ESG Hot Topics: Understanding ESG, Impact, and Social Entrepreneurship: A Path to Positive Change

Welcome to ESG Hot Topics, the fifth blog post. In this post, I aim to explain the three fundamental aspects of sustainability, ESG, and impact. I will highlight how these three are distinct and why it's crucial to understand each of these branches, given their significant role in the green movement and our ongoing transition. I understand that many of you have busy schedules and limited time for in-depth reading. However, I wish we could all devote more time to diving into these subjects and grasping their nuances and complexities. But I also recognize that time is precious, and it's running short. So, please allow me to provide you with a high-level overview of these three vital branches.

1. This is sustainability: Sustainability has gained prominence due to global warming. We must reduce emissions to limit the rise in temperature to 1.5 degrees.
2. This is ESG/Sustainable finance: ESG is reevaluating risk-adjusted returns by incorporating environmental, social, and governance metrics into financial analysis. This aims to enhance our understanding of risk mitigation and hidden opportunities that can create value. To understand this in practice, investors should ask themselves key questions when evaluating their portfolios, such as environmental and social risks, the appropriate investment time horizon, and the integration of additional analyses for risk-adjusted returns. It's essential to assess whether our approach to investing contributes to a sustainable economy, which underpins our ability to achieve long-term investment returns.
3. This is impact investing: Impact investment goes beyond traditional financial returns and seeks to generate positive and measurable social or environmental outcomes alongside financial gains. It focuses on intentionality, as investors consciously support projects, businesses, or initiatives that align with their values and contribute to a better world.

One key distinction of impact investment is its focus on a broad spectrum of objectives. Unlike traditional investments, which primarily aim to maximize financial returns, impact investments prioritize a diverse range of outcomes, such as poverty alleviation, environmental sustainability, healthcare access, education, and social equality. Investors actively seek opportunities that drive positive change in areas they care about, whether related to societal issues, environmental challenges, or both.

Impact investment can be seen as a sub-category within thematic investments, a broader approach targeting specific sectors or themes that are believed to have growth potential or the potential to create positive change. Impact investments have a dual bottom line: generating returns and addressing pressing global challenges.

As the world grapples with urgent issues like climate change, inequality, and health crises, impact investment has gained momentum. It offers investors a way to align their capital with their values and contribute to solutions for the world's most significant challenges. By actively pursuing investments that drive meaningful change, impact investors are not only seeking financial prosperity but also striving to make the world a better place.

In summary, more companies than ever are now incorporating ESG considerations into their strategies. They report on non-financial information within the ESG spectrum, with GRI being the most common standard, alongside TCFD and the upcoming CSRD. Financial institutions show significant interest in funding ESG investing. Given this trend, you might wonder why we still need a separate conversation about "impact." This uncertainty arises because the distinction between ESG and impact remains unclear, especially as both terms are used interchangeably with "sustainability." ESG and impact are both crucial, but they represent two different concepts.

At its core, ESG focuses on identifying societal factors that materially affect business success and managing them as business opportunities and risks. ESG primarily revolves around aligning societal engagement with commercial success, with the hope that ESG efforts also lead to desirable social and environmental outcomes. However, ESG is primarily driven by the "business case" rather than by maximizing impact as an end goal. ESG ties into various articles like 6, 8, and 9, each requiring specific metrics and reporting for funds. Understanding the complexities involved is crucial, as the SFDR and Taxonomy provide structured frameworks for various investment strategies rather than boxing managers into a single category.

What is sustainability, and why has it become more important:

Global warming is a critical environmental issue that has gained worldwide attention in recent years. It refers to the long-term increase in Earth's average surface temperature, primarily caused by human activities such as the burning of fossil fuels and deforestation. The primary driver of global warming is the release of greenhouse gases into the atmosphere, including carbon dioxide (CO2), methane (CH4), and nitrous oxide (N2O). These gases trap heat from the sun, leading to a gradual rise in global temperatures. The burning of fossil fuels for energy production and transportation is the largest source of CO2 emissions.

