ESG Is Not Enough - Part IV: What’s Next? Individual Impact Portfolios
Author: Isabelle Pierotti; Editors: Massiel Valladares, Anas Attal, Saeyeon Kwon; Managing Editor: Jaishree Singh
Sour Milk and ESG
Society is constantly redefining cultural norms. While dairy milk was considered “healthy” throughout the twentieth century, consumers increasingly demanded plant-based milk in the mid-aughts. Major coffee chains like Dunkin’ Donuts and Starbucks now offer several kinds of plant-based milk and food corporations like Nestle and Unilever have expanded their non-dairy milk, cheeses, and confectionery products.
Consumer demand for healthy, sustainable food represents a growing effort to treat the planet and fellow humans with more respect. Consumers recognize that past behavior not only did insufficient good but actively caused harm.
Measuring current trends and predicting future ones is core to finance, and it’s time for the industry to critically examine its own “souring milk” – ESG investing.
Similar to how consumers realized dairy milk with every meal wasn’t beneficial for the environment or their gut health, ESG investing is not conducive to creating healthy, long-term financial returns. This is because ESG is not related or equipped to account for stakeholder and community impact. Measuring these areas is important because companies that innovate and find solutions to environmental and human capital problems outperform their competitors and the market.
Companies that do not actively adjust their business models to account for climate challenges and social impact are at increased risk of financial blowback from climate change, loss of customers, and loss of employees. Further, with increased demands for global and national government regulations for the environment and workers' rights, companies that aren’t already prioritizing stakeholders will fall behind– and their shareholders will follow suit.
Unfortunately, current ESG investment strategies do not adequately assess knowledge areas necessary to achieve long-term returns. When deciding where to put their money, individual investors and account managers who only look at “ESG funds” risk investing in companies that will not provide lasting returns. To measure the future success of companies, investors will need to measure the real-world impact of companies; ESG is not equipped to do so.
ESG Is Its Own Laggard
One of the most significant limitations of ESG is that evaluating the impact of investments on the environment and society is extremely difficult. This is due to “ESG’’ being ill-defined, unfocused, and too broadly applied to different industries, with every actively managed fund using its criteria for what qualifies as an ESG investment. Original ESG strategies focused on simply divesting from companies, such as tobacco, alcohol, or guns– a strategy that has not been shown to have any social impact. Since then, strategies have multiplied and adopted new acronyms and definitions, but this only contributes to a lack of consistency and understanding of what ESG is.
Another problem with ESG investing is that the impact of investments on stakeholders is not systematically collected, reported, or studied. Strategies often involve using external ranking systems that evaluate companies’ ESG risk and activities. However, these ranking systems can be too focused on industry-specific factors and often ignore the larger impact that a company has on society. An energy company could have a better rating than other energy companies, giving it a better ESG score, but that does not account for its net negative impact on the environment and its workers. Moreover, with over 600 rating agencies using different methods, there is no guarantee of rating consistency. These agencies also rate based on investment risk, not on the company’s stakeholder impact.
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For example, in BlackRock’s 2022 Prospectus on their U.S Impact Fund, Global Impact Fund, and International Impact Fund, they write, “The Fund intends to make investments that are expected to provide measurable social and environmental impact outcomes as determined by Fund management, in part using its proprietary methodology.” However, they do not provide data related to these “measurable social and environmental impact outcomes,” and solely focus on how these funds performed financially.
While BlackRock has some information on the companies’ corporate social responsibility initiatives, there isn’t information on the impact of these “Impact Funds.” Without measuring the impact outcomes themselves, investors and managers are missing valuable information, and an external review of their “proprietary methodology” is null.
Introducing: Individual Impact Portfolios
To measure the true impact of sustainable investments and provide accurate reports, investment strategies need to move away from vague, catch-all ESG portfolios and towards individual portfolios separated by different areas of development defined by the United Nations’ Sustainable Development Goals (SDGs). These goals include climate action, sustainable cities, poverty eradication, and quality education. This investment approach is necessary to measure impact for multiple reasons.
First, devoted accounts allow for easier accountability of the investments included. A Gender Equality portfolio must include companies that measurably improve gender equality within their stakeholder community, not simply hire female board members. Separate portfolios better demonstrate the intentionality of investments. Under ESG-style frameworks, a company could pass by simply having a lower carbon footprint, but within separated portfolios, companies need to exhibit purposeful impact in a given area.
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True impact measurement requires statistical methods, such as correlation and causation, which cannot be calculated with nonspecific factors, like those from traditional ESG accounts. Variables in environmental and social sciences spheres, such as access to education and clean water, are notoriously difficult to isolate and correlate because they are deeply interwoven.
For example, the educational success of a child can be influenced by internet access, public transportation, and the working hours of guardians. But also, the working hours of guardians can be influenced by the proliferation of public transportation and internet access. Both factors are related to neighborhood factors, and the neighborhood is related to guardians’ salaries. To summarize, social factors (or independent variables) all interact with each other as well as the studied subject (or dependent variable) in endless fashions. This issue arises when the data is explicitly calculated and studied. If a business isn’t collecting relevant data on its social or environmental impact, variable isolation will be even more challenging.
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To manage and adapt accounts that optimize both financial and social returns, high-quality, defined data is imperative. Separating investments by their impact sector will also aid in understanding the distinguished impact and financial return timelines of the various development areas. Impact investments and projects will deliver returns at differing rates; sequestering carbon requires radically different steps than those required to increase internet access for students.
Additionally, the path toward achieving each development goal will look different and require separate measurement tools for evaluation. To address and balance the timelines and factors influencing investments for each goal, differentiated funds allow managers to better understand the unique properties of each investment and optimize the returns for each fund. Using a differentiated SDG framework for building portfolios allows for easier evaluation and management of funds, and is a necessary framework for impact-focused investment strategies.
Closing Thoughts
SDG-differentiated investments are the key to creating lasting financial value. Development-focused investments will keep investors and managers ahead of the curve by accounting for looming regulations, environmental risks, and consumer risks as people continue to vote with their dollars. Building intentional and impactful investment products will also appeal to astute young investors eager to grow their wealth holistically.
Finance has always reflected the whims of society as well as tried to predict them. ESG investing is not sophisticated enough to predict and solve our greatest challenges. Money is made and alpha (α) is delivered when investors use capital to challenge the status quo. Individual, issue-based investing is the next way capital can shape the future.