Untapped Potential: How impact investing constitutes a real opportunity for institutional investors.
May 15, 2023
“There are only two people in the world whose opinion matter. It is not your mom, your dad, your spouse, your kids, your friends or your boss. It is the 8-year-old version of you and the 80-year-old version of you. You have lived a good life if you impress those two people.” - Author Unknown
Context
The global climate crisis is the defining challenge of our time. More frequent and intense catastrophic storms, floods, droughts, severe fires, and other climate change related threats will result in disastrous social, environmental and economic consequences. Evidence of this can be found in the latest United Nations Intergovernmental Panel on Climate Change (IPCC) report titled AR6 Synthesis Report: Climate Change 2023. The report is a culmination of six years of research involving more than 700 scientists representing 90 countries. This reality should both frighten and disappoint the 8-year-old and the 80-year-old version of you.
Institutional investors should pay attention because the climate crisis will have a negative effect on financial markets and pose a material risk to investment portfolios. However, as the old adage goes, challenges can be turned into opportunities. Transitioning to low-carbon economies, provided that transition is just and equitable, will present real opportunities for institutional investors.
This article focuses on the opportunities impact investing presents to institutional investors. Impact investing is different from and goes beyond analyzing environmental, social and governance (ESG) factors when making investment decisions (follow this link for a definition of impact investing). Many institutional investors do not consider the measurment of positive social or environmental outcomes when making investment decisions because they believe fiduciary duty compels them to only consider traditional financial factors.[1] For this reason, the article starts by examining fiduciary duty in the context of impact investing. It then explores investment risk, regulatory requirements, return expectations, and concludes with a look at changing stakeholder, contributor, and beneficiary preferences.
Fiduciary Duty
Fiduciary duty legally defines the relationship between a person or organization (a fiduciary) acting on behalf of someone else (a principal or beneficiary). A fiduciary, for example an institutional investor such as a pension fund, has a legal obligation to act in the best interest of the person or persons they are representing such as a person saving for retirement by contributing to the pension fund.[2] An investor has a fiduciary duty to consider traditional financial factors and consideration for social or environmental factors is perceived as a breach of this fiduciary duty.
This outdated argument ignores the fact that fiduciary duty is a dynamic concept reflecting investment practices and social norms[3]. Investment practices and social norms are constantly changing due to f increasingly complex social and environmental crises, and our understanding of fiduciary duty is changing to reflect this. For example:
Investment practices are changing. The private impact investment market at the end of 2021 was valued by the Global Impact Investing Network (GIIN) at approximately $1.2T USD; up 63% from 2019.[4] In public markets, citing their fiduciary responsibility, 36 institutional investors managing $5.5T in assets have signed a new Canadian Investor Statement on Climate Change.[5]
Social norms are also changing. A recent YouGov global survey found that almost 90% of people believe climate change is real and most people feel that it will destroy the world’s economy.[6]
Fiduciary duty does not pose a legal barrier to impact investing. The UK Law Commission, a statutory independent body that reviews laws and provide reform recommendations, stated that accounting for ESG factors in the investment decision making process does not constitute a breach of the law.[7]
In fact, not considering ESG factors may be a breach of fiduciary duty. The United Nations Principles for Responsible Investing (UN PRI), a global network of investors with 7,000 corporate signatories, argues that “failing to consider long-term investment value drivers, which include ESG issues, in investing practice is a failure of fiduciary duty.”[8]
Mitigating Risk
Point number four above is tied to the increasing investment risks posed by the climate crisis. Negative systemic impacts, such as increasing inequality leading to political instability, or climate events leading to the destruction and write-off of assets in floods or wildfires, can directly influence the long-term investments across industries and asset classes. Developing investment strategies that consider these effects to manage investment risk is a growing imperative.