Global warming, a consequence of human activities, is causing a gradual but substantial increase in the Earth's temperatures, leading to significant changes in our planet's climate. The Intergovernmental Panel on Climate Change (IPCC), a leading international authority on climate science, has consistently emphasized that human activities, particularly the burning of fossil fuels, are the primary cause of rising temperatures.

Scientists around the world overwhelmingly agree that global warming is real and poses a grave threat to our planet. Their consensus is based on an extensive body of research and a deep understanding of the Earth's climate system. The evidence is clear and compelling. ??

Recent scientific research has provided a deeper understanding of global warming's consequences. Key findings include:

??? Temperature Rise: Earth's average surface temperature has increased by approximately 1.2°C (2.2°F) since the late 19th century, with most of this warming occurring over the past few decades. The Paris Agreement, an international accord, seeks to limit global temperature rise to well below 2°C above pre-industrial levels.

??? Extreme Weather Events: Global warming has intensified extreme weather events, such as hurricanes, heatwaves, and droughts. These events can have devastating impacts on communities and ecosystems.

?? Melting Ice and Rising Sea Levels: The melting of polar ice caps and glaciers, combined with the thermal expansion of seawater, has led to rising sea levels. Coastal regions are increasingly vulnerable to inundation, threatening millions of people worldwide.

?? Ocean Acidification: The absorption of excess CO2 by the oceans has led to ocean acidification, which harms marine ecosystems and the species that depend on them.

?? Biodiversity Loss: Global warming disrupts ecosystems, causing shifts in species distributions and contributing to biodiversity loss. Many species struggle to adapt to the changing climate.

However, the impact of global warming extends beyond the realm of science. It has profound implications for the field of sustainability. Sustainability is about how we use our resources - not just energy and materials but also ecosystems, biodiversity, and even human well-being. The implications are far-reaching and interconnected. Global warming disrupts ecosystems and threatens the availability of resources, and thus, our ability to meet the needs of the present without compromising the ability of future generations to meet their own needs, which is at the core of sustainability.

Sustainability is a concept that asks us to see the big picture of what we are taking from the Earth and how our actions affect future generations. Climate change, caused by the global increase in temperatures, is a major challenge for sustainability. Its impacts can be devastating and include extreme and changing weather patterns, rising sea levels, and threats such as food and water scarcity, which can lead to conflict. Climate change and sustainability are interconnected. The global increase in temperatures triggers multiple negative effects on the planet, which interrelate with each other and increase their violence, putting at risk the species that inhabit the Earth, including humans. For instance, a warming Earth will make it harder to grow enough food, and clear-cutting forests to grow that food contributes to climate change. In human systems, climate change affects and destroys crops and food production, causes disease and death, destruction and loss of economic livelihoods, and migrations of climate refugees.

To combat the climate crisis and secure a safe future below 1.5°C, the world needs to cut emissions of planet-warming greenhouse gases by 50 percent within the decade. Research shows that lifestyle changes could help the planet slash emissions by up to 70 percent by 2050.

One of the most noticeable impacts of global warming is the intensification of extreme weather events. More frequent and severe hurricanes, droughts, floods, and wildfires are capturing media attention with alarming regularity. These events disrupt communities, damage infrastructure, and place enormous pressure on emergency services. As a result, the media is inundated with coverage of these events, making them impossible to ignore for the public.

Additionally, global warming contributes to rising sea levels, which pose a significant threat to coastal regions. The increased risk of coastal flooding and erosion affects not only the livelihoods of people living in these areas but also prompt coverage in the media as these events unfold. It becomes apparent that these changes are not isolated incidents but part of a broader pattern of climate disruption.

The consequences of these climate hazards extend beyond the immediate physical damage. They lead to economic losses, displacement of communities, food and water scarcity, and health risks, further exacerbating their impact on both media coverage and the general population. These events increasingly dominate news cycles, drawing attention to the urgency of addressing global warming.

Scientists worldwide agree that global warming is real and poses a grave threat to our planet. Recent research has provided a deeper understanding of its consequences, including temperature rise, extreme weather events, melting ice, rising sea levels, ocean acidification, and biodiversity loss.

