ESG investing might not be what you think
We often speak with investors who are shocked to see what’s inside their ESG portfolio: "Why am I invested in Shell, Facebook or Amazon?"
This is not because your bank or other financial advisor is secretly adding companies that you might not associate with ‘sustainable’. It is because ESG (environmental, social, and governance) investing is often widely misunderstood.
At the same time, ESG investing has quickly asserted itself as a mainstream sustainable investing strategy. According to the Global Sustainable Investment Alliance, ESG-related assets now account for one in three dollars managed globally.*
The growth of ESG investing is a clear indicator to us of individuals' concerns about climate change and other societal issues.
Despite its strong rise, ESG investing does not simply mean your money is being invested in positive solutions that help make our world a better place. Investors deserve to know that ESG investing will not solve the environmental and social challenges in front of us.
Let’s break it down.
What is ESG investing?
Today’s ESG ratings do not measure a company’s impact on our earth and society. Rather, they measure the financial opportunity of an investment by considering the impact that environmental, social and governance conditions may have on a company’s profits, losses and shareholders.
In other words, ESG investments protect assets against the effects of, for example, climate change, but they do not necessarily help solve climate change.
ESG investing is about the E, S and G risks that can have a negative impact on the future financial performance of a company. Externalities, including the CO2 emissions from oil and gas companies, are only accounted for in a company’s ESG scores based on their expected impact on future returns.
Most ESG ratings only focus on scope 1 and 2 emissions (emissions produced by the company’s own activities), and not scope 3 (emissions from the use of products themselves). Therefore, the total impact of those emissions on the climate, our economies and societies are not accounted for.
This is partly why oil and gas companies can have a great ESG score. Have a look at this ESG rating: Royal Dutch Shell has a higher ESG score than Vestas, a wind turbine company:
Why? Shell is treated as part of a different industry than Vestas and is only compared to other oil and gas companies. They can therefore receive a higher emissions score (98 versus 92), although Shell’s products mostly contribute to increasing emissions, while Vestas products help reduce emissions.
According to Henry Fernandez, CEO of the leading ESG ratings provider MSCI, ESG doublespeak has confused most individuals, many institutional investors, and even some portfolio managers.*
The confusion about ESG investing harms the fight against climate change
Bloomberg New Energy Finance (BNEF) estimates that we need to invest between $3.1 trillion and $5.8 trillion per year until 2050 to reach a net zero economy.* As you now know, these trillions are not represented in the trillions of ESG investments currently being made.
The danger of ESG’s rise into the mainstream is that it has implied to many investors that their capital has been invested in solving the world's biggest challenges. While in reality, there’s been little to no impact.
That said, it can make a lot of sense from a financial perspective to buy stocks of companies with good environmental, social and governance practices.
For example, the S&P 500 ESG Index outperformed the broader S&P 500 for the past 10 years.* And for 20+ years, companies with high ESG values have shown consistent resilience and growth. One example of this is the 2018 and 2020 market contractions, where companies with strong ESG performance showed a greater ability to bounce back.*
However, we must not confuse ESG investing with real climate or societal impact investing.
Many investors want to have a positive impact on the world alongside making a financial return; however, it is not just as simple as selecting a ‘sustainable’ ETF or fund.
Picking a sustainable ETF or fund requires a good diligence process of thoroughly reading a fund’s statement, checking its MSCI ratings and reviewing it on As We Sow — but this still does not ensure real impact.
This article will tell you how you can invest with real impact — and how this compares to other sustainable investing strategies.
By taking an intentional approach to investing, you can be more confident your capital has a positive impact on the environmental and social outcomes in our economy.
The maze of investing sustainably
You can divide different sustainable investing approaches by their impact and financial goals — from superior-financial-returns (ESG integration) to impact-first (catalytic). Everything in between is currently talked about as investing sustainably. Exactly here is where most investors' confusion arises.
How do I actually make an investment decision that helps high-impact solutions?
We will discuss 4 main approaches from low to high sustainability: ESG integration, Responsible, Sustainable and Impact.