The transitioning to low carbon economies will result in a massive shift for the energy sector. As businesses move away from fossil fuels and towards renewable energy sources like wind and solar, supported by energy storage solutions, fossil fuel related assets will become a liability.[9] Resources and infrastructure linked to these types of assets such as pipeline and power plants may become “stranded assets” because of:
government regulations limiting the use of fossil fuels through carbon pricing and other policy instruments.
a change in demand for these types of products due to the declining cost of renewables and evolution of clean technologies.
legal action against emitters by the public and governments.
Integrating sustainability and impact objectives in investment decision making is increasingly seen as critical to long-term profit maximization and a way to mitigate risk. The idea of “double materiality” is making inroads with institutional investors; big financial players, such as JP Morgan, already subscribe to the idea.[10] Double materiality represents a feedback loop where companies’ activities impact society and the environment, and society and the environment also impact companies’ intrinsic value. This is in contrast to current investment decision processes only based on information included in company financial statements. ESG considerations are financially material and for this reason, companies should be required to report ESG related data for investors.
Getting Ahead of the Curve
National governments have reached an unprecedented global consensus on emission reduction targets, and objectives for reconciling economic progress with social justice and conservation of natural resources. The Paris Agreement, which is a legally binding international treaty on climate change agreed to by 196 countries. The 2030 Agenda for Sustainable Development established 17 interlinked Sustainable Development Goals (SDGs) calling on the world to act in addressing global challenges including poverty, inequality and climate change.
Institutional investors see themselves as playing an important role in reaching net-zero targets and contributing to the achievement of the SDGs. This is commendable, but there is another reason to pay attention. National governments have and will continue to advance climate-related financial disclosure standards and regulations.
The Task Force on Climate-Related Financial Disclosure established by The Financial Stability Board in 2015 released recommendations on climate-related financial risk disclosures in 2017. Since then, the European Union and the United Kingdom adopted new sustainability disclosure laws; the United States Securities and Exchange Commission is proposing new rules on climate-disclosure for investors.[11] It is still unclear if the latter will survive the current US culture clashes between Republicans and Democrats, but many other countries like Canada are considering similar legal requirements. Getting ahead of the curve and integrating ESG or impact measurment approaches would be appropriate action for fulfilling the requirements of fiduciary duty.
Expanding the Opportunities Landscape
Investment strategies with environmental and social objectives will not only mitigate risk, but also expand the opportunity landscape. The climate crisis is global, so establishing pathways for a Just Transition in both developed and developing countries will lead to entirely new industries with high-growth potential. For example, the market for electric vehicles (EVs) is growing rapidly with sales of EVs forecast to make up about half of new car sales worldwide by 2035.[12] The market for EVs currently sits at $208.95B USD and is expected to reach just under $1T USD by 2030.[13] The growth of the EV market presents credible and tangible opportunities for institutional investors.
Many mainstream investors still believe that a tradeoff exists between making risk-adjusted financial returns and generating social and environmental impact. An argument compounded by a dearth in performance data availability on impact investment portfolios. As impact investing moves from a niche market to the mainstream, data gaps will be filled, and this myth should be dispelled. The following two examples demonstrate that risk-adjusted returns need not be sacrificed for impact.
In 2021, the GIIN analyzed the financial performance of equity and debt investments made by 161 market-rate-seeking impact investors managing USD 111B in impact investing assets. Nine in ten in the sample met or exceeded their financial performance expectations.[14] The top 10% of emerging-market private equity investments earned the highest realized returns, generating returns in excess of 29%.
In 2022, Tameo analyzed 157 private asset impact funds across fixed income funds, equity funds, and mixed funds, targeting emerging and frontier markets. The analysis found that fixed income strategies made returns of 2.4% and equity strategies made returns of 6.8%.[15]
This is a limited sample set, and more performance data is needed for impact investing to become mainstream. Approaches such as blended finance can help address risk inherent in making impact investments while the industry matures. Governments can also advance other policy instruments to catalyze institutional capital to grow the global market.
