When the Arctic is on fire and Iceland is melting, it’s difficult to continue with business as usual.
In the last ten years, the global spotlight has fixed on a number of critical social and environmental issues. These have prompted international conversations with significant and far-reaching ramifications: just consider #MeToo, which went from a Twitter hashtag to the driving force behind sweeping public and private sector reforms.
Whether it’s the onset of climate change, resource scarcity or populist politics, corporations and consumers alike have been paying attention. As a result, so have investors.
‘Impact investing’ wasn’t a term that appeared in many investment outlooks, presentations or conferences ten years ago. A decade later, you can’t escape it. Defined as “investments made into companies, organizations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return,” [1] the market is estimated at $502 billion and growing. Fast.
There are broadly three incentives to invest with impact.
1. The global diversification premium (or, in non-jargon terms, risk): Evidence suggests impact investments are uncorrelated to market movements, given they tend to follow themes which aren't subject to the same booms and busts. As a result, they can protect portfolios from market downturns.
There are other ways that integrating environmental, social and governance (ESG) factors into investment analysis mitigates risk. Of course, it makes sense that the long-term viability of a company rests, at least in part, on how it treats employees (Sports Direct), handles corporate scandals (Volkswagen), monitors supply chains (Tesco), and otherwise engages with its stakeholders.
Investing for environmental and social impact goes a step further, however, by taking into consideration factors outside a company’s control. Climate change in particular poses three significant risks to the financial system, as outlined by Bank of England Governor Mark Carney in 2015: physical risks (i.e. asset depreciation and insurance losses); liability risks, (i.e. the ripple effects of compensation claims); and transition risks (i.e. stranded assets, or the value that will evaporate in the shift to a low-carbon economy).
But transition risk has a flip side…
2. The global opportunity premium (or, in non-jargon terms, reward): If ESG integration is primarily about managing risk, impact investing builds on it by uncovering investment opportunities. A frequently cited example is renewable energy, with the value of wind and solar energy companies expected to rise in the transition to a low-carbon economy. Just as increased regulation and lower consumer demand will negatively effect ‘old-economy’ companies and lead to stranded assets, it will also see sectors that cater to new demands (like clean water, social and economic equality and renewables) thrive.
That’s the opportunity from a performance point of view. For asset managers, impact investing yields another upshot: clients.
We’re on the precipice of an unprecedented generational wealth transfer between two broad investing cohorts with very different values. Over the next 30 years, Baby Boomers are expected to transfer $30 trillion to Generation X and Millennials. Research data vary, but it’s clear an overwhelming majority of Millennials want to invest in line with their values and towards positive environmental and social outcomes. As a result, the demand for ESG and impact investment products is only on the rise. It seems likely that the next generation of investing comes of age at the same time as the next generation of investors.
Which leads us to the final incentive: simply doing the right thing.
3. The global citizen premium (or, in non-jargon terms, doing the right thing): Call it the feel-good factor. Or, if you’re a cynic, just call it good reputation. Whatever your motive, advancing positive social and environmental outcomes is increasingly expected of investors and the companies in which they invest.
Ultimately, investors have the power and impetus to direct capital towards a more sustainable future. When it comes to climate change in particular, we’re at a critical juncture: ignoring it simply isn’t an option anymore. In the words of the recent plaque commemorating melted Icelandic glacier Ok: “we know what is happening and what need’s to be done. Only you know whether we did it.”
And that’s where ESG integration meets its limits. It’s absolutely critical, so much so that it’s now becoming ubiquitous in investment portfolios. But it’s also the investment equivalent of a financial stress test, flagging the problem rather than rooting it out.
The next step is investing for better outcomes. In part two, we will discuss how the investment industry reached this tipping point and what comes after.
[1] Global Impact Investing Network
