You say tomato, I say to-mah-to…..
–George and Ira Gershwin
Over the past few years, the growth of the term impact investing has also coincided with the growing interest in Environmental Social and Governance (ESG) investing. The two terms are often conflated or used as synonyms, which they are not. ESG is actually more applicable than impact investing across the board, and to that extent is where investors could have more systemic impact. This isn’t to imply impact investing and thematic emphasis isn’t equally important, but understanding the differences will help to align our capital and economic system with social and environmental needs.
Impact Investing is a focus on what the business does
Impact investing has been widely defined and used by a range of different groups from foundations to private equity firms. The Global Impact Investing Network uses this definition: Impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.
So the output or outcome of the business is really what is the focus of whether it defines impact. This could be measurable social benefits like improved education outcomes or health outcomes, as well as environmental impacts like zero-carbon transit or improved water quality. As I’ve mentioned in this article, impact is defined by the values of the investor, so the specific companies that deliver widely accepted social and environmental benefits are generally accepted by most investors as qualifying as impact investments. This typically includes education, health care, economic development and equality, clean air, water, soil, food, among other sectors.
ESG is more about how you run a business
The focus on ESG is fundamentally different in that it can be applied to all companies. So the focus on ‘what’ the company does for ESG factors is less important than ‘how’ it does its work. This can include the governance standards of board diversity, independence, integrity, etc. For social factors, it can be related to how a company engages with its workforce, talent management, community relations and other factors. For environmental areas, it can be the carbon footprint, water use, emissions or pollution of the operations of the business.
As an example, I don’t know of any impact investors that would consider a mining company as an impact investment. Indeed, most would see the environmental degradation of the land and extraction of scarce resources as something to be avoided if at all possible, hence more impact investors focus on recycling and reuse business models. However, it’s unavoidable that we will have some level of mining for the resources needed to sustain our modern economy. So ESG can be applied to find the best mining companies that employ the best practices across E, S and G. As many mining operations operate globally, corruption and bribing government officials, either for access to mining rights or to skirt environmental requirements is a common challenge. Even in the last few weeks Rio Tinto has made headlines on this front, as the CEO has been forced out for poor governance decisions and the associated environmental impacts of operations at a mining site. The best companies will have transparent and auditable approaches to make sure they aren’t engaged in these approaches. Environmental issues are also far more relevant for mining operations as their activities have an outsized impact on the environment where they operate. The example of Rio Tinto can be viewed as both a governance and environmental failure.
Whether a company’s E, S or G is most material to their business largely depends upon the industry the company is in. A business that is heavily capital intensive and has lots of physical processes is likely to be far more susceptible to environmental criteria where it can fall down or shine accordingly. This is largely due to the materiality of the environmental factors being far more significant on the profitability and viability of the company than social factors. This isn’t to imply they shouldn’t focus on social factors, but more that the risk associated with environmental factors likely exceeds the social factors. It’s great if BP or Exxon Mobil develop strong proactive programs to achieve gender, racial and socioeconomic diversity in their workforce. However, a scandal such as a lawsuit regarding discriminatory promotions or pay based on gender bias does far less to the value of the companies than the Exxon Valdez oil spill, or the BP Deep Water Horizon blowout. The environmental factors are more likely to impact their viability than the social factors.
By contrast, a knowledge business like an ad agency, consulting firm or large bank like Goldman Sachs is far more sensitive to social factors than environmental. Similar to the example above, it doesn’t mean environmental doesn’t matter at all, but more that the most relevant and material factors are in the social arena. In the case of Goldman, there are very few areas where the environmental upside or downside would be material, while the social factors related to how employees are recruited, remunerated and retained is more likely to be where they could get tripped up. Much like the Rio Tinto example, Goldman’s 1MDB scandal in Malaysia is a prime example where the governance and social factors created an environment that promoted and retained individuals in the portion of the bank that lost the plot and crossed the line.*
If you think about ESG, the examples in this article highlight that governance is applicable to everyone. Rio Tinto had improper governance (led to ousted CEO) and controls that led to the environmental damage they caused. I believe the culture and governance of BP prioritizing profit led to weakness in funding their safety standards, which ultimately led to the Deep Water Horizon blowout. Hat tip to TPG on this concept of G being paramount, as they don’t do an ESG report but a GES report with the view that if you don’t get the governance right it’s pretty hard to get the E or the S right as well. Depending on the industry, the E or S may materially matter more after you have quality G.
* As a disclaimer, I have worked at Goldman on three separate occasions. The vast majority of the people I worked with there are highly ethical and great colleagues that I’d work with again in a heartbeat. Additionally, Goldman has typically paid far fewer claims for wrongdoing than its big bank brethren (JP Morgan, Wells Fargo, Bank of America, etc.) So I try to use them as an example as often as possible because 1) I have first hand experience working there and 2) I have a strong bias in favor of Goldman, so forcing myself to look where the firm I worked for isn’t perfect is part of holding myself accountable for my own implicit biases.