The movement of investment capital into funds that seek to effect positive change has been substantial in recent years. Environmental, social and governance (ESG) assets rose to more than $35 trillion in 2020 to account for more than one-third of total global assets under management, according to the Global Sustainable Investment Alliance. This figure is expected to rise above $50 trillion by 2025.

Despite this rapid growth, there remains deep skepticism about the effectiveness of the ESG framework. Some of this is because ESG classifications and regulations remain somewhat underdeveloped. There is still significant ambiguity about what investments can potentially be defined as ESG compliant. It was only in November 2021, for example, that the Chartered Financial Analyst (CFA) Institute published new guidelines on ESG product-level disclosures in the United States. In Europe, the challenge of consistent ESG labeling was highlighted by the implementation of the Sustainable Finance Disclosure Regulation (SFDR) across the continent in March 2021, following which more than $2 trillion in assets had ESG labels dropped.

ESG: A Defensive Framework
At its core, it is important to remember that ESG is only intended to be a risk framework and should be judged as such. While an ESG fund’s specific approach or theme can vary, ESG is fundamentally defensive, informing what an investor does not invest in as much as what they do.

An ESG framework is designed to systematically incorporate relevant factors—e.g., sustainability, climate change and environmental impact, emissions, or racial and gender equality—into the selection process, helping investors to identify opportunities and risks that might be material to performance. It is effectively a screen, defending investment returns from ESG-related risks.

Furthermore, ESG applies almost exclusively to public markets, which provide limited exposure to the companies with the greatest potential for positive impact. For investors looking to actively make a difference, the most innovative and impactful businesses are generally found in the private space via impact funds.

Impact Investing: A Strategy Aligning Investing With Values
Impact investing is a defined strategy rather than a framework and is therefore proactive rather than defensive. It exclusively seeks out companies whose primary products and services are directly tied to a quantifiable positive social or environmental impact—while also hopefully generating market-rate returns, the so-called “double bottom line.”

All impact funds are (or definitely should be) ESG compliant, but ESG-compliant funds do not necessarily have to actively make an impact.

We can illustrate the difference by looking at greenhouse gas (GHG) emissions. An ESG framework might generally prevent investment in companies that produce significant GHG emissions. But an impact fund can only invest in businesses providing a product or service that actively helps reduce them.

Private Markets Take The Lead
Many of the businesses with the most innovative products or services in ESG-related sectors are in the early stages of their development and are private and likely to remain so for a significant period of their growth. For example, in climate tech alone there are now 45 unicorns globally, which have collectively raised more than $46 billion in funding in the last decade and are, in aggregate, valued in excess of $130 billion. There is little sign of a slowdown: In 2021, dry powder among dedicated climate tech funds rose by $35 billion.

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