportunities others don’t see.
It’s important to note that an ESG approach won’tnecessarily exclude (or divest from) companies based on your values or your ethics.
ESG investors analyse non-financial factors, and this gives them an edge. But it’s not easy, ESG factors are far more difficult to measure than the clean-cut financial data of earnings, profit and loss.
Environmental factors include:
Climate change, carbon emissions, water management, waste, biodiversity, renewable energy, green building and clean technology.
Social factors include:
Human capital, labour standards, product and chemical safety, privacy and data security, controversial sourcing, access to healthcare and finance.
Governance factors include:
Board and leadership structure, pay equality, ownership, ethics, corruption, taxation transparency and anticompetitive behaviour.
ESG is a form of Best-of-Sector investing. Instead of ‘excluding’ whole industries from your investable universe, you identify the companies that performed best among their industry peers in terms of E, S and G factors.
Engagement is another important tool when trying to find ways to influence company behaviour, and to protect your investment portfolio. Engagement involves opening-up a dialogue with a company to express your concerns as an investor, and even suggest some solutions, to key problems you’ve identified. It avoids the blunt-instrument of simply divesting, and it gives you a seat-at-the-table to influence positive change.
Aligning your investments with your values
Also known as Socially Responsible Investing (SRI), Ethical Investing focusses on avoiding investments that aren’t in-line with your principles, morals or ethics.
This most often comes in the form of exclusions, or negative-screens in industries with poor ethical standards.
This is one of the oldest forms of shareholder activism, adopted by religious groups many centuries ago, and deployed in the 70’s to protest apartheid in South Africa.
It’s often referred to as a ‘do-no-harm’ approach.
Essentially it operates as a filter for your portfolio. Common exclusions include: fossil-fuels, tobacco, weapons, gambling and pornography.
This approach reduces the investible universe that is available within a portfolio, but, it may also reduce risk as the excluded industries are more likely to face challenges like; customer-backlash, regulatory barriers or public relations scandals.
Thinking long-term, and backing the companies of the future
Sustainable investing is less about avoiding sin-stocks, and more about identifying sectors that are leading the way on sustainability and progressive technologies.
This approach uses a positive-screen to highlight companies that are solving environmental and social challenges.
Renewable-energy is a key example; it can avoid the pollution of fossil-fuels, to produce clean energy from the sun and the wind. And fossil-fuel companies are increasingly facing stranded-asset risks and onerous regulations.
But as with ethical investing, it also reduces your investible universe.
Supporting companies solving big challenges
Impact Investments intentionally aim to make a positive impact, and a positive return.
Impact investing is the most rigorous investment approach in this series, and it has the greatest potential for positive change.
The concept began with private equity investors who wanted to support high-impact companies that otherwise may not have been able to access funding. Plus, the investors offered managerial expertise to the companies, to maximise returns, and to oversee the continuation of the impact mission.
In 2020 the field has grown to encompass all major asset classes; including green bonds, public equities and property funds. The market in Australia is expected to grow to $100 billion by 2025.
Being able to measure the impact of an investment is key. Impact measurement needs to be as rigorous as the accounting standards we apply to profit and loss. These metrics can shift an investments interest rate, the rate of return and sometimes ever a fund manager’s remuneration.
The challenge is that as yet there are no universal measurement frameworks. IRIS+ from the GIIN is a good start, and the SDGs have been widely adopted as a unifying approach, but there are many other metrics out there, and so far it’s difficult to compare one impact strategy with another.
The field is evolving at a rapid pace. The potential for impact is clear, and the ability to accurately and transparently measure it has been proven. The challenge now is to broaden and deepen the market, with the hope of influencing all investors.
This is Part 02 of the ‘Future of Investing’ series.
Part 01 is here: What is Impact Investing?
Part 03 is here: 5 ways ESG investing is changing the world of finance