Making (Some) Sense of ESG: For Investing with Impact and Private Sector Engagement (Part 2)

This is the fourth post in a four-part series exploring impact investment and finance for development authored by Autumn Gorman of USAID's Private Sector Engagement Hub. Access the series' first, second, and third installments.

The last entry discussed why Environmental, Social, and Governance (ESG) is a growing factor in business and investment, how the concept of fiduciary duty has evolved to include stakeholders, and how companies are responding. It also discussed the challenge of how most ESG efforts are self-selected, self-reported, limited, and unverified. Some regulators are trying to step in to address some of these challenges. However, it is important to note that those regulations typically apply only to publicly traded companies whereas private investment is expected to continue its fast growth (16% for debt and 11% for equity per year). Therefore, many investors will still need to rely on voluntary disclosures.

For public and private capital alike, as well as for the companies in which they invest, all evidence suggests that ESG momentum is growing. This means there will be more and more opportunities to mobilize finance for development and for private sector engagement.

How will new regulations drive demand for ESG PSE? 

The Securities and Exchange Commission in the U.S. recently released new disclosure requirements around climate change — and are seeking public comments about them. It’s a complex topic, but one reason for its creation is “investor demand for, and company disclosure of information about, climate change risks, impacts, and opportunities has grown dramatically. Consequently, questions arise about whether climate change disclosures adequately inform investors about known material risks, uncertainties, impacts, and opportunities, and whether greater consistency could be achieved.” The move is geared towards standardization and reliability of information for people who want to incorporate such information into investment decisions.

The European Union developed a Taxonomy for Sustainability and has issued its own Sustainable Finance Disclosure Regulation (SFDR), which extends beyond climate to include other ESG areas. It is intended to align with the EU’s proposed Corporate Sustainability Reporting Directive, or CSRD.

It remains to be seen to what extent these developments will affect capital markets and public companies. There may also be indirect effects. For example, some companies may choose to remain private so as not to incur the additional costs of reporting and paying a third party to audit and verify each new metric. As many of these regulations affect supply chains, these are more important to our work than they may seem. Case in point, the SEC’s climate change disclosures include three scopes. Scope 1 relates to direct greenhouse gas (GHG) emissions from a company’s operations; Scope 2 relates to indirect GHG emissions from the purchase of heat, cooling, electricity, etc.; and Scope 3 relates to all other GHG emissions which are part of a company’s value chain — upstream and downstream! 

This means there is a HUGE role for development practitioners in preparing the companies and countries with which we work to not only respond, but perhaps even do so proactively. For example, practitioners could help prepare companies to become parts of new value chains and help governments to position themselves better with credit rating agencies, which are already starting to integrate ESG considerations into ratings. In addition, some impact-oriented investors are already starting to consider new forms of pay-for-results type financial incentives, such as lower interest rates to borrowers that achieve positive development outcomes. Such tools have significant potential to scale around things like Scope 3, and we can be there to facilitate and strengthen such efforts.

It is not yet clear what that might look like, or how all of the various moving parts might come together, but these developments, like those mentioned in the previous blog, are worth following. 

What are the critics saying?

Like any major shift in markets, there are concerns. As noted earlier, demand for ESG investments is currently exceeding supply, and one area for criticism is around the creation of ESG “supply” to meet those demands. The controversy generally isn’t in the ESG label itself, but rather how the label is being used. A company might report on GHG emissions but not on employment practices. A mutual fund manager may also be looking just at GHG emissions but not diversity at leadership levels — which might be equally, or even more, important to the mutual fund shareholder. Whether funds go deep, or barely scratch the surface on any single ESG issue, much less several, they may all call themselves an ESG fund.

There is also criticism around ESG raters, which often disagree and apply vastly different metrics, algorithms, definitions, and due diligence-type processes — or none at all. Mostly they rely on self-reported information without any verification, which is not a best practice, but it is a start. Bloomberg Businessweek did a piece on the largest ESG rating company, MSCI, which talks about this, as well as the divide between impact and ESG investment. 

