Impact investments: why they’re inevitable and how to measure them

Luis Torres-Farrell - Redington

Luis Torres-Farrell

Associate, Reporting
Monday, Jun 28
|   6 mins

Not long ago, ESG funds were considered a niche investment choice for those willing to sacrifice returns in order to invest more responsibly. Today, however, rather than ESG being a subset of funds, we’re seeing more ‘standard’ funds incorporate ESG into their core investment philosophy. This isn’t surprising, given most asset owners now agree that ESG presents both an opportunity as well as a financially material risk. But with increased scrutiny around the impact of our investments, it’s worth asking whether seeking wider environmental or social impacts should – or will – become as integrated into investments as ESG has.

Using impact investing to tackle global warming

Impact investing usually refers to positive impact, but it’s worth remembering that impacts can also be negative: investments continue to contribute to industries and activities responsible for the current climate crisis. So, addressing the climate emergency will require both minimising or eliminating negative impact as well as funnelling capital towards those companies that seek positive impacts.

The climate policy initiative estimated that in order to meet the Paris Agreement’s target of keeping temperature rises to within 1.5 degrees above pre-industrial levels, we’ll need between $1.8tn and $3.8tn of climate finance per year. This is more than triple the current rate of investment directed towards global warming mitigation and will require a tangible framework for measuring progress. Although still under development and consultation by the Task Force on Climate-related Financial Disclosures (TCFD) (the current global standard in climate reporting), global warming temperature trajectory metrics are seen as the next best step towards measuring climate impact.

Impact investing more broadly

Impact is, of course, pervasive in every investment and much broader than climate impact alone. Due to its international acceptance, the most popular way to approach impact investing is through the 17 UN Sustainable Development Goals (SDGs). These goals are as much about solving environmental issues as they are social issues – like reducing inequality or providing access to clean water and quality education. Given how interconnected these issues are, tackling them in conjunction with climate change will be key to solving the climate crisis.

Unfortunately, the pandemic has only exacerbated how far off-track we are in meeting the SDGs by 2030. And, to add fuel to the fire, most impact reporting is of little use. A recent report from PwC highlighted that although 70% of firms cite support for the SDGs in their annual reports, only 1% measure their progress. This is partly because the UN SDGs were designed for governments and there’s no standard way of measuring progress towards them, nor any compulsion for companies or investors to demonstrate their impact.

So how can we assess whether our investments are impactful or not?

Impact data providers work to fill the gaps left by organisations by reporting the impact generated by each individual company. Having an independent body calculate a company’s impact also removes the inevitable bias that is likely to occur when companies report on their own impact, potentially highlighting negative impacts or at the very least not overstating positive ones.

One of the most popular measures of impact looks at the revenues derived from a company’s products or services connected to an SDG. This enables the impact to be compared on a like-for-like basis.  However, although simple to understand, we see three main problems with this approach:

1. By working backwards to calculate the impact from existing products and services, we’re implicitly applying an impact measure to companies that have no real intention of creating an impact. Such methodologies can make SDG-washing by fund managers more likely.

2. Monetary figures can be abstract and non-intuitive. For example, if your portfolio is contributing £50.4m towards Goal 4, Quality Education, is that a lot? How much investment does the UN estimate that quality education requires? What is that as a percentage of the portfolio, or of what is required? Without this context it’s hard to gauge a sense of scale relative impact.

3. By attempting to monetise impact, we actually trivialise it. Suppose we were able to price assets such as clean air, forests and human rights. In theory, a net positive impact could be achieved so long as the revenues from positive investments were higher than the revenues from negative investments – this means a company making water filters using child labour could be seen as an impactful investment. By making social and environmental goods interchangeable, we reduce the intrinsic value of these assets.

So, how else can we measure impact?

Whilst revenue-based models are relatively simple, providing a useful starting point to measure impact in the absence of widely endorsed impact reporting standards, we found analytics and data solutions Impact Cubed’s model to have a number of advantages over its revenue-based counterparts:

1. Impact Cubed identifies 14 data points across the E, S and G of impact that are connected to the UN SDGs and are either widely available from company disclosed data or can be reasonably estimated. These data points are then plotted onto a spider web using standard deviations relative to a benchmark. Through this, we can understand the relative impact position of a fund versus its benchmark or peers without the need to manipulate data. This allows for effective engagement and can help to screen out any potential SDG-washing.

 

2. Using their quantitative model, Impact Cubed are able to cover a far greater portion of the universe than their more qualitative-based counterparts that score companies based on a number of ESG factors.

3. Using data points that are widely available across companies and are objective measures of company impacts, such as water use relative to water availability in the geographical area where the company is based, allows Impact Cubed to control for potential biases. The methodologies of other data providers typically rely on assumptions around the types of products that fall under each impact, as well as what activities may be considered to have a positive or negative impact. Furthermore, the ability to compare to a benchmark allows each investor to assess the areas which require their attention.

For more information regarding Impact Cubed’s approach, we recommend their white paper measuring the Sustainability Impact of 25 European ESG funds, shortlisted by the UN PRI in 2019.

Ultimately, all our investments have an impact, be it positive or negative. And, due to regulatory requirements, we’ve seen clients begin to measure the climate impact of their portfolios (by mapping their carbon emissions against the goals of the Paris Agreement) – which is essential if we’re to address the climate emergency. But if we want to address social disparities and injustices too, then broadening our impact measurement is a no brainer: it will help us channel our capital towards those activities that are part of the solution, as well as engaging with those firms that are having a negative impact. The higher the quality of our analytics, the better the impact of our investment decisions.

Unless indicated, these are the views of the author’s and may differ from those of the firm.

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