ESG and impact investing: what’s the difference?

Living a more sustainable lifestyle is a priority for many of us as we have begun to see the effects of climate change. There are several ways to reduce your carbon footprint including changing your diet or travel habits and cutting back on energy usage at home.

However, rethinking where you invest your wealth could have a far greater effect. For example, Make My Money Matter calculated that “greening” your pension by investing in more sustainable funds could cut your carbon footprint by 21 times more than:

  • Going vegetarian
  • Giving up flying and/or
  • Switching energy providers.

As a result, sustainable investing has grown in popularity in recent years. Many people are choosing to reduce their investment in fossil fuel companies or businesses that engage in environmentally harmful practices such as deforestation.

If you’re interested in sustainable investing and have started researching your options, you might have come across the terms – “ESG” (Environmental, Social and Governance) and “impact investing”.

Many investors are unsure about the difference between these two investment options, and which is more suitable for their financial plan.

Read on to learn more about the difference between ESG and impact investing.

Companies must meet certain criteria to qualify for ESG investment status

ESG investing involves using a set of criteria to assess companies and see whether they operate in an environmentally and socially conscious manner.

The criteria are:

  • Environmental – How sustainable are the company’s operations? This might include their energy use practices, how they manage waste, and efforts to reduce their effects on the surrounding environment. It also considers companies that produce products that benefit the environment, such as renewable energy technology.
  • Social – Does the company follow positive social practices? This may include charity work and contributions to the local community, as well as the way they treat their employees.
  • Governance – Is the company run in an ethical way? This could include accounting practices, considering diversity when appointing leadership roles, and actively avoiding conflicts of interest.

If a company performs well in these three areas, they may receive a positive ESG score. When searching for ESG investments, you may find a mixture of companies who work specifically in “green” sectors such as renewable energy, and businesses that operate in a generally sustainable way.

Fund managers might assess companies themselves to build funds from shares with good ESG credentials. Alternatively, there are several organisations that assign ESG scores to investments. These scores provide a framework for choosing sustainable investments though there isn’t currently a standardised system for scoring companies, so the ESG rating may vary depending on the source.

An ESG investing strategy typically incorporates sustainability ratings into the usual process for selecting investments and balancing risk. This allows you to create a portfolio that helps you work towards financial goals, while also directing funds towards companies that align with your values.

Impact investing involves choosing specific companies that work to drive positive change

Impact investing is similar to ESG investing in that it aims to improve the world by directing wealth towards positive practices. However, impact investing may require a more hands-on approach.

While ESG focuses on scores and investing in companies that are improving their sustainability credentials, impact investing focuses on backing businesses that are solving specific problems.

For example, you might find a company developing innovative ways to deal with water pollution. By investing in that company and helping them bring their products to market, you have contributed to improving the environment in a specific, measurable way.

In some cases, impact investors may see financial gains as a secondary goal because promoting positive change is their priority. That said, well-placed investments could generate positive returns as these companies are developing products and services to solve crucial issues. As a result, the companies may perform well in the future.

Additionally, many of these problems exist in emerging markets, such as Africa, Asia and South America. Consequently, impact investors may search for opportunities in growing markets with less competition, and this could generate positive returns in the future.

However, you may adopt a higher level of risk if you’re investing in less-established markets or backing companies that are developing experimental products.

59% of impact investors feel their returns are in line with their expectations

Impact investors have varied expectations about financial returns. Some aim to generate market-beating returns to help them achieve their long-term goals. Others are willing to accept below-market-returns to support causes they feel strongly about.

A survey from the Global Impact Investing Network (GIIN) found that:

  • 59% of impact investors feel their financial returns are in line with their expectations
  • 20% said that their gains exceeded expectations
  • 70% of investors feel that their investments have the intended impact
  • 18% believed they had a greater impact than expected.

Conversely, 16% of people surveyed felt that their investments were underperforming. This demonstrates that, while some fall short of their expected returns, many impact investors feel that they’re able to work towards their financial goals.

Interest in ESG funds is falling after poor performance in 2023

Interest in ESG investments has grown in recent years as environmental issues remain at the forefront of public discussion.

However, in 2024, investors may be turning away from ESG options. According to the Financial Times, only six new ESG funds launched in the second half of 2023, compared with 55 in the first half of the year.

This may be because ESG funds underperformed compared with conventional funds in 2022 and 2023, despite outperforming them in 2019, 2020, and 2021.

There could be several reasons for this. Firstly, oil and gas companies saw record profits after the Russian invasion of Ukraine. Yet, ESG funds would, in all likelihood, have missed out on this growth as they don’t invest in fossil fuel companies.

Additionally, the Financial Conduct Authority (FCA) introduced new guidelines about ESG labelling to prevent companies or funds falsely claiming to have green credentials (known as “greenwashing”). As a result of these new rules, some funds have removed the ESG label.

Despite this dip in interest, ESG funds might still be a suitable investment option if they align with your ethical values. However, you may decide that impact investing provides more direct opportunities for supporting good causes and growing your wealth.

That said, impact investing often involves backing smaller, less stable companies and this could mean that you adopt more risk.

It’s important to understand your own goals and attitude to risk when choosing an investment strategy

If you want to adopt an investment strategy that supports the environment, ESG and impact investing could both be suitable.

It’s important that you consider your own unique financial goals and risk profile when deciding how to invest your wealth. This ensures that you can continue working towards your long-term goals while also supporting your ethical values.

Get in touch

If you want to explore sustainable investing options, we can give you some guidance.

Email or call 0333 241 9900.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term (minimum of 5 years) and should fit in with your overall risk profile and financial circumstances.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.

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