The intensification of extreme weather events, and more frequent and severe hurricanes, droughts, floods, and wildfires, disrupt communities, damage infrastructure, and pose significant challenges to emergency services. Global warming also contributes to rising sea levels, threatening coastal regions and millions of people.

Global warming's impact extends beyond physical damage, leading to economic losses, displacement of communities, food and water scarcity, and health risks. As a result, the media frequently covers these events, raising awareness about the urgency of addressing global warming.

ESG and Sustainable investments - An overview and walkthrough of the subject:

Demystifying ESG:

Rethinking risk-adjusted returns. Before we continue, let's clarify what E, S, and G mean:

• "E" stands for Environmental analysis, which reveals strategies for energy efficiency, better water and waste management, reduction of greenhouse gases, and deployment of renewable energy alternatives. It also highlights a company's impact on the environment throughout its product and business life cycle. Environmental analysis can reveal a company's vulnerability to regulatory changes and preparedness for extreme weather trends.
• "S" is for Social analysis, which reveals a company's commitment to human rights, worker health and safety, labor rights, stakeholder engagement, and preparedness for operational risks. Social criteria can significantly impact a company's reputation and license to operate.
• "G" refers to Governance analysis, which assesses a company's management systems, standards, and practices for accountability. This includes board and management commitment to social and environmental performance expectations, executive compensation tied to sustainability goals, board diversity, and transparency regarding policy positions and political contributions.

Now, as economies and financial markets recover from the COVID-19 pandemic, ESG investing is more important than ever. The pandemic has underscored the need to invest in companies navigating unforeseen crises and contributing to a more sustainable future. As we ponder how to ensure a green recovery, it's crucial to understand the intersection of ESG and sustainable investments. The European Commission is at the forefront of this conversation, shaping regulations that will define the future of sustainable finance. ????

Sustainable Investing

RESPONSIBLE INVESTMENT FRAMEWORK

Responsible Asset Selection

Responsible investment entails considering ESG (Environmental, Social, and Governance) issues that can impact the long-term performance of an asset and the sustainability of the issuer's business model. This is what we call responsible asset selection.

This concept materializes in two broad categories:

1. Screening
2. ESG Integration

(1) Screening represents one of the most common methods of incorporating ESG criteria into asset selection. It involves excluding assets that fail to meet specific predefined standards, which can be rooted in norms or a more dynamic ESG approach. Typically, screening is associated with norm-based exclusions applied to specific companies, entire industries, or other assets. This approach translates ethical values into a responsible investment policy. However, it's crucial to note that a blanket screening approach disregards price considerations. Some investors opt for this approach when screened companies' revenue sources directly conflict with their organization's mission, and ownership is uncomfortable (potentially including shorting).

Conversely, others favor a dynamic ESG approach, which excludes assets based on their ESG scores. This relative approach adapts over time as companies change their ESG policies and procedures, demonstrating greater flexibility. The degree of dynamism varies, impacting profit opportunities. One example is the "best-in-class" approach, a form of positive screening that selects companies or industries with exceptionally strong ESG scores compared to their peers. However, it can significantly reduce the available investment universe, focusing solely on the most ESG-friendly companies. This approach may be applied within or across industries but doesn't consider companies' momentum as they enhance their ESG policies and procedures.

Screening can also take a thematic approach, often concentrating on specific goals and employing either a negative or positive screen. Notable examples include green investment, which prioritizes companies or projects dedicated to conserving natural resources, alternative energy sources, clean air and water initiatives, and other environmentally conscious practices. Impact investing, another instance, generates revenue from entities providing constructive solutions for society, whether targeting equality or environmental protection. These strategies represent forms of positive screening applicable to both liquid and illiquid asset classes.

On the other hand, (2) ESG integration differs from screening. It's a comprehensive assessment of an investment's prospects, leveraging all available financial and non-financial data relating to ESG factors. This approach doesn't preemptively exclude any investment, distinguishing it from screening. In an integrated approach, a manager may hold a company with a poor ESG ranking if other investment attributes compensate for its subpar ESG profile; a security may be appealing if it trades at a discount to its fair value, offsetting potential associated ESG risks.