- What is ESG integration investing?
- What is responsible investing?
- What is sustainable investing?
- What is impact investing?
- What is the future of impact investing?
What is ESG integration investing?
Goal: Achieve superior financial returns
Strategy: Weigh the ESG risk/opportunities on an asset’s value when investing
Responsible investing integrates ESG to assess the financial risks and opportunities of a company’s environmental, social and governance performance, with the goal of making a superior financial return.
In any sector, environmental, social, and governance issues pose serious risks to operations and profits. Here are a few examples of what factors fall under Environmental, Social and Governance:
To get it right, you must find evidence that the fund uses ESG data on a deal-by-deal basis to develop a view on its proper valuation — and uses that to make investment decisions that they hope will lead to superior returns. You can typically find that info on the website of an ETF or fund.
For ESG integration investing, you can use MSCI ESG quality score or Morningstar ESG data.
You will quickly notice that the same company can have different scores depending on the rating agency. That’s why we advise you to always do your own ESG diligence and try to understand how those ratings were established.
What is responsible investing?
Goal: Do not fund damaging sectors
Strategy: Exclude certain sectors based on negative ESG impact
Responsible investing works on the premise of avoiding harm, by screening out certain sectors.
Avoid harm is also known as negative screening. Negative screening is the process of leaving out certain sectors such as tobacco, alcohol, weapons or oil companies.
In practice, negative screening is often combined with ESG integration. However, this is something to pay close attention to when selecting funds. Many funds that call themselves ESG funds only actually conduct negative screening and do not actively integrate ESG risks into their investment approach.
For responsible investing, the independent non-profit tooling called Fossil Free Funds, by As We Sow, is a good way to check how what sectors your fund or ETF excludes.
What is sustainable investing?
Sustainable investing typically includes exclusion like in responsible investing but also works on the premise of benefiting stakeholders. It does so by selecting category winners or focusing investments on a specific theme.
Goal: Fund sustainable companies across sectors
Strategy: ‘ESG leaders’ or the best ESG companies per sector
Investment in sectors, companies or projects selected for positive ESG performance relative to industry peers, and that achieve a rating above a defined threshold.
As you now know, you cannot simply just look for the term ESG or sustainable investment to know whether an investment will actively focus on companies that consider a broad set of stakeholders.
Quite a few funds that say they’re doing sustainable investing in practice only do exclusion or ESG integration. To check for positive screening, ESG data that is provided by independent parties such as MSCI ESG quality score or Morningstar ESG data can be used.
Goal: Support and benefit from a specific environmental or social theme
Strategy: Invest in a theme like clean energy or gender equality
Sustainability-themed investments contribute to addressing social or environmental challenges by investing in companies offering solutions to these issues. The most important issues tend to be population growth, rising wealth in the developing world, natural resource scarcity, energy security and climate change.
For a climate themed selection, it would be important to explore the products being made by the companies you are investing in.
Are these products and/or technologies needed to build a net zero economy? Are these technologies focused on reducing greenhouse gas emissions in the key sectors (i.e. Energy Production, Industry, Food & Land Use, Transport, or Buildings)?
You would want to think about companies working on renewable electricity, green industrial processes, alternative proteins, carbon accounting and carbon removal.
For our perspective on which technologies are needed to reach net zero across every sector, take a look at our Ultimate Climate Tech Guide to Net Zero.
For sustainability-themed investing, MSCI ESG quality score or Morningstar ESG data can be used — but we like using the independent non-profit tooling Fossil Free Funds by As We Sow to quickly check how ‘sustainable’ a fund or ETF is.
What is impact investing?
An impact driven investment approach works on the premise of contributing to solutions.
It uses all the considerations of the previous approaches. Plus, it actively looks for investments that focus on solving problems (example: alternative protein) rather than mitigating a company's impact on a topic (example: a company with carbon emission disclosure).
Impact investing is premised on three ideas:
Intentionality: Being intentional about what you want to achieve and designing your investment strategy to meet this objective.
Additionality: In investing, it’s the result of your investment that would not have happened without your participation.