Shareholders, Contributors, and Beneficiaries
Globally, we are all concerned about climate and social issues. For this reason, people are increasingly choosing to align their investment portfolios with their values. Public pressure is recognized by the UN PRI as one of the drivers for responsible investing. But the financial industry is too complex for many citizens. Even if they are interested in impact investing, finding the right investments can be challenging. As the anxiety mounts, the voice of shareholders, contributors and beneficiaries will continue to get louder. Like the inevitable climate related regulatory requirement, institutional investors would benefit from getting ahead of this public pressure curve.
Conclusion
The transition to a low carbon world is happening, and there is significant opportunity in investing for a Just Transition. Ignoring the transition or choosing a wait-and-see approach poses risks for institutional investors. At the same time, impact investing presents real opportunities to make competitive risk-adjusted financial returns while generating impact. The current financial and corporate structures present some barriers for institutional investors to fully embrace impact investing. It is time for action to ensure the 8-year-old version of you and the 80-year-old version of you are impressed by your contribution to the inevitable transition to a cleaner and more just world.
This article was published by the Canada Forum for Impact Investment and Development (CAFIID). It is a product of a collaboration led by CAFIID’s Thought Leadership Committee. It is the first of a series of articles exploring the challenges and opportunities impact investing presents to Institutional Investors. The next articles will discuss these barriers, examples of barriers being overcome and some practical solutions. The authors are:
Dr. Brian Carriere is the Chair of CAFIID’s Thought Leadership Committee and a Senior Program Officer, Social Innovation and Impact Investing at Colleges and Institutes Canada.
Geoff Moore is a board member of CAFIID and is the Founder & CEO of Impactᴬᴺᴰ Inc.
Jason Sukhram is a member of CAFIID and is the Impact Services Lead & Engagement Manager, Quinn+Partners.
Pranay Samson is a member of CAFIID and is the Director, Innovative Finance at Plan International Canada and Managing Director of PlanCatalyst.
References:
[1] Muir, D. M. 2022. Sustainable Investing and Fiduciary Obligations in Pension Funds: The Need for Sustainable Regulation. American Business Law Journal. V.59, Issue 4, 621-677.
[2] Fiduciary Duty. (n.d.). LII / Legal Information Institute, Cornell Law School.
[3] Bauslaugh, R. (2014). The Lorax Speaks to Pension Fund Administrators - And They Better Listen! McCarthy Tetrault.
[4] Hand, D. Ringel, B. and Danel, A. (2022). Sizing The Impact Investing Market. Global Impact Investing Network.
[5] Responsible Investment Association. (n.d.) Canadian Investor Statement on Climate Change.
[6] Smith, M. 2019. Most People expect to feel the effects of climate change, and many think it will make us extinct. YouGov.
[7] United Kingdom Law Commission (2014). Fiduciary Duties of Investment Intermediaries. Controller of Her Majesty’s Stationery Office.
[8] Sullivan, R., Martindale, W. Feller, E. and Bordon, A. (2020). Fiduciary Duty in the 21st Century. United Nations Principles for Responsible Investing.
[9] S&P Global (2020). What is Energy Transition?
[10] Schwartzkopff, F. (2022). What New ESG Approach ‘Double Materiality’ Means — and Why JPMorgan Is a Fan. Bloomberg News.
[11] Lashitew, A. (2022). The coming of age of sustainability disclosure: How do rules differ between the US and the EU? Brookings Institution.
[12] Goldman Sachs. (2023). Electric vehicles are forecast to be half of global car sales by 2035.
[13] Bondarenko, V. (2021). Electric Vehicle Market May Quadruple to $957 Billion By 2030. TheStreet.
[14] Hand, D., Sunderji, S., Nova, N. and De, I. (2021). Impact Investing Decision-making: Insights on Financial Performance. Global Impact Investing Network.
[15] Estoppey, A. and Narayanan, R. (2022). Private Asset Impact Fund Report 2022. Tameo.