The Abilities of a Dollar
What is in a dollar? Consumers view dollars as the power to purchase goods and services. Conventional investors view dollars as the power to raise more dollars. But impact investors view dollars as the power to create change.
The goal of impact investing is to invest in companies that are deliberately aiming to achieve certain social or environmental outcomes. These outcomes are often classified into three categories, known as ESG metrics: environmental, social, and corporate governance metrics. Whether impact investors fund products to fight climate change or leverage their financial influence to advocate for racial equality, impact investing changes the world.
The Arguments Against ESG
$35 trillion. The ESG industry is currently valued at $35 trillion and set to climb to $50 trillion in just three years. With the sustainable investment industry growing tremendously in the past couple of years, ESG has drawn both ire and hope from leaders across sectors. Government leaders, specifically, are divided on how to approach ESG.
ESG is bound by the allure of the opportunity to make an impact and change the world, potentially offset by smaller financial returns. But over a dozen governors are resisting the implementation of ESG in their purview. In the last couple of weeks, Governor DeSantis (R-FL) and Governor Abbott (R-TX) have moved to restrict investment firms that follow ESG principles.
Governor DeSantis (R-FL) directed the state’s taxpayer and retirement fund managers to invest “without considering the ideological agenda of the environmental, social, and corporate governance (ESG) movement.” While the governor of Florida opposed ESG on ideological grounds, Governor Abbott (R-TX) banned ESG due to financial reasons. ESG might expect lower financial returns, and Texas, like many states, mandates their asset managers to focus only on increasing financial returns without regard to any other motive. ESG appears to reject that mandate.
An Analysis on Fiduciary Duty
ESG, ultimately, rejects fiduciary duty. At least, that is the belief of nineteen states that wrote in opposition to BlackRock’s embrace of ESG. State law requires fund managers like BlackRock to prioritize financial returns for many government funds. Even if BlackRock considered ESG only one percent of the time, these states would still view the decisions as breaching fiduciary duty—the absence of conflict of interest when managing financial assets.
ESG, however, might not infringe on fiduciary duty. While collateral-benefits ESG prioritizes impact over returns (in a sense, impact investing), the more common risk-return ESG incorporates these metrics in the financial evaluation, embracing fiduciary duty. Investors who incorporate risk-return ESG select companies on the belief that ESG metrics can identify risks better than traditional investing. These risks, called tail risks, are often low probability but catastrophic events. Companies with high ESG metrics are often less sensitive to tail risks.
An oil drilling company, for example, is one of the leading contributors of climate change. Divesting from the company due to environmental concerns would be, as the states suggests, encroaching on fiduciary duty. Instead, a risk-return ESG analysis might believe there are potential environmental regulations that would dramatically reduce operations of the company. Using ESG metrics, reducing investment into the oil drilling company could represent financial prudence.
While the concerns that states have with ESG violating fiduciary duty might be founded, a risk-return ESG approach to investing could lead to both sound and impactful investments.
The Application to Impact Investing
Impact investing goes further than ESG. While ESG, especially risk-return ESG, gives financial returns the prerogative, impact investing is the opposite. In its name, “impact” precedes “investing,” for impact comes first. Positive outcomes are paramount in impact investing. While financial returns are still necessary for impact investors, the pecuniary matters are secondary.
By design, impact investing does not guarantee the financial returns of conventional investing—but it often comes close or even matches market returns. Over two-thirds of impact investors reported seeking competitive, market-rate returns. But at the minimum, impact investing will result in an entire financial return on investment.
Perhaps more important, though, is the greater good that can be accomplished by putting over $715 billion in capital toward changing the world. Compared to ESG, impact investing more intentionally makes a difference through capital. Water, sanitation, and hygiene (WASH) and financial services were the two sectors that experienced the most growth—33 and 30 percent, respectively—from 2015 to 2019. It is no surprise that these are two sectors that could most dramatically develop a community.
On September 22, the cleantech venture capital firm Emerald Technology Ventures made a follow-on investment in FIDO Tech, a pioneer in using artificial intelligence to detect, size, and locate water leaks efficiently and effectively. This technology has been used on five continents as a tool to preserve clean water over 2.5 million times so far. The ability that clean water has to drive economic growth and better living conditions cannot be overstated. The impactful investment into FIDO Tech encapsulates the good that the industry can do.
ESG does good. And impact investing does good.
Have a comment? Write to Nathan Wong at uclaiig@gmail.com