An unprecedented proliferation of large multinationals across industry sectors is seeking to align their businesses with the global climate and sustainable development agenda. Looking at climate change alone, more than 1,500 companies, representing $11.4 trillion, have made net zero commitments, equivalent to half of the US’s GDP.1 Given the market power and far-reaching supply chains of large multinationals, it is vital that they deliver on those commitments.
Start-ups, small and medium-sized enterprises (SMEs) are crucial too. They are job creators, vital for inclusive economic development in industrializing and industrialized countries alike, and driving positive social impact. Globally, 90 per cent of all enterprises and 50 per cent of the global work force are estimated to be or employed by SMEs.2 In the formal economy of emerging markets, SMEs are responsible for 45 per cent of jobs and 33 per cent of national GDP.3 These sectors will be vital in meeting SDG 8 on decent work and economic growth and SDG 9 on industry, innovation and infrastructure. Indeed, start-ups and SMEs are often the disrupters and innovators that are needed to develop new solutions to achieving radical emission reductions and a sustainable resource economy.
But the finance industry is not keeping up with providing growth capital for positive impact. Sustainability-focused businesses remain under-served by traditional financial institutions and venture capital while several aspects of institutional approaches to assessment and evaluation are holding them back from realizing the potential of purpose-driven enterprises.
Most investment models focus on value creation through fast growth and quick exit strategies which, by definition, excludes the sustainable, longer-term business models required by some companies with purpose. And start-ups and innovative business models that deliver social and environmental goals as well as financial return can struggle to attract finance from institutions that look for traditional track records. The spectrum of capital below gives an overview of the types of activities and strategies used across investments.
Spectrum of capital
Traditional: Limited or no regard for ESG practices.
Negative screening: The exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria.
Positive screening: Investment in sectors, companies or projects selected for positive ESG performance relative to industry peers.
Norms-based screening: Screening of investments against minimum standards of business practice based on international norms.
ESG integration: the systematic and explicit inclusion by investment managers of environmental, social and governance factors into financial analysis.
Sustainability themed: Investment in themes or assets specifically related to sustainability, for example, clean energy, green technology or sustainable agriculture.
Impact investing: Targeted investments aimed at solving social or environmental problems.
Philanthropy: Address societal challenges that cannot generate a financial return for investors.
Corporate engagement and shareholder action: The use of shareholder power to influence corporate behavior.
Impact investment is growing fast
Impact investment models – which set out to generate positive social and environmental impacts as well as a financial return4 – look beyond the short-term and challenge the outdated perception that making impact central to investment strategies means lower financial returns. Indeed, 88 per cent of respondents to a survey by the Global Impact Investing Network (GIIN) report meeting or exceeding their financial expectations and 67 per cent seek risk-adjusted, market-rate returns for their assets.5
Investing with impact is a vibrant space that is growing fast. The Global Impact Investing Network estimated the size of the market to be $715 billion as of the end of 2019, comprising a diverse range of institutions,6 while, just two years earlier, that number was $228 billion.7 Of the 1,720 investors that make up this estimated market size, 60 per cent invest in both environmental and social endeavours. Within the organizations included in the survey, 65 per cent are asset managers, 14 per cent are philanthropies, 2 per cent are pensions funds and 1 per cent are insurance actors.8 Numerous mainstream banks – including Credit Suisse and UBS – are establishing dedicated impact vehicles too.9
The growth of active impact-seeking investing is encouraging yet it’s still a niche end of the market: compare that $715 billion in impact investing assets with the $104.4 trillion10 – at least – of total assets under management at the end of 2019. And, while mainstream players are taking steps to move into the impact space, these remain relatively small and ring-fenced funds.
Most importantly, ‘impact’ is not an asset class; it is a management approach that must be fully integrated in an explicit way into all investment decisions. Lessons can be learned from the values-based investing that is prevalent within the faith-based investors where the whole goal is to use their investments to create a better world for people and planet.11
To maintain their social license to operate and be prepared for future client demands and potential risks, mainstream financial institutions need to begin to move beyond basic environmental, social and governance (ESG) risk screening and embed impact into all their decision-making.
In order for impact investing to become mainstream, a concerted effort will be required to create a suitable enabling environment. Furthermore, innovative mechanisms and pathways need to be devised to bridge the demand and supply of financial capital for companies with purpose while finding ways to measure social and environmental impact information and use it to inform decision-making will be key as will embedding integrity standards to shut down the potential for greenwashing. Finally, capacity-building will be needed to build skills within mainstream financial institutions in new evaluation and investment approaches.
