Are ESG investors getting the most impact for their buck? That’s the question posed by a growing chorus of ESG critics, who argue that an unregulated ratings system is misleading — to the point that, as one headline reads, “The World May Be Better Off Without ESG Investing.” JTC’s Reid Thomas argues for a better way forward.
Though claims that ESG investing is bad for the earth might be hyperbolic, the related concerns are not. How is it, for instance, that corporations like Phillip Morris and Chevron receive such high ESG scores? Or that Vanguard’s ESG U.S. Stock ETF is .9974 correlated with the S&P 500? ESG has clearly lost its way.
In large part, this stems from the fact that most ESG ratings calculate the “degree to which a company’s economic value is at risk due to ESG factors” rather than their actual impact. What’s more, since E, S and G scores are often aggregated into a composite in a non-standardized way, organizations that many believe do great harm can still receive a high rating. That’s why Phillip Morris’s commitment to a “smoke-free future” can get it on the Dow Jones Sustainability Indices, or why global soft drink manufacturers are among the largest holdings in ESG funds.
The solution is, at least on its face, simple: to measure not merely ESG inputs or outputs — like a carbon neutral pledge or effective governance — but tangible outcomes. If done right, this should be a win for investors (who will make the impact they’re investing for), executives (who can better navigate mounting backlash), compliance leaders (who will have to meet new reporting standards, like the SEC’s climate disclosure rule) and, most importantly, society writ large.
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“To the extent investors incorporate existing ESG metrics into their investment decisions today, they are investing based on inputs or outputs, not impact, forcing an assumption that similar inputs produce equal impacts across funds,” notes the Harvard Business School’s Impact-Weighted Accounts (IWA) website. The IWA project aims to drive the creation of financial accounts that reflect a company’s financial, social and environmental performance.
They illustrate their process through an example most executives are familiar with: employee training. Some might measure how much they spend on training (an input, measured financially), or the number of training hours (an input, measured non-financially), or the increase in employee engagement (an outcome, measured non-financially) — whereas the sweet spot, at least per IWA, is an increase in employee salaries subsequent to training (a financially measured outcome, linked to corresponding inputs).
One can easily translate this to ESG initiatives. For instance, instead of merely measuring efforts to reduce carbon emissions (e.g., a carbon-neutral pledge or X dollars spent on such an initiative), organizations should measure the tangible outcome as a result of those inputs (e.g., reduction in pollution in targeted communities, in monetary terms). Other ESG/impact investing outcomes could include jobs created or number of housing units built for underserved populations, increases in accessibility to clean water or reductions in utilities costs, to name just a few.
Crucially, by translating impact into traditional financial measurements, decision-makers can more easily evaluate, compare and justify ESG and impact. Such a framework removes some of the subjectivity of non-financial metrics and makes impact more akin to recognizable accounting and financial reports. Howard W. Buffett’s Impact Rate of Return methodology also takes this approach.
“In my experience, there has been a clear need to think about impact beyond just metrics and measures,” Buffett told us in JTC’s 2023 ESG and Impact Investing report, which surveyed ESG advisers, fund managers and investors. “The organizations and communities I worked with wanted ways of understanding how their design and allocation decisions would affect the potential impact effectiveness of a given program or investment. Therefore, it seemed practical to me to devise a way to calculate an impact rate of return, in a similarly rigorous and applicable way as one would calculate a financial rate of return.”
Challenges
Of course, measuring outcomes this way is easier said than done. For instance, findings from our report illustrate a few elements:
Less than half of respondents — across the U.S. and UK — find impact investing reporting “easy.” Top challenges include a lack of defined standards (58%), access to data (43%) and changes to legislation (42%).
When it comes to existing frameworks for ESG and impact investing reporting, respondents are using (or planning to use) a number of different standards, suggesting a lack of any widespread standardization.
Efforts are often stymied by confusion over who at the organization (or outside of it) is responsible for them. Some companies may have a natural “point person” to manage collection of impact data, for instance. But for those that don’t, these tasks are frequently handed off to someone with no particular specialty or experience in ESG and who already has a full-time job doing something else. It’s no surprise, then, that respondents were relatively split when asked about who is responsible for reporting efforts — and that many use both in-house and outsourced solutions.
A better way forward
Measuring (and monetizing) outcomes is no simple task — there’s a reason Harvard Business School found that only 56 companies had undergone some process to monetize an aspect of their business impacts and a disproportionate number are based in Europe.
That said, solutions exist, be it outsourcing certain functions — like regulatory compliance or data collection — utilizing new technologies or simply understanding the methodologies needed to measure impact in this way and assigning the right people to get the job done.
The ESG and impact investing market will continue to grow at a rapid clip for years to come. But with additional interest (and capital) comes additional scrutiny. Adopting this measurement philosophy can help.
Reid Thomas is managing director of JTC, where he is responsible for overseeing the day-to-day operations of the specialty financial administration business unit. 
