Over the coming years, individuals and investment management companies are going to experience a profound shift in the way they invest. At the moment, they invest according to a very standard set of criteria: prospective rates of return, calculable risks and portfolio concentration risks.
In the not too distant future, I expect that single publicly listed company – and practically every single investment management company – will have to justify the social and environmental benefits of their investment policy.
Welcome to the world of impact investing.
Impact investing is defined as investments that are made in companies, organisations and funds with the intention of generating a measurable, beneficial social or environmental impact alongside a financial return.
You’ll notice that the financial return comes at the end of the sentence, but this doesn’t mean that financial considerations take second place. The real aim of impact investing is to make money while making the world a better place. This is a profound shift in the investment ethos for most individuals and organisations, and I think it is only the beginning.
The impetus behind impact investing comes from millennial consumers who want their investments to be socially and environmentally beneficial. Millennials have a bad reputation for being whiny and work-shy, but they are more socially and environmentally conscious than any other generation in recent history.
Millennials across the world want to make an impact in terms of their careers and increasingly in terms of their investments. It is a mistake to consider this a passing trend. Millennials will eventually inherit their parents’ wealth, meaning that impact investing is in its infancy, and will only grow in terms of scale and importance over the coming years.
Today’s column looks at the institutional set-up for impact investing and examines some of the challenges and opportunities in this space. The United Nations sustainable development goals (SDG) are a good starting point for potential impact investors.
They are a blueprint “to achieve a better and more sustainable future for all”, and they address challenges related to poverty, inequality, climate, environmental degradation, prosperity and peace and justice. They cover 17 specific areas including poverty reduction, climate action, responsible production and consumption, affordable and clean energy, clean water and sanitation, gender equality, and health and wellbeing.
As a base case, impact investments should be broadly consistent with many of the themes listed above, though the list is not exclusive. As one can see, the scope for investments is enormous.
A small sample of the sector includes companies that focus on renewable energies, climate change, electro-mobility, female and minority-led businesses, affordable housing initiatives, improved healthcare initiatives, life and plant sciences, and waste reduction.
It is an enormous arena and clearly one in which there is a growing need for specialisation. As the impact investing universe expands, investment managers will need to improve and increase their sector-specific knowledge and capabilities.
Impact investment fund managers already analyse the entire life cycle of a company’s activities, from raw material extraction to the manufacturing and distribution stage and then the ultimate use and disposal of a company’s product. But there is more to do, especially regarding data capture, more of which anon.
There are two ways of investing in this manner. First, impact investors can invest in start-up companies. This brings a set of specific challenges which any entrepreneur will be familiar with.
It also requires patient capital: investors have to be prepared to wait for a number of years before they start to see financial returns on their investments. Valuing start-ups is more of an art than a science. It is also very time-consuming.
Secondly, fund managers will increasingly look at existing publicly listed companies and choose those which best satisfy many of the UN’s SDG criteria. Consequently, many impact investment funds will follow a thematic approach and will invest in specific sectors.
The benefit of buying existing publicly listed companies is that investors will be able to make financial return comparisons against traditional investment benchmarks. At the same time, they will benefit from seeing how their investment basket compares to those traditional benchmarks in terms of carbon dioxide emissions per sales of goods, water usage in production processes, and the use of renewable energy.
Over the medium to longer term, I expect that every single publicly listed company in the advanced economies will be scored and rated according to impact investing criteria, making it easier for investors to judge where they want to invest.
Ultimately, I envisage a scenario whereby an investor will receive an annual statement showing not just investment returns, but a detailed breakdown of the quantities of carbon dioxide emissions avoided, the quantity of tons of plastic removed from the sea, and the energy saved per year.
The same will apply to companies as well. They will have to disclose much more about their carbon footprint and give a detailed breakdown of the environmental impact of their activities.
Importantly, impact investment fund managers will exclude investments that have interests in the arms trade, in nuclear energy and the tobacco industry. This gives the end-use investors the confidence that, at a minimum, their investments are not making the world a worse place.
Because impact investing is still in its infancy, there are a number of teething problems. The most obvious and pressing concern is how to choose which companies to invest in (methodology) and how to measure the performance against environmental, social and governance (ESG) criteria.
This is an issue because many companies, like society as a whole, are just starting to take environmental concerns seriously. Consequently, recent company track records on ESG criteria are non-existent or where available, unimpressive. This means that a company’s intentions will form an important part of the investment process.
Therefore, in the current phase, engagement between impact investors and potential companies is crucial, but very time-consuming. Indeed, in some respects this granular approach could be seen as a barrier to entry for investment firms.
A further point relates to the gauging of a company’s commitment to making changes consistent with ESG goals. How do we judge a publicly listed company’s commitment to ESG issues in the absence of meaningfully measured impacts? Simple measures such as the proportion of revenue emanating from ESG activities are all we have to go on at the moment.
A pressing issue is the quality of available data, especially in emerging markets. The levels of disclosure on sustainability issues are still woefully low, owing to companies being unaware of the importance of these issues or due to resource constraints.
This is really significant considering that emerging markets have the most to lose from climate change and sustainability issues (and the most to gain from impact investing). I assume that this will change over time as consumers and investors in developed and emerging markets demand greater disclosure regarding ESG issues from the public and private sector.
Estimates of the size of impact investing around the world vary considerably, but a recent report by the Global Impact Investing Network (GIIN) estimates the quantity of assets managed by impact investors at around $500 billion. This is around 1 per cent of all invested assets in the world, which gives an idea of the sector’s growth potential.
The average quantity managed by a single firm is only $29 million, which shows that there is tremendous scope for increasing allocations towards the impact investing sector. Around 60 per cent of these funds are managed in the US, 20 per cent are managed in Europe and the remainder are scattered across the globe.
Impact investing is a relatively new phenomenon, so there is a limited body of academic research on investment returns. However, industry studies have shown that such investment can drive strong returns which compare favourably with, and in some cases exceed, traditional equity benchmarks. The bottom line is that if impact investment firms can illustrate strong and compounding returns over a few years, the sector will go from strength to strength.
There is a role for government in this regard. If governments mandate companies to illustrate their environmental, social and governance performance against set criteria, this will raise awareness for consumers and potential investors alike.