We identify two avenues for ESG integration:

1. Valuation
2. Risk

This guide refrains from entering the debate about how much ESG affects the risk and return characteristic. Still, the vestment, but these lenses—valuation, and risk—offer crucial perspectives on integration. Asset valuation generally reflects reflections of the issuer's health and can be easily integrated with non-ESG metrics. ESG measures vary in specificity, and managers may concentrate more on one aspect (E, S, or G).

Like non-ESG strategies, ESG integration can be applied along a spectrum from purely qualitative to purely score-based or quantitative. Regardless of its application, ESG integration dynamically evaluates investment candidates based on their performance across various financial and non-financial metrics. Much like a dynamic ESG screen, it continuously considers adjusting the investment universe as assets change in terms of price, risk, and ESG alignment. The extent to which a strategy tilts towards or away from companies based on their ESG profile may vary, depending on preferences such as tracking error bounds.

It's important to recognize that most ESG incorporation methodologies aim to align with the primary objectives of the asset owner and achieve market-rate or even superior returns. Whether this is attainable depends on the quality of the investment, ESG analysis, and implementation. Some asset owners may be willing to accept slightly lower returns, especially when engaging in static screening of entire industries, driven by their values or a desire to create positive real-world impact. However, this is a discretionary decision for the asset owner rather than a universal truth about responsible investment.

Responsible Ownership

Responsible investment doesn't conclude with the decision on asset selection. It necessitates an understanding that there are other ways to influence companies' businesses beyond the investment decision. Thoughtfulness in ownership is increasingly formalized, with several countries launching stewardship codes that outline expectations and guidance for investors to be responsible, active owners of the shares they hold in listed companies. The Organization for Economic Co-operation and Development (OECD) guidelines for multinational enterprises, covering global investors, also emphasize the need for investors to mitigate potential negative effects of business activities linked through their investments.

Responsible ownership takes four common forms:

1. Voting
2. Engagement
3. Activism
4. Direct management

Voting is a privilege that ownership affords, and as such, it carries a vital responsibility for investors to establish appropriate policies and procedures for evaluating proxies and determining whether to vote on specific issues. Responsible approaches to voting can vary. ESG may be the primary focus of proxy votes (ESG-focused) or a factor within a broader set of considerations (ESG-aware). Voting policies may differ by account, starting with a general policy aimed at promoting good governance, and ESG enhancements may be considered based on client direction or the scope of a given fund. ESG considerations may be best defined on an issue-by-issue basis, and the process for determining voting direction is a valuable metric in ESG incorporation. Voting can lead to engagement, especially in cases where a shareholder feels strongly about unsuccessful votes.

Engagement begins with a dialogue and can be pursued individually or collectively, aligning with like-minded asset owners.

Demystifying Impact: A Matter of Intentionality

Leaders of impact-driven companies build their entire business around the guiding principle of impact—a process commonly referred to as either social entrepreneurship or impact entrepreneurship. The distinction between ESG and impact involves understanding intentionality—the fundamental purpose behind an organization's activities.

Social impact leaders can punch far above their weight by shifting their entrepreneurial focus. Instead of concentrating on expanding the reach of their own project or organization, they can shift gears toward developing new types of models for delivering impact—even on a small scale—that could serve as role models or templates for others to adopt. Innovate well and make your experience widely available; then, the scale of impact will naturally follow without the need to grow your organization. ????

An impact business might start off more as a social enterprise, using its freedom from short-term financial constraints (such as the need for quarterly shareholder reporting) to determine a robust business model for making money. Once it is s, it can go on to become a profitable business—maybe establishing a franchise, going public, or being acquired by a larger company. ????

But, given the tough issues and contexts they deal with, some social enterprises might need subsidies even in the long run. For them, establishing evidence of impact is particularly important: The investors supporting them are essentially buying impact and looking at the price of that impact. Once the cost-effectiveness of a model is established, exploring adoption by other organizations, including the government, becomes a natural direction for scaling up impact. ????

