Expect to Hear More About Impact Investing

If you’ve been investing for decades or are just starting to think about it, you’ve probably encountered the terms “impact investing,” “ESG investing,” and “sustainable investing.” These terms may seem interchangeable, but they’re not. And increasingly, you’ll hear more about impact investing.

What’s the Difference Between ESG and Impact Investing?

Investors often consider environmental, social, and governance factors as a key element of avoiding material financial risks that can markedly affect a company’s business performance. ESG risks can come in a wide variety of forms, including climate change and human rights violations. Some companies manage these risks well. Others don’t and therefore are exposed to financial and reputational risk that can affect their performance.

On the other hand, “investing for impact” considers how a company, fund, or investment portfolio positively or negatively impacts the environment and society through its policies, practices, and behaviors. Impact investors are typically interested in investing in companies and funds with positive environmental or social impacts. These can include scaling affordable and clean energy, for example, or protecting ecosystems. The list of potential goals is vast.

It’s worth noting that neither approach is better than the other. They are just different kinds of sustainable investing.

Increasingly, many investors are eager to help drive more just and sustainable outcomes in their communities or in the world. For these investors, successfully applying an impact lens requires understanding one’s own sustainability preferences and investment objectives. And it requires being aware of what information and tools are available to help zero in on the appropriate investments.

The Power of Impact Investing

I’ve seen firsthand the power of impact investments. While I worked for the World Health Organization in Belize, I saw how investing could drive better health outcomes for local communities. Before I joined Morningstar Sustainalytics, I worked at the United Nations Global Compact, helping companies invest in programs ranging from human rights to climate change that allowed them to responsibly navigate the communities in which they operate.

For many individuals, as it is for me, the idea that you can invest in a way that addresses social or environmental issues that you care about is exciting and empowering. Typically, the impact investor is looking for ways to create positive, measurable, real-world social and/or environmental outcomes. These investors are also interested in two other things: how an investment contributes to sustainability and how it meets their risk and return goals. For example, individuals may want to understand both whether they are well-positioned for retirement and which of their investments emits the most carbon and thereby exacerbates climate change.

There’s no one-size-fits-all approach to impact investing. Some people may be focused on reducing the severe negative impacts of their investments. Others want to see a clear connection between their investment and global objectives, such as the United Nations Sustainable Development Goals. Often, impact investors have in mind specific themes that are driven by their interests and experiences. Some investors, for example, are interested in companies that are advancing women in the workforce.

Helping Investors Determine Their Impact Goals

So, how do investors understand and express expectations around the impacts and issues that they care about?

First, an investor needs to identify which themes or issues matter most. Here, the Morningstar-Sustainalytics Impact Framework, which consists of five key themes that cover a range of social and environmental issues, can guide this process. The environmentally focused themes are: 1) Climate Action: mitigating or adapting to the effects of climate change; 2) Healthy Ecosystems: addressing biodiversity degradation or the effects of land, air, or water pollution; and 3) Resource Security: minimizing the use of raw materials and improving recycling. The two social themes are: 4) Basic Needs: ensuring fundamental human needs such as housing, essential healthcare, clean water, and food; and 5) Human Development: enhancing and promoting humans through education, diversity, equity and inclusion, and employment opportunities.

Second, an investor should consider what “having an impact” means to them. Here, I recommend the Morningstar Sustainable-Investing Framework as a guide, as approaches can vary. Some may be satisfied if they are avoiding the worst negative impacts. For example, if I’m focused on health, I may be satisfied if none of my investments are linked to tobacco production. Others may believe that behavioral change is the best way to have an impact. For example, if I am focused on the issue of water, I may be satisfied with selecting a fund whose manager is actively engaging with the fund’s holdings to encourage improved water consumption. Still others may prefer companies that are providing solutions to major social or environmental challenges. If I’m focused on climate change, I might invest in companies that generate renewable energy, manufacture electric vehicles, or construct green buildings. Investors should think about what approaches align with their interests and investment objectives.

Harnessing Data to Understand the Real-World Impacts of Your Investments

At Morningstar Sustainalytics, we rely on two types of data to help us understand a company’s or fund’s real-world environmental or social impacts.

The first tells us about positive or negative impacts resulting from the way in which a company conducts its business. These might include carbon emissions or gender distribution of a workforce. Typically, this data is reported by companies on an annual basis and reflects the company’s positive or negative impacts over the previous year (for example, amount of water it consumed or the amount of waste it recycled in the last fiscal year). This data can be used to compare companies to one another or to industry or category averages. Some investors may also choose to monitor these metrics over time in the hopes of seeing steady improvements toward positive outcomes.

The second type tells us about the degree to which a company focuses its business model on creating products and services needed for a more just and sustainable future. Typically, this is expressed as revenue, such as the percentage of revenue an automaker derives from electric vehicles. Revenue data doesn’t measure impact directly. It doesn’t, for example, measure the amount of carbon emissions that are avoided or water that is saved. But it does provide insight into how focused the company is on scaling activities that are proved to deliver better social and environmental outcomes.

Morningstar Sustainalytics collects and measures these two types of impact data against our five key impact themes, as well as the SDGs. You can find them on Morningstar Direct or ask your financial advisor to access the data for you on Advisor Software.

Let’s explore a few examples. If you look up biopharma giant Amgen AMGN, which produces drugs to treat kidney disease, cancer, and other illnesses, you will find that a fourth of its board directors are women and that it contributes not only to impact themes like Basic Needs but also to SDG number three, which promotes good health and well-being.

Or you could look up a fund such as T. Rowe Price Global Impact Equity TGPEX, which by prospectus selects “companies that can achieve above average returns and cashflow growth and generate a positive impact under one of three pillars: (1) climate action and resource impact (2) social equity and quality of life (3) sustainable innovation and technology.” You will find that 12.2% of the fund’s portfolio companies have revenues that align to climate action, and 11% of holdings align to SDG 11, which addresses sustainable cities and communities.

A Reality Check: Impact Data Shows There’s Room for Improvement

Unsurprisingly, a recent review of our impact data shows that only a limited set of companies have meaningfully pivoted their business models to contribute to a more sustainable future. My colleague Adam Fleck, director of equity research, ESG, at Morningstar, recently found that only 1,329 of the more than 12,000 companies in Morningstar’s ratings universe have revenues that are aligned to any of Morningstar Sustainalytics’s Impact Themes, and only 449 have more than 50% of revenues aligned to one or more of these themes (you can read more here). There are many reasons for this, including the absence of consistent corporate disclosure, the difficulty for companies to expand their sustainability data, and the cost of scaling the solutions themselves.

Nonetheless, at Morningstar Sustainalytics, our goal is to help interested investors successfully implement an impact lens to their investment approach by easily identifying and evaluating the positive and negative real-world impact of companies, funds, and portfolios.

More Options Are on the Way for Impact Investors

Over the next few years, I believe that the options available for individuals who want to practice impact investing will improve and expand. They will become more accessible, more varied in the issues they address, and more wide-ranging in approach. I also expect that the insights and data available for evaluating real-world impacts will swell. This means that successfully practicing impact investing in this dynamic landscape will require investors to reflect on which sustainability issues matter most to them and to consider what having a “positive impact” on these issues means to them. All of these are good things for the world of sustainable investing.