Duncan Paterson, The Sustainability Report, 6 April 2018: https://goo.gl/kWkFSN
Impact investment is taking off – but is there a risk that its benefits might be diluted as everyone tries to get on the bandwagon?
Investors we have worked with over the last two decades are mindful of the non-financial impact of their investments. More recently, as modern institutional investors have become more accepting of responsible investment practices within their own portfolios, the impact investment discipline has emerged as a powerful tool for investors seeking to engender positive social and environmental change.
As asset owners start reviewing impact investments for portfolio inclusion, service providers are rightly moving to fill a gap in the market with appropriate products. In this environment, however, there is a high risk that greenwash could trump integrity of approach when it comes to labelling impact investment products.
This poses a problem for the trustees who are considering these investments – they need to look beyond the marketing spin and reassure themselves that there is a genuine ‘impact’ behind the investments they are making.
As more impact-themed funds come to market, we are seeing a number that run the risk of confusing the process of measuring impact with the actual outcomes that investors looking for impact are seeking – impacts on the ground, businesses operating that wouldn’t otherwise be operating. Examples here include mid- large-cap equity funds with a sustainability theme; and products that measure and report on impact but don’t necessarily change their investment approach.
Everything old is new again
In the earliest days of responsible investment, the environmental and social outcomes of investments were often front of mind. The Quaker movement was a pioneer of ethical investment in the UK, and some of their earliest businesses were associated with a determination to achieve social goods – for instance their founding of chocolate companies was partly motivated by a desire to combat the public addiction to gin in the 19th century, combined with improved working conditions for their employees. Australian Ethical Investment, a pioneer of ethical investment in Australia, included loans to small sustainability-focussed enterprises in the early versions of their fixed interest offering.
The primary challenge faced by originators of impact investments has traditionally been the scale of the investment opportunities they dealt with. As soon as an investor with the scale of a pension fund looked at an individual impact investment, it rapidly became uneconomical for them to manage such small investments directly – the contribution to the overall fund’s returns would be vanishingly small, no matter how well or poorly the investment performed.
Solutions to this problem have arisen in the last few years, however, as service providers work to aggregate and package impact investments in a range of different ways, and much larger scale investment opportunities arise, particularly in areas traditionally serviced by the public sector. As the industry moves ahead, the inevitable question arises: When is an investment an impact investment?
A new opportunity – for jargon?
The responsible investment industry has always been replete with jargon that is only comprehensible to insiders. Indeed, a 2011 Australian survey of key superannuation industry players conducted by CAER and Seacliff Consulting identified inconsistencies and uncertainty around terminology and language in the responsible investment industry as one of the key blockages to broader uptake of the approach at that time.
It can be difficult to come up with a hard-and-fast definition for impact investment. The Global Impact Investing Network (GIIN) offers the clearest approach, identifying three key characteristics for impact investments:
Intentionality – ie a desire on the part of the investor to support positive social or environmental outcomes
Return expectations – the deployment of capital must be done with a view to receiving some kind of return – otherwise we are talking about a donation rather than an investment
Range of asset classes – while there were early attempts to characterise impact investment as its own asset class, in practice there are opportunities for impact investment across most asset classes and risk/return profiles
GIIN also offers a 4th characteristic – impact measurement. In other words, impact investors should commit to measuring and reporting on the impact of their investments. This last category reflects one of the challenges modern impact investors need to deal with. Not only should they ask: “Are my investments having an impact?” They should also ask: “In the absence of my investment, would the targeted social or environmental good have come about anyway?”
A key responsible investment sector has already grappled with this issue – the carbon market. Regulators issue credits to projects that are reducing greenhouse gas emissions, but in order to earn credits a project proponent must demonstrate that the emissions reductions wouldn’t have happened in the absence of the project. To manage this issue, they rely on the concept of ‘additionality’.
Implications of additionality for impact investors
Australia’s Climate Change Authority makes the following comments about the concept of additionality:
Assessing additionality is a key feature of all baseline and credit schemes. An additionality test assesses whether a project or activity creates ‘additional’ emissions reductions that would not have occurred in the absence of the incentive. The baseline for the project assesses how much emissions have been reduced.