The new generation of business leaders is keener than ever to employ its skills not just for making money but also for making progress on critical issues like climate change and inequality. However, the never-ending debates on whether to rely on the market mechanism or on deliberate efforts to create societal value can get very confusing. It is time to recognize the value of both approaches as different vehicles for impact, each with its own strengths and limitations.

Professionals who want to do their part for the world (most of us) should first understand the different options that exist, so they can decide where they can do the most good. In the range between "pure" business and philanthropic paradigms, we find it useful to think of three organizational approaches (with admittedly blurry boundaries) reflecting a hybrid intention:

• Sustainable business: Thinking long term, reducing negative externalities to mitigate business risks, and using sustainability efforts as a way of finding new growth opportunities and reducing costs. A leading example is Unilever, which has pursued ambitious social and environmental goals alongside growth targets as a part of its Sustainable Living Plan. ????
• Impact business: Starting with a specific societal mission as the non-negotiable element in seeking a positive impact, yet still managing to find a way to profitably integrate impact into strategy. Given their more aggressive stance, impact businesses—like Patagonia in the environmental space—tend to be smaller in size and privately owned. ????
• Social enterprise: Recognizing that sometimes business is still a useful tool for addressing a societal issue even if significant financial compromises are involved. ????

In conclusion, it's essential to have realistic expectations about what ESG can and cannot achieve. ESG initiatives are primarily driven by institutional investors, large funds, and even venture capitalists with a specific focus on environmental and social goals. ESG's main purpose is to manage risks and potentially extract value from assets, serving as a tool for risk mitigation.

On the other hand, the concept of "impact" takes a more intentional approach. Impact businesses aim to achieve a societal mission alongside profit, making them a force for good. These businesses are often smaller and privately owned, and they prioritize making a positive impact on specific issues like environmental activism, as exemplified by companies like Patagonia.

It's worth noting that while many aspire to create thriving "impact businesses," it's crucial to remember that both ESG and impact have their places. In the excitement of pursuing "win-win" scenarios, there can be confusion between two statements:

• "We can find opportunities where profits and impact align" (TRUE)
• "We can align profits and impact for every issue that matters" (FALSE)

Leaders of impact-driven companies build their entire business around the guiding principle of making a positive impact, commonly known as social entrepreneurship or impact entrepreneurship. The key difference between ESG and impact lies in their intentionality - the fundamental purpose behind an organization's activities.

For ESG, societal engagement serves as a means to achieve long-term business success. In contrast, impact businesses view contributing to society as an end in itself, guiding all strategic decisions. "Sustainable business" typically refers to companies pursuing ESG, while "impact business" is more mission-driven and focused on integrating impact into strategy.

Social enterprises recognize that, at times, business can still be a useful tool for addressing societal issues, even if it involves significant financial compromises.

At its core, ESG aims to identify societal factors that affect business success and manage them as opportunities and risks. ESG's primary focus is aligning societal engagement with commercial success, with the hope that it will lead to more desirable social and environmental outcomes. However, ESG is driven by the "business case" rather than impact maximization as an end goal.

Understanding the intricacies of ESG and impact is crucial. It's important to grasp the differences and complexities involved in reporting on ESG metrics, as outlined in Articles 6, 8, and 9. Article 6 involves knowing and screening ESG metrics, Article 8 focuses on improving these metrics, and Article 9 signifies a core commitment to responsible investment, often linked to the Sustainable Development Goals (SDGs) or decarbonization goals. These concepts offer diverse investment strategies, allowing for flexibility in aligning with sustainability and impact goals.

Feel free to reach out to us if you need an ESG advisor or help with ESG data collection to support your existing ESG workflows and compliance efforts. At A Triple C Consulting , we have ESG legal expertise (Magic Circle Law firm based in Luxembourg), ESG data platform (Seneca ESG ), and ESG climate and carbon accounting capabilities. A true end-to-end service offering at your disposal. ?? ?? ??

Best regards,

Albin Axelsson

Founder & CEO of A Triple C Consulting

[email protected]

www.atriplecconsulting.com

Note: The content provided in this newsletter is for informational purposes only and should not be construed as financial or legal advice.