Finance 2.0 – The rise and rise of investing for impact

Is ESG as transformational as the hype says it is? Ben Smith shines a light on responsible investing.

The rise of environmental, social, governance (ESG) investing has been dramatic. Flows of capital into ESG funds globally have risen significantly from US$285 billion in 2019 to US$659 billion in 2021. This trend is set to continue, with analysis from Broadridge Financial Solutions estimating that ESG assets will reach US$30 trillion by 2030.

ESG falls under the umbrella of “responsible investing” – a term used for investment strategies which consider the impact an investment has beyond financial. This umbrella covers a plethora of approaches – from ESG investing (explicitly acknowledging the relevance of ESG factors in investment decisions) to impact investing (specific intent of generating positive, measurable impact alongside financial returns). The range of terms are often, unhelpfully, used interchangeably despite having different objectives. They also create complexity rather than focus on the simplicity underpinning the concept: consider the impact that every investment makes on the environment and society.

The most common form of responsible investing is ESG. This is due to a growing understanding of the world’s social and environmental challenges – the frequency of extreme weather events, George Floyd’s murder, and the stark inequality highlighted by COVID-19 – and the growing body of evidence showing ESG financial outperformance. Asset manager Fidelity analysed global ESG investments between 1970 and 2014, and discovered that half “beat” the market.

Although the concept of responsible investing is not new – tracing back to the 17th century where religious groups laid out guidelines and excluded activities (now known as “negative screens”) to their followers – its recent exponential growth has fund managers clamouring to offer new ESG products to meet demand.

See also: Look how far we’ve come – Impact investing

On the face of it, more capital flowing to assets which consider the ESG characteristics of an investment is positive. However, the ESG market has been chastised for impact washing and greenwashing – unsubstantiated marketing claims that an investment has positive social or environmental impact. The lack of definitions, common standards and guidelines are causes of impact washing. Not only does impact washing weaken and distort the market, it can also lead to a loss of investor confidence which will hinder growth and ultimately derail the movement towards finance having a positive impact on society and the environment.

The challenges surrounding impact measurement are well documented. Given that neither the world nor impact is black and white, we will never be in the position where there is a universally recognised currency of “impact”. This is, however, where the role of regulation becomes crucial. Governments are often approached about supplying capital; their role as regulators is likely to be far more transformative to the market.

Fortunately, there is a growing body of best practice which can be followed; the European Union (EU) are market leaders. The EU’s Sustainable Finance Disclosure Regulation (SFDR) is a set of rules which forms part of the EU’s action plan on sustainable finance in response to 2015’s Paris Climate Agreement. SFDR places emphasis on transparency and disclosure by imposing mandatory ESG disclosure obligations for asset managers. Perhaps the most impactful element of SFDR is the classification of funds and mandates: ranging from article six funds (no integration of sustainability) to article nine funds (funds targeting sustainable investments).

Linked to the SFDR is the EU’s “taxonomy” – a classification system establishing a list of environmentally sustainable economic activities. In doing so, this sets out criteria for determining if an activity is sustainable or not.

Other institutions such as the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-related Financial Disclosures (TCFD) are also working to form standards to facilitate incorporation of ESG factors in investment reporting and support meeting such regulation, enabling consistent reporting and greater transparency. And we have seen well respected entities, such as the CFA Institute, developing courses like the Certificate in ESG Investing. These courses aim to instil an awareness for the practice of responsible investing and, consequently, reduce the likelihood of ignorance and malpractice in the area.

There is no doubt that finance has the ability to have a positive impact on the social and environmental challenges that dominate our newsfeeds. However, if we are truly to achieve the holy grail of transitioning to a “finance 2.0” – in which the financial system is reset to consider (and account for) the role of finance in tackling the world’s challenges – then more must be done.

Scratching beneath the headlines which inflate the volume of capital generating genuine good, reveals an often opaque world of impact washing. We are undoubtedly on a positive trajectory; the role of regulation as well as learning from, and applying, best practice is essential if we are to take the next step.