Measurement: Data transparency allows investors to understand the realized versus intended impact and identify further improvement areas.
Impact investing is a direct approach to creating change through focused investments — typically on earlier-stage companies and/or less developed markets.
The reason for this is that with impact investing, you are looking for your money to have an impact. Well-established companies typically don’t need equity investments to grow, as they can borrow money to do so. Smaller companies or companies that operate in markets where there is less capital available need that money more, hence that’s where you can have the most impact.
Additionally, almost all ESG funds invest in securities that trade in secondary markets*.
As a result, only 1.4% of all sustainable investments in 2020 were categorized as impact investments according to the Global Sustainable Investment Alliance (GSIA).*
However, impact investing is impact investing (and catalytic investing) are not niche investments anymore. In 2020, the impact investing market size was estimated at $715 billion.*
We wrote a piece on Private Equity and Public Markets: an Investor's Guide to Climate Impact Investing, where you can dive deeper into how you can make investment decisions that have impact.
Goal: Maximize impact while accepting that it may lead to lower returns (this doesn’t mean that they will)
Strategy: Invest in solutions that need ‘patient capital’
Catalytic investing is a type of investment that requires investors to be:
- Patient: have a long-term investment horizon to achieve returns
- Risk-tolerant: be willing to take on higher risks than other investors
- Concessionary: accept the possibility of lower expected returns
- Flexible: allow funds more room to help companies (i.e. a mixed investing strategy that includes both equity and debt financing)
Note: Catalytic capital doesn’t always yield lower returns. For example, Lilac Solutions raised a 150M Series B from renowned investors, including from BMW. However, it got it’s seed funding from catalytic investor Azolla Ventures.*
That said, on an impact level, catalytic investing is significant because investors are supporting impact-driven companies lacking access to capital through conventional markets.
Catalytic investing is an essential way for some climate technologies to obtain funding. Especially, for technologies that take longer to reach commercialization, need large scale-up investments for something like a big factory, or have a lower estimated upside.
According to MacArthur Foundations’ Catalytic Capital Consortium, catalytic investing aims to unlock additional capital that would not otherwise reach these impact-driven businesses to:
- Help prove new and innovative products and business models
- Demonstrate the financial viability of high-need geographies and populations
- Establish a track record for new and diverse managers
- Grow small-scale efforts so they can attract conventional investment
This makes it an important tool to bridge the capital gap for different types of climate tech companies until mainstream investors want to invest in these companies. In doing so, catalytic capital can strengthen communities, expand opportunities and economic growth, and fuel innovation that advances the wellbeing of people and the planet.
The future of impact investing
The future of impact investing is in the private market.
According to the research done by The Center for Sustainable Finance and Private Wealth at the University of Zurich*, there are three ways an investor can have impact:
1) Enabling green companies to grow
2) Encouraging brown companies to improve
3) Public discourse on your investments
Certainly, investors can encourage improvement at ‘brown’ companies on the public markets through active ownership (#2) and influence public discourse by being vocal, for example in media (#3). However, the first point on enabling the growth of impactful companies (#1) isn’t so straightforward and requires some elaboration.
As we mentioned above, when you buy public stocks, you generally buy them in the secondary market — meaning you buy the stock from someone else and not from the company itself. According to the Center for Sustainable Finance and Private Wealth at the University of Zurich:
“There is no empirical support for investors’ capital allocation influencing the growth of large, established companies. These companies usually have sufficient access to capital markets and are more constrained in their growth by product demand and competition than by access to capital.”
The impact of capital allocation for enabling growth in private markets is much greater. Private startups and scaleups depend 100% on private capital to fund their growth and product development.
By investing in private companies, investors can directly provide working capital to emerging leaders in climate tech — and new climate innovations not yet commercialized.
Sounds like high-impact investing, right?
At Carbon Equity, our investing opportunities let you channel your capital into a portfolio of private startups and scaleups fighting climate change. Plus, by pooling your capital together with other investors, you get to invest alongside the climate investing experts of leading private equity funds.