New metrics are needed to measure impact
Awareness and implementation of broader investment impact measurements is growing but impact metrics that can be translated into investment decisions remain a sticking point. Mainstream investment decision-making relies on metrics related to the terminal value of a company. Often though, companies with impact-oriented products or services deliver additional social and environmental value beyond these parameters that are not fully recognized. The lack of systematic impact-data capture tools and methods for interpreting impact-data throughout the growth trajectory of a business can act as a barrier especially for the large institutional funders.
Analysis of investment performance metrics still mostly focuses on backward rather than forward-looking information. While the past is more easily assessed than the future, past datasets can give the wrong signal about the trajectory of a company or process.
A more forward-looking evaluation approach can better identify companies that are well placed to maintain business models in a disrupted world and to track progress towards future targets and12, as the urgency of the climate challenge grows, approaches that integrate future longer-term uncertainties and disruptions into decision-making will be needed.
Promising signs are emerging that show a marrying of broader measurements of investment performance with voluntary standards. For instance, the Task Force on Climate Related Financial Disclosure (TCFD) has been instrumental in promoting the inclusion of climate risk in financial assessments while the Impact Management Project is leading efforts to build consensus among standard-setting bodies. The UK Financial Reporting Council is also supporting the development of non-financial reporting and recently conducted a comprehensive review of climate-related issues as they affect governance, reporting and audit in the financial industry.13
The next step will be to develop more mandatory impact reporting processes across the finance supply chain to achieve standardization and ensure the integrity of impact claims. While the growing energy around impact investing is encouraging, the recent flurry of products claiming to be ‘impact’ has led to confusion and highlighted the ambiguity within the sector. By providing increased transparency and setting ground rules, mandatory standards should reduce the haziness which enables certain actors to overstate their impact.
The UK government’s 2021 consultation on the proposal to require mandatory TCFD climate-related disclosures for large, privately-held businesses, as well as for publicly listed companies by 2022, is a step in the right direction14 adding to the EU by which periodic reporting will be required from January 2022.15
Expanding the mandatory reporting standards will help to provide certainty for investors and form a foundation for further policies that reward investments that deliver social and environmental benefits. The EU Green Taxonomy is a leading example of defining what counts as sustainable economic activities in order to provide security for investors, tackle greenwashing and ultimately shift investments to where they are needed for the sustainability transition.16
Skills and knowledge
Financial institutions will need to upskill workforces to build up the knowledge needed to invest with impact. The growth in impact investing is set to change investment professionals’ jobs and the skills they need to do them especially at mid-to-high levels.17 Practitioners therefore need to be provided with easy to access education in how to evaluate less traditional social and environmental investment opportunities. This is some gap to fill: the CFA Institute found that less than one per cent of investment professionals disclose sustainability-related skills on their LinkedIn profiles.18 Indeed, time restraints can inhibit many professionals’ ability to undertake investments in companies with purpose, which often requires more time and nuanced steps.
However, there are promising signs that this upskilling is taking place. Industry bodies and training mechanisms are increasingly incorporating impact investing modules. Examples include the Chartered Banker Institute’s Green Finance Certificate which aims to upgrade financial services professionals’ knowledge of the science and practices behind green finance. The CFA Institute has also launched a certificate in ESG Investing, developed by practitioners, which benchmarks the knowledge and skills investment professionals need to integrate ESG factors into the investment process.19
Opportunities to learn
The financial sector needs to explore the opportunities to harvest experience from pioneering institutional and faith-based investors on how to integrate positive impact into investment portfolios and embed sustainability considerations into company culture at all levels. Supporting both entrepreneurs and employees to share lessons and best practice within, and between, institutions will help accelerate the spread of these practices. Sharing of these best practices still needs to be tied to real term progress goals, however, and the precise actions needed to reach these. Collaboration among practitioners can bring about a cross-fertilization of ideas and capabilities that enables the replication and scaling up of emerging best practices.
Looking ahead, the array of impact funds currently in the market needs to be better connected with more mainstream investors too. This would help to unlock the financial flow into companies with purpose and enable the sector to move on from current practices which relegate ‘impact’ to additional or external tranches of funding.
Crucially though, unlocking more impact-led investment requires a concerted effort on the supply-side to remove significant blockages. Investment capital passes through a complex chain of financial actors, each with a range of incentives and capabilities. Focusing on these structural challenges will be key to identifying what is blocking investments that create societal and environmental value.
This article was informed by a series of workshops, enabled by the generous support of Porticus. Thanks to the valuable contribution from Florian Reber, Tomos Harrison and Stephanie Loo in the development of this article.