Environmental, Social and Governance (ESG) risks have really been the hottest topic in the investment industry for the past 2 years. I can’t remember the last client meeting that I attended where those three letters, E, S and G, weren’t mentioned. More specifically this has been focused on climate risk which, before COVID-19, was the hottest topic in town. Many institutional investors have previously looked at this topic from a risk management lens, however, more recently many of our clients have begun to wonder whether they can do more with their money than solely chasing attractive, risk-adjusted returns.
Historically, the majority of the investment industry has taken the notion that in order to have a positive impact it’s likely that you would receive dampened financial returns. As a result of this, environmental and social issues have typically been addressed through charities, NGOs and governments. Recently attitudes have been changing. Profit and purpose are no longer seen as mutually exclusive. We’ve seen a host of products, across both public and private asset classes, focused on providing market-rate returns whilst looking to achieve some positive environmental and social impact.
One question that often gets asked is whether you can create impact through public equity investments as well as private markets. In the case of listed markets, are you just moving the chips around in rather than redeploying them to good use? It’s a good question and something that my colleagues and I have spent some time thinking about recently.
So, what exactly is impact investing?
The Global Impact Investing Network (GIIN), a market-leading research body, define impact investing as “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return”. These are typically aligned with one or more of the UN’s Sustainable Development Goals (SDGs).
The Impact Management Project was launched to build consensus on how to measure, compare, and report impacts of investments. They use the below framework to consider the impact of your investment.
Impact investments can be made across a range of different asset classes and can target a range of financial outcomes. Investors with a particular environmental or social benefit in mind, may sacrifice some of the financial benefits. However, this article will focus on the asset classes that can help investors achieve their risk-return objectives whilst providing positive impact. Specifically, focusing on creating impact in public and private equity investments. I’ll leave the blog on Social Impact Bonds to my colleagues in fixed income.
How can impact be achieved?
Typically, impact investment has been taken to mean that the investment would need to be made through Private Equity or Venture Capital style investments. I think that most people agree that having a positive social or environmental impact is possible through this route. You purchase a company which intentionally aligns itself with a particular goal (usually the UN’s SDGs) that is measurable so you can track the impact that your capital is making. For example, owning an agricultural technology company that seek to improve crop yields and reduce fertiliser consumption would align with SDG #2 “end hunger, achieve food security and improved nutrition and promote sustainable agriculture.”
It’s widely accepted that private equity investments can achieve impact, as an investor is typically directly providing the company finance with their investment, but can this be replicated in public equity markets? Capital invested in public companies is typically invested by purchasing an existing share from another investor in the market. For example, you could purchase shares from the market for a listed green technology company that specialises in carbon capture, the impact of your investment would be a reduction in carbon emissions. Similarly, you could purchase equity in an equivalent private firm and have a very similar outcome. So it’s reasonable to believe that you can have impact through both means.
The public equity investment could be perceived to be ‘purchasing’ impact that would still exist without your capital, rather than creating impact. That said, buying listed shares can drive up their valuation and in turn can reduce the cost of accessing capital. This could allow them to finance via banks or the debt market in order to expand further and hence have a greater reduction in carbon emissions.
Private firms often get to a stage where stakeholders look to exit their investment and a common route of exit is a public listing. However, it can be difficult to find buyers that completely align with the existing business model and especially in respect to sustained impact. The Global Impact Investing Network, in addition to BlackRock’s Impact Investment team, support the idea that public equity impact investors need to “create a better marketplace for responsible exits.” Impact investors can act as a longer-term capital provider that help companies scale to reach potential financially and in terms of impact.
I recognise that the above example is for a company already “doing good“ and is the approach most impact funds are taking at the moment. What about those companies that have a long way to come? Public equity investors can also actively engage with management if they exercise their shareholder voting rights and influence a desired impact decision from there. Otherwise, and probably more commonly, there is an argument that investors can always “vote with their feet” and simply disinvest if firms aren’t moving in the right direction. It will be interesting to see if more asset managers take a more active approach to stewardship.
What are the complications with seeking impact through public equities?
The tricky part comes when you what to quantify the impact of your investment. If a listed company I invest in reduces C02 output, how can I know how much of that is attributed to my capital? Or whether management made the decision due to shareholder pressure? Equally, if I disinvest, what quantity of C02 emissions have I saved the planet from? The ‘How much’ and ‘Contribution’ dimensions in figure 1 become more difficult to articulate.
There can also be issues with data. Impact investment requires measurable impact and the data for listed companies is not broadly reported or consistent across firms. However, we are seeing improvement in this with C02 data now becoming more readily available due to investor/consultant demands. Funds are now much more readily able to report on their carbon intensity (carbon emissions per $1m of revenue) and reporting tools (e.g. MSCI Carbon Analytics Tool & Transition Pathway Initiative) doing the heavy lifting on behalf of investors as well as standardising methodologies. However, there is still a way to go as often these datasets are only available for the largest cap companies and are limited in terms of the types of measurable impacts that investors are seeking to gain. These issues also persist in private markets but it’s easier for these firms to move quickly to improve them. Although the data available is not perfect, an estimate is a useful starting point and we shouldn’t let precision get in the way of progress.
Private equity investments are likely to give a greater impact for each £1 invested, relative to listed investments. However, they don’t offer the same scale to create impact as public markets as they typically account for a much small proportion of portfolio. The size of the private equity market is estimated at c.$4 trillion versus a market cap of $45 trillion in public equities. Even though you may get more “bang for your buck” in terms of impact in the private market, chances you have more bucks in the public markets, so if you want to have create impact this can’t be overlooked.
Sources: GIIN, MSCI, Transition Pathway Initiative, The Impact Management Project, Prequin & BlackRock