ESG” (Environmental, Social, and Governance) and “impact investing” get tossed around pretty frequently. Interchangeably, even. While these terms are undoubtedly part of the official PE newspeak, they represent distinct approaches with varying objectives and implications. They are different terms with different meanings. Understanding their differences and similarities is helpful for shaping your investment strategy—and for achieving your desired outcomes.
This article will explain:
- Why it’s so important for investors to choose the right investment approach.
- How each strategy aligns with both financial and impact goals.
- How they ultimately impact your overall investment process.
A quick comparison of ESG investing and impact investing
In a nutshell, ESG investing incorporates non-financial data into financial analysis. The goal is to mitigate risks, boost investment outcomes, generate stronger returns, and increase competitiveness in the market. ESG goes beyond traditional financial approaches by taking into account the impact of these environmental and socioeconomic factors on investment outcomes. Metrics are identified based on how material they are to the financial performance of the portfolio, as well as their relevance to the asset owners.
Impact investing, on the other hand, involves making capital allocations with the goal of generating intentional and measurable positive impact alongside financial returns. It explicitly targets investments that contribute to specific social or environmental goals. Impact investors seek to address pressing global challenges such as climate change, poverty, inequality, and access to education or healthcare, while also seeking financial gains. Often they commit to various reporting frameworks that help assess and track how successfully targets have been achieved. For instance, impact investing is closely aligned with the United Nations Sustainable Development Goals (SDGs), a guiding framework for identifying and pursuing investment opportunities that address worldwide challenges.
Perhaps the most notable difference between the two approaches is the perspective each one takes in relation to impact: ESG looks inward, while impact investing looks outward.
As defined by the WRI (World Resources Institute), “ESG integration is inward-looking and very positive in the sense that companies and investors are recognizing, for example, the ever-increasing risk of climate change and environmental degradation to the value of an investable entity.” Any investor worth their salt will test their investment thesis against inward-looking ESG risk factors and reporting requirements (including impact investors). On the other hand, an impact investor’s thesis is tested against “outward-looking IMM [impact measurement and management] standards that articulate the positive social and environmental change they aim to effect—the impact.”
A survey conducted by IFC, a member of the World Bank Group, revealed that only 3% of investors globally were engaged in impact investing, whereas 26% incorporated ESG factors into their investment decisions. This disparity highlights the distinctive nature and relatively narrower scope of impact investing compared to ESG investing. If you haven't already, we highly recommend reading our follow-up article, which maps out the differences between ESG and impact investing frameworks.
5 reasons to know the difference between ESG vs. Impact
- Clarity in investment strategies: Distinguishing between ESG investing and impact investing helps private equity investors better target their allocation of capital. It also sheds light on the underlying reason driving their investments. Do you want to integrate ESG factors into financial analysis to strengthen your portfolio outcomes? Or do you want to generate meaningful change for stakeholders through your investments? Understanding the difference results in a stronger alignment with the appropriate approach.
- Investor expectations and communication: Differentiating between ESG investing and impact investing allows private equity investors to effectively share their impact thesis, ESG narrative, and overall sustainability progress. Investors can set clear expectations regarding the financial and non-financial outcomes they seek to achieve. Transparency and data-driven disclosure are the bare minimum these days. Knowing (and effectively communicating) where one stands will deepen the trust between LPs, portfolio companies, and other stakeholders.
- Impact measurement and reporting: ESG investing and impact investing require distinct measurement and reporting frameworks. Distinguishing between the two allows private equity investors to commit to the appropriate impact measurement methodologies, helping them report accurately on the financial, ESG, and impact-related outcomes of their investments. This supports transparency, accountability, and the ability to track progress toward sustainability goals.
- Deal sourcing and investment opportunities: Understanding the differences between ESG investing and impact investing allows private equity investors to identify and pursue the most suitable investment opportunities. By distinguishing between the two approaches, investors can proactively seek out companies or funds aligned with their specific investment criteria, whether that involves ESG integration or generating measurable impact.
- Risk and return profiles: ESG investing and impact investing can have different risk and return profiles. Differentiating between the two approaches helps private equity investors evaluate and manage risk effectively. ESG investing may primarily focus on mitigating risk through comprehensive ESG analysis and negative screening, while impact investing may involve additional risk considerations related to the achievement of specific impact goals. Understanding these distinctions enables investors to make informed decisions and appropriately balance risk and return expectations.
Examples of ESG vs. impact investing
Environmental
ESG Investor: An ESG investor evaluating an energy company would focus on environmental criteria such as the company's carbon emissions, renewable energy investments, and environmental management practices. They might prioritize companies that have implemented energy-efficient technologies, adopted clean energy sources, and actively monitor and reduce their environmental footprint. The ESG investor's goal would be to steer their portfolio toward being environmentally responsible companies, mitigating climate risks and promoting sustainability.
Impact Investor: An impact investor assessing an environmental project, such as a solar farm development, would go beyond the environmental considerations of an ESG investor. They would focus on the measurable impact the project can generate, such as the reduction of greenhouse gas emissions, the amount of renewable energy generated, and the positive effect on local communities. The impact investor's objective would be to invest in projects that directly contribute to addressing environmental challenges and achieving specific impact outcomes, while also aiming for financial returns.
Social
ESG Investor: When evaluating a company from a social perspective, an ESG investor might assess factors such as labor standards, diversity and inclusion practices, and community engagement. They would analyze the company's policies on fair wages, employee benefits, workplace safety, and diversity in leadership positions. The ESG investor would steer their portfolio companies toward strong social practices, promote equality, and maintain positive relationships with their employees and communities.
Impact Investor: An impact investor considering a social initiative, such as an affordable housing project, would focus on the direct social impact it creates. They would evaluate the number of affordable housing units provided, the accessibility to underserved populations, and the potential improvement in residents' quality of life. The impact investor's objective would be to invest in projects that address social inequalities, promote social well-being, and create positive social change, while also seeking financial returns.
Governance
ESG Investor: When assessing governance factors, an ESG investor would analyze a company's board composition, executive compensation, risk management practices, and transparency in financial reporting. They would steer their companies toward having strong corporate governance structures, independent boards, and effective risk oversight. The ESG investor's aim would be to mitigate governance risks and create value through ethical and responsible business practices.
Impact Investor: While governance is rarely the primary focus for an impact investor, they may still consider governance factors as part of their investment evaluation. For example, when assessing a social enterprise, the impact investor might evaluate the governance structure, decision-making processes, and accountability mechanisms in place. Also, an impact investor may be looking toward investing in companies that are more representative of an underserved class.
To sum it all up
Both ESG and impact investing play valuable roles in sustainable investing. They complement each other—ESG provides a framework for evaluation and risk assessment, while impact investing focuses on generating meaningful change. These differences shape how investors align their investment strategies and big-picture goals. By understanding the nuances between ESG investing and impact investing, private equity investors can navigate the evolving landscape of sustainable investing with confidence.
Don’t miss these other articles in this series for more useful insights on ESG and impact investing:
How to Incorporate ESG into Investor Due Diligence
Investors Want Proof of ESG Impact. Here’s How Tablecloth Helps You Get There.