Additionality is important to ensure that a baseline and credit scheme does not pay for emissions reductions that would have occurred anyway. Purchasing non-additional reductions would reduce both the environmental effectiveness and economic efficiency of the scheme.
While impact investment is rightly recognised as being a discipline with applications across all asset classes, when looking at funds that invest primarily in publicly listed equities, one is forced to ask questions about the additionality of the investment. In other words, if the investor wasn’t holding those shares, would that make a difference to the positive impacts of the company issuing the shares? The answer is fairly obviously no – the public equity market is characterised by its liquidity, with shares readily changing hands from one beneficial owner to another.
Should investment in publicly listed equities therefore rule out a fund from labelling itself as an impact investment fund? Certainly not, there are numerous instances where an impact investor might reasonably hold listed equities:
a VC-type fund might be left holding equities as part of their exit strategy from a company that they have supported through the growth and pre-listing phase
a fund with a specific environmental or social theme holding micro-cap stocks that fit within that theme, as part of a broader impact investment strategy
an investor might support a specific share issue from a company that is looking to raise additional capital for a positive purpose
Simply holding equities isn’t a problem in the impact investment space – but concerns should arise when a fund that holds predominantly listed equities markets itself as being an impact fund. There are two primary reasons why this is the case:
Firstly, it is inherently problematic to try to link a particular investment decision to invest in a listed equity with a specific positive environmental or social outcome. This is the problem of additionality – if you hadn’t held that specific share, someone else would have held it. One struggles to tie additional support back to the ownership of a publicly traded security. It would raise problems under the 4th characteristic of the GIIN definition of impact investing – its ability to measure and report on its impact.
Secondly, and perhaps of most importance, in the competitive world of finance, labels matter. Impact investors have been striving for several years to develop products that will attract the attention of large-scale institutional investors. Leveraging significant pools of capital offers tremendous opportunities for finance to play a truly transformative role in society. It would be very disappointing if at the moment when these efforts are starting to pay off, we see the emergence of a range of funds primarily focussed on investing in listed equities, but marketed as impact investments. Given the familiarity that asset owners already have with the listed space, there is a real risk that more progressive products get crowded out, to the ultimate detriment of broader society.
What’s in a name? Quite a lot, actually…
This is not intended to be a criticism of sustainability-themed equity funds – far from it. It is instead a call for a disciplined approach to labelling funds, and encouragement for funds not to use the term ‘impact investment’ simply because it is the flavour of the month. If a fund
invests predominantly in small- to mid-cap listed equities with a focus on climate change solutions, it is an ethical investment or a cleantech fund – there is no need to use the term impact investment. The capital of the asset owners making the ultimate investment decisions might otherwise be more productively utilised investing in one of the products profiled on the GIIN website.
We would also note the emerging science of assessing a mainstream equity fund’s environmental and social impacts, frequently in the context of the UN’s Sustainable Development Goals. Impact measurement and management offers a range of exciting opportunities for fund managers to improve their responsible investment practices. But a fund that measures and reports on its impacts is not necessarily an impact investment fund.
Impact investment is an approach that can be applied to a range of asset classes, and that can offer a broad range of risk/return profiles. The amount of impact in absolute terms will also vary from product to product – some investments will have profound positive impacts on the environment and on people’s lives, while other investments will struggle to show positive impacts in excess of business as usual.
The impact investment movement is gaining steam, and it has the potential to be one of the most directly impactful responsible investment styles in terms of positive environmental and social outcomes.
This potential needs to be protected. Labels matter when marketing funds, and when funds are competing for asset owners’ attention, it is important that the term ‘impact investment’ is one that can be relied upon.
Unfortunately in the absence of an agreed certification process for impact investments, there is no magic bullet to address this problem. The solution lies in thorough education for asset owners and their gatekeepers, and responsible behaviour from the marketing teams in the asset manager space.
If we get this right, impact investment can grow to be a critical ingredient in the finance sector’s approach to bringing about the positive social and environmental outcomes that are so urgently needed in the world today.