One of the most comprehensive critiques on ESG investing is this three-part piece from Tariq Fancy, the former Chief Investment Officer at BlackRock. Between Larry Fink and Tariq Fancy, there are many companies like Morningstar and researchers such as the City Political Economy Research Centre trying to make sense of it all. 

The bottom line? Everyone is right — to a degree. Yes, there is room for improvement. Yes, there will continue to be many bumps along the way. Yes, there will be bad actors that take advantage of trends. But this is true of anything new. As a whole, we are heading in a direction that can be good for development. Could ESG investing really look more like “true” impact investing? Probably, but not overnight. And — more importantly — how can we make it happen faster and lead to better development outcomes?

ESG as a path to engagement

As previously mentioned, actions that companies, investors, and regulators are taking around ESG elements provide opportunities for alignment with development objectives. Companies that have been voluntarily reporting on efforts to reduce water use, for example, might be good ones to engage on water issues and help identify specifically what aspects around water have the best potential for alignment. Those reports would also be worth reviewing as part of any due diligence process (for what is there as well as what is NOT there).

Development practitioners can also influence businesses proactively using ESG considerations as a conversation starter. The Donor Committee for Enterprise Development (DCED) has developed a resource on Promoting Responsible Business Conduct (RBC), which is about considering and integrating environmental and social issues within core business activities. The parallels to ESG considerations are there. Companies will be seeking support to meet RBC and ESG standards, including Scope 3 emissions. Development projects and practitioners can provide that support, and in ways that can help build markets and link companies in emerging markets to global supply chains. Another DCED report, “Leveraging Private Sector Practices to Guide Green Business Environment Reform,” explores how the experiences of the private sector can inform business environment reform and policy development for green growth.

Going back to where this series started, how can you determine whether you are working with an ESG investor or an impact investor? This report from the International Finance Corporation identifies impact investors by three observable attributes that distinguish them from other investors. One they have intent to achieve social and/or environmental goals through their investment. Two, there is a credible narrative by which their investment contributes to achievement of the intended goals — that is, how the actions of the impact investor will help achieve the goals. Three, they have a system of measurement in place that links their intent and the contribution of their investment to improvements in social and environmental outcomes delivered by the enterprise in which the investment was made. ESG investors, on the other hand, are commercial investors seeking market-based (or higher) returns and are driven by fiduciary duty. For them, measuring impact for impact’s sake may be seen as an “unnecessary” cost that could violate that principle, but they are increasingly incorporating such factors into how investment risks are assessed. Both ESG and impact investors are important, but for different reasons, and it is important to understand those differences when engaging with them.

What you can do - as an investor

Morningstar provides a sustainability rating for stocks and funds and has an ESG Screener investors can use to search for funds based on their own sustainability preferences, such as “low carbon.” It also provides a list of “stand out” funds in different categories in this blog post.

As You Sow, a nonprofit that promotes corporate social responsibility, also created the Invest Your Values search tools, which investors can use to learn more about their investments. Investors can search by name or symbol of mutual funds or ETFs in one of six search tools, including Deforestation Free Funds and Fossil Free Funds, and will be provided with a “report card” on the fund related to the issue.

For More

• Mobilizing Equitable Finance by Addressing Systemic Gender Bias | Marketlinks (Gwen Synder, USAID)
• Promoting-Responsible-Business-Conduct_Scoping-Paper-for-Donors-supporting-PSE | DCED
• Leveraging Private Sector Practices to Guide Green Business Environment Reform | DCED 
• What is ESG Investing? MSCI Ratings Focus on Corporate Bottom Line | Bloomberg.com
• Embedding ESG and Purpose in Your Organization | McKinsey
• What is Sustainable Finance and How it is Changing the world | World Economic Forum (weforum.org)