Impact investing: A sustainable fix for capitalism?
Intended and unintended consequences of caring about more than financial returns
TLDR: Impact investors intend to make a positive social and environmental impact alongside some financial returns. With a market size of around one trillion dollars, impact investing is becoming a considerable segment of the investment industry. Some questions remain though: How large can tradeoffs between impact and financial returns become? Might a sizable lack of financial returns distort the investment market? Is impact investment the future? And what can all of this teach regular investors who just want to make some money?
Money bears social responsibility. Where investors put their cash, economies can grow. If nobody invests, growth is limited because the resources to grow faster are not there.
Many investors, however, are selfish. They invest there money in hopes that it will multiply over time, not to help other people or the planet. There is nothing fundamentally wrong with that — almost the entire investment industry is built on this sense of greed for more money. This makes them very nimble and helps them spot, and fund, the key industries of tomorrow.
There is, however, another approach: Investors can seek financial returns while also pursuing environmental or social goals in parallel. This is impact investing, a term first coined in 2007 by the Rockefeller Foundation.
Impact investing is becoming a financial behemoth of its own right: According to some estimates, its market size has crossed the $1 trillion mark in 2022. This begs the question whether impact investing is how all investors should operate, or whether necessary tradeoffs between financial performance and social and ecological impact would make financial markets cumbersome to navigate.
Impact investing is more than philanthropy
Historically, regulation and philanthropy have been at heart of mitigating unindented consequences of business activity. Such consequences might be air pollution through the production and sale of cars and petrol, or addictions through unsupervised sale of pharmaceuticals.
Impact investors, on the other hand, want to use their financial might to mitigate harm and enact positive outcomes. Three principles define impact investing:
Intentionality: The capital allocation reflects the investor’s desire to generate a measurable social or ecological benefit.
Additionality: The investment actually contributes to the measured impact.
Measurability: All impacts can be measured, using frameworks that have been agreed upon before the investment was made.
The third point is of particular importance: Impact investing is not just about warm fuzzy feelings, but about impact that can be objectively measured and compared with impacts by other projects.
One important measurement framework is the Impact Standards for Financing Sustainable Development by the OECD. In many cases, however, investors create their own framework based on their specific values.
Measuring this impact is not trivial, because it is a result of many factors. A car manufacturer might buy car pieces from a supplier, which essentially encourages that supplier’s labour practices, governance oversight, and environmental contribution. They then put the pieces together, which creates jobs and might cause pollution. The cars are then sold, which gives car sellers something to do. The buyers can now use their cars, which helps them move around the world but also pollutes the environment. The total impact of a car manufacturer is the sum of all these impacts on labour, pollution, and other factors.
Some investors and non-profits are now arguing for a new practice called impact accounting. This entails translating social and environmental impacts in monetary terms, so that they can be used alongside regular financial accounts. This is hoped to encourage financial analysis, capital allocation, and decision-making.
At Wangari, we are somewhat skeptical about putting a price tag onto nature and labour rights. Practices like ecosystem accounting might be a better tool to properly understand impact, which can then be translated into monetary terms when that is appropriate. Nevertheless, such standards from impact accounting might be useful in order to integrate impacts into financial modeling.
Whether or not they embrace impact accounting, impact investors typically take a number of steps to ensure that the desired impact is being made. These range from defining strategic impact objectives, monitoring the progress of each investment, to publicly disclosing any impact principles. Impact investors might choose to focus on particular steps more than on others, and apply their own methodologies in each step.
How much do impact investors earn?
With so many other criteria beyond financial performance, it is natural to assume that there would be tradeoffs between financial and extra-financial goals. In a survey of almost 300 impact investors, however, two thirds of the respondents targeted market-rate returns. Another 18 percent targeted slightly below-market returns. Only 15 percent of impact investors only targeted enough returns to preserve the initial capital.
Overall, it seems that tradeoffs between financial and extra-financials are a lot rarer than one might intuitively expect. This is corroborated by the fact that, in the aforementioned survey, almost half of all impact investors were, in fact, for-profit asset managers who tend to face pressure from their clients to grow their portfolios. Impact investing is a branch to be taken seriously.
If tradeoffs become more common and more sizable for some reason, this could, however, distort the market. Let us imagine a (very simplified) scenario of a world where half of all investors are impact investors, and half are traditional investors. Some projects worth investing in would be interesting for impact investors, others not. Some projects are more lucrative than others, and some carry less risk than others. Let us imagine further that all impact-friendly projects have significant financial downsides and do not grow the capital initially invested.
In a market without impact investors, most investment would go to the impact-unfriendly projects. This would be bad news for the planet and its people, but financial markets would remain stable. In a market with only impact investors, the only projects receiving any investment would be impact-friendly. This is problematic because impact-unfriendly projects might still provide benefits to society that are not captured in most impact methodologies.
Finally, in a world in which both types of investors prevail, the return would decrease for all investors. The market for impact-friendly projects would already be crowded, so traditional investors would have even less incentive to diversify their portfolio with these. The risk would go down with so many other co-investors, but the returns would also need to be divided between more parties. For traditional projects, traditional investors would need to invest as usual, but the risk is elevated because no impact investors are there co-invest. In addition, explosive growth is often unlikely with tried-and-tested unsustainable projects, which diminishes the upside potential for traditional investors. Unless some additional explosive growth happens on the impact-friendly side of the market, all investors lose. (The planet and its people would experience a net benefit though.)
It is therefore lucky that tradeoffs between financial and extra-financial performance are not as common as many people starting out in this field might think. Nevertheless, one should keep an eye on the evolution of such tradeoffs, in order to avoid nasty surprises in the future.
Whether impact investment is the future therefore depends on whether tradeoffs between financial and extra-financial performance become common or not. Of course, in reality every extra-financial action that a business takes would have financial consequences. A manufacturer of plastic cups might choose to shift their production towards paper cups, which would increase costs in the beginning because of that shift, and might decrease costs for raw materials in the mid-to-long term. It might positively or negatively impact their revenue, profit margin, and access to capital, too.
If financial modeling is sophisticated enough to integrate all extra-financials in the valuation of a project or of a company, then tradeoffs would not happen: The plastic cup manufacturer could only profit from shifting to paper cups because the cost of plastic waste and the ensuing environmental damage would be factored into its valuation. Such financial modeling, however, is still in its early stages and is precisely what Wangari is developing for investors.
What can impact investing teach regular investors?
Not all investors have the luxury of being able to choose between sustainable projects with some extra risk, and relatively risk-free but unsustainable projects. Insurance firms and pension funds, for example, have a lot of capital but also a lot of obligations because they need to pay out funds to insureds and to pensioners, respectively. They often cannot commit a significant part of their funds to high-risk investments that often play out over long time periods — hallmarks for many sustainable investment targets.
Even investors that do not have as many obligations, such as university endowments or family offices, might not want to commit too much of their capital to sustainable projects. This is understandable.
Nevertheless, they can learn from impact investors: Their methodologies for assessing social and environmental impact might prove interesting for a large variety of portfolio companies. Such methodologies can also enhance their capabilities for assessing risk and upcoming opportunities. They might also use these methodologies to probe for any correlations between positive impact and positive financial performance (or vice versa). Should the results be convincing, they might be able to optimize their capital allocation regarding impact-friendly projects.
Being an investor can often feel like drinking from a firehose. There is so much to learn, so many exciting projects and potential investment opportunities. Nevertheless, many investors would benefit — financially and extra-financially — from making impact investment methodologies part of their mandatory curriculum.
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