Digitalisation has largely changed the conditions for doing business.Some talk of a fourth industrial revolution that will redefine not only business but also how we live, work and relate to one another. It can easily be argued that a parallel, yet highly related trend, is the aspirations to build a more sustainable society, through more responsible business. And perhaps even more than that, business that not only settles with avoiding being part of the problem – but attempts to be part of the solution. It is within that context we should look at impact investments.
Is there a business in making a difference?
” When we decided to half the size of our bags of maize seeds, we reached a new category of customers – smallholder farmers. You may call it impact investment, I call it business.”
Those were the words of a CEO of a seed company in Southern Africa, that I spoke to a few years ago. You’ll find plenty of similar examples from emerging markets around the globe. It may be about doing good but the main driver is rather that poor people are also customers and if you sell enough you make a good profit.
This is crucial for the telecom industry in for example Africa and increasingly so also for the energy market where small solar panels are sold or leased out at an impressive pace. So, does investing in a mini-grid in Zambia or a wind-farm in Sweden make you an impact investor? Not necessarily.
There are plenty of definitions trying to grasp the meaning of impact investment.
Generally they refer to financial investments that generate a return in both financial and other dimensions. Those other dimensions can often be characterised as either Environmental, Social or Governance (ESG) related. Often impact investment is characterised by:
1) An expectation of a financial return on investment (though it doesn’t always have to be at pair with market rate) as well as
2) An expectation of the investment having a positive impact on society and/or the environment. Sometimes an ambition to measure the impact is added as a third characteristic.
Investing in a wind-farm becomes an impact assessment only – it can be argued – if the investor is prepared to accept a trade-off between ESG-impact and financial return. If an investment is done only on financial grounds and regardless of its impact on environment or society, it’s consequently not an impact investment. Which does not exclude, as the quote from the CEO of the seed company above illustrates, that it can have a hugely positive impact on planet and society.
Responsible investments can be said to differ from impact investment in that the former focuses on reducing the negative impact of an investment, while the latter goes a step further by explicitly wanting to have a positive impact. Responsible investments are often about excluding e.g. weapon production, fossil fuels etc. (often called “value-based exclusion”). It may be assumed that most impact investments are also responsible investments, though in theory it doesn’t have to be that way.
When a responsible investment becomes enshrined in the business strategy of a company regardless of financial implications it may no longer make that much sense to distinguish it from impact investments. Some companies argue that
“whether we are obliged to by law or not, we see it as a necessity, or a hygiene factor if you wish, to behave responsible; to pay our labour a reasonable salary, to avoid virgin materials and so forth.”
(the quote is from a CEO of a medium sized Swedish company that I interviewed during a market research study for Cartina AB). Even though use of non-renewable resources would have increased profit, the company choose another route. A route they consider as a long-term sustainable route.
Is there a price premium associated with sustainability?
There are also plenty of companies and investors choosing an ESG route because they believe there is a price premium in sustainability. The issue of price premium is a little complicated though:
“Academic and industry research strongly suggest, notwithstanding a selection of non-negative and contradictory results, that incorporating ESG metrics may increase risk-adjusted returns. Our results, however, would indicate that any beneﬁt from incorporating ESG credentials into a portfolio is already captured by other well deﬁned and known equity factors. An ESG-tilted process does not deliver higher risk-adjusted returns, since, once we remove the market cap and volatility bias, ESG as an equity factor has returns compatible with noise (t-statistics of less than 1).” (Breedt et al, The Journal of Investing )
As the quote above illustrates ESG is, despite all the talk and a fair amount of research, still not considered a traditional factor in investments. This may be because there still isn’t any solid evidence that high ESG scoring in investment portfolios results in higher stock value. It doesn’t behave like other traditional factors such as value, size, volatility and quality.
There may be several reasons for the lack of strong correlation between sustainability and value but it should not automatically be assumed that ESG – or sustainable business – does not, under certain circumstances, yield higher returns and a higher stock value. Looking at some of the research generated using the Sustainability Accountant Standard Board´s, (SASB) materiality index reveals some fairly solid evidence that ESG actually can generate material value. But: you need to know what to look for.
Some questions you should ask if you are interested in impact investment
So, if you are an investor wanting to apply an ESG approach, wanting to have a decent financial return on investment as well as an impact beyond profit the following set of questions may be a good start:
- What factors or parameters to look for in order to ensure a return and what kind of return are you expecting? This question is dependent on what time perspective you have, which – needless to say – also impacts risk and volatility.
- What kind of impact are you interested in? And how do you ensure you get “good value for money”, i.e. that your investment is efficient enough regarding the impact that you are expecting?
- How do you expect to measure your impact beyond financial profit?
Many investors are prepared to lower their expectations on their return slightly, if they also know that their investments have an impact on for example the sustainable development goals. This may partly be out of solidarity, but it sometimes also stems from a belief that impact investments also contributes to the betterment of the world, including the stock market. An expectation that their investment may actually be rational in the long run. This is only true, however, as long as the investment also gives a financial return.
Very few people are prepared to lose money on their investments; then it is charity, not sustainability.