Why should you care?
Sustainable investing, simply put, means investing in companies and projects that prioritize environmental, social, and governance (ESG) factors alongside financial returns. Unlike philanthropic investing, sustainable investing is financially driven, requiring competitive returns in line with industry standards, but with the added goal of positive ESG outcomes.
The focus on sustainable finance has surged in recent years, propelled by growing awareness of global challenges, increasing pressure from investors and regulators alike. New regulations like the SFDR (Sustainable Finance Disclosure Regulation) in Europe have significantly accelerated this trend. The SFDR aims to increase transparency and prevent "greenwashing" by requiring asset managers and other financial institutions to disclose how they incorporate sustainability into their investment decisions and the potential impact of their investments on the environment and society. This has led to greater scrutiny of ESG claims and a heightened focus on the impact of investments.
Simultaneously, Limited Partners (LPs), are placing increasing emphasis on ESG, impact, and climate investing in their own strategies and assessments of fund managers. Furthermore, LPs with mandates focused on these areas are raising the bar, demanding demonstrable expertise and track records in delivering not only financial returns but also measurable positive impact. Some are even taking the drastic step of withholding investments in subsequent funds from managers who fail to meet their standards.
Understanding what is sustainable investing, the different strategies and some of the main subcategories is relevant for any investor -both LPs and GPs, both emerging and established managers- but also to founders at every level of the funding ladder, as this is defining present and future capital flows and is prompting rapid shifts in investors investment priorities and investment decision-making processes.
Two main approaches
Sustainable investing offers two main approaches, each with distinct strategies for aligning investments with sustainability goals. Investors can approach sustainable investing in two main ways:
- Integrating Sustainability Principles: This approach involves incorporating environmental, social, and governance (ESG) factors into the traditional investment process at every stage. This means considering ESG performance alongside financial metrics when screening, evaluating, and making investment decisions. Three main strategies to do so:
- Exclusion: Avoiding companies or sectors with negative ESG impacts, such as those involved in fossil fuels or with poor labor practices.
- Promotion: Prioritizing companies that demonstrate strong ESG performance, such as those with robust environmental policies or a commitment to social responsibility.
- Best-in-Class : Choosing the top ESG performers within each sector, investing in companies that are leading the way in sustainability.
- Investing Directly in Sustainability: This approach focuses on investments that directly address sustainability challenges and contribute to positive environmental or social outcomes. This includes:
- Thematic Investing: Targeting specific sectors or themes related to sustainability, such as renewable energy, clean technology, or sustainable agriculture. This allows investors to focus on areas they believe will have a significant impact on the future.
- Impact Investing: Investing in companies or projects that aim to solve specific social or environmental problems while also generating financial returns. This could involve supporting initiatives like affordable housing, clean water access, or education in underserved communities.
Both approaches and subset of strategies offer distinct ways to align investments with values and contribute to a more sustainable future. Investors can choose the approach or combination of strategies that best aligns with their individual goals and priorities.
RI vs ESG vs Impact vs Climate Investing
While the terms "sustainable," "ESG," "impact," and "climate" investing are often used interchangeably, they represent distinct approaches with varying implications for investment decisions, risk assessment, and impact measurement. Understanding the difference between the sub-categories in sustainable investing is crucial for investors seeking to align their portfolios with their values and effectively engage with founders and Limited Partners (LPs) who operate within specific niches of sustainable finance.
Let's break down and explain the differences between some of the main subcategories: Responsible Investing (RI), ESG Investing, Impact Investing, and Climate Investing.
- Responsible Investing (RI): The foundation of sustainable investing, RI employs negative screening to exclude companies involved in harmful activities deemed harmful to society or the environment, such as weapons manufacturing or tobacco production. While RI aligns investments with ethical principles, it doesn't actively seek out solutions to global challenges.
- Environmental, Social, and Governance (ESG) Investing: Building upon RI, ESG investing takes a more comprehensive approach. It evaluates companies based on their environmental impact (e.g., carbon emissions), social responsibility (e.g., labor practices), and governance structures (e.g., board diversity). By integrating ESG analysis into investment decisions, investors can identify potential risks and opportunities that traditional financial metrics may miss. ESG investments prioritize companies with strong ESG performance or those whose activities promote positive ESG practices.
Example: Spotify, the Swedish music streaming giant, has made significant commitments to reduce its carbon footprint and promote diversity and inclusion within its workforce. - Impact Investing: A more targeted approach within ESG, impact investing actively seeks investments in companies or projects that directly address social or environmental challenges. The goal is to generate measurable positive impact alongside financial returns, often focusing on directly solving global issues like poverty, inequality, and environmental degradation.
Example: Too Good To Go, a Danish app, tackles food waste by enabling users to purchase surplus food from restaurants and stores at discounted prices. - Climate Investing: A subset of impact investing, this approach specifically targets investments in companies and projects that address climate change, either by reducing greenhouse gas emissions (mitigation) or promoting adaptation to its effects.
Example: Northvolt: A Swedish battery manufacturer focused on producing sustainable batteries for electric vehicles.
It's important to note that these subcategories are not always complementary and each of them require the development and implementation of different strategy and investment assessment processes. A company with strong ESG performance may not necessarily have a positive impact on a specific social or environmental issue, or the other way around. Take Tesla as an example: while it addresses climate change by promoting electric vehicles, the company faces criticism for its labor practices. Or take Patagonia: while conscious of the recycling and durability of their fabrics, the fashion company does not solve any global social, environmental or governance challenge. Not every ESG company can be considered an impact company, and certainly not every Impact company is an ESG positive company.
How to get started
Start by clarifying what you hope to achieve through your investments. Are you focused on avoiding harm, promoting positive practices, tackling specific challenges, or addressing any specific global change? Identifying your priorities will help you choose the right approach.
Based on your goals, select the sustainable investing strategy or subcategories that align with your values and objectives. From there, the next step is to effectively develop and adapt your investment strategy, focus, assessment processes, portfolio management approach, and returns measurement framework. This ensures that your investments have real, positive, and measurable environmental, social, or governance outcomes.
Remember, even if a company is creating incredible solutions for carbon capture, it doesn't automatically mean they are best-in-class when it comes to ESG standards. Make sure each of your investment values and goals is integrated into your investment process and focus.