ImpactAlpha – “ESG and impact management are converging as investors turn their attention to real-world outcomes”
This piece was originally published in ImpactAlpha.
Between the COVID-19 pandemic, the escalating climate crisis, and the movement for racial justice, there has been a growing recognition that social and environmental sustainability must be embedded in both business and investment decisions.
Yet confusion persists about the differences among investment approaches that claim to incorporate environmental, social, and governance (or “ESG”) considerations and those that seek to make a positive “impact,” leading to accusations of greenwashing and impact-washing. Understanding this distinction—and how to combine best practices from the worlds of ESG and impact—will be critical to move both markets forward.
At its most basic, “sustainable and responsible investing” involves the consideration of a company’s ESG operations in the investment decision-making process, including factors such as a company’s carbon footprint, workplace diversity, or board composition. Meanwhile, “impact investing” focuses on measuring and managing the contribution of investees to particular impact outcomes, such as expanding access to healthcare or more affordable housing.
In practice, however, the distinctions are not as simple as looking at what a company is doing inside its walls, versus what it is doing outside. Yet thanks to a significant amount of market progress in recent years, the nuanced differences in ESG and impact strategies are becoming easier to navigate, thanks in large part to the work of the Impact Management Project (IMP) and its partners.
The ABC’s of ESG and impact
The IMP’s ‘ABC’ framework has helped to classify different approaches based on whether they seek to: A) Avoid harm (e.g., by mitigating emissions); B) Benefit stakeholders (e.g., by focusing on companies that provide workers with better pay or benefits); or C) Contribute to solutions (e.g., by investing in a wind farm), with most ESG strategies falling in the ‘A’ or ‘B’ categories and most impact investment strategies falling in the ‘C’ category.
What’s often missed in the ABC framework, however, is the notion that the categories usually build on each other. For example, an investor may first develop an ‘A’ approach via a negative screening strategy, and then layer on ‘B’ with ESG integration, and finally add ‘C’ via an impact fund. As a result of this improved clarity, the market segmentation is now giving way to a confluence and cross-fertilization of best practices between “ESG” and “impact” approaches.
In a sign of things to come, we are now beginning to see sustainable and responsible investing standards move towards reporting on “outcomes,” whereas impact management standards are encouraging impact investors to incorporate ESG risks and performance issues into their investment processes.
For example, the Operating Principles for Impact Management (“OPIM” or the “Impact Principles”) were launched in April 2019 by the International Finance Corporation (IFC) and 60 founding signatories to “provide a framework for investors to ensure that impact considerations are purposefully integrated throughout the investment life cycle.” The guidance for Principle 5 specifically asks signatories to “identify and avoid, and if avoidance is not possible, mitigate and manage ESG risks” and also “monitor investees’ ESG risk and performance, and where appropriate, engage with the investee to address gaps and unexpected events.”
In other words, impact investors are expected to avoid and/or mitigate ESG risks (e.g., paying a living wage to all workers, promoting diversity and inclusion in the workforce, providing a safe working environment, etc.) as part of their impact management processes – an important step toward the maximization of net positive impact.
In a recent Tideline report on verifying investor alignment with the Operating Principles, “Making the Mark,” we discovered an interesting contrast in how signatories implemented an ESG risk identification process that was aligned with industry standards. We found that some mainstream asset managers who were first-time impact investors benefitted from their experience implementing ESG performance and risk management processes for many if not all of their portfolio companies. Meanwhile, some of the “pureplay” impact investors were new to some of the more nuanced aspects of ESG risk and performance management and were still in the early stages of developing robust systems for minimizing negative impacts and proactively addressing ESG risks.
There remains much that mainstream asset managers and dedicated impact investors can and should learn from each other.
What’s next for ESG and impact investing
The convergence is essential for the financial community to move beyond simply tallying a discrete set of metrics and toward driving real positive outcomes and helping build a more sustainable and inclusive society. Investors fluent in ESG and impact understand that measuring the “right” ESG risks for any given investment strategy and context is an important part of understanding where the most investable impact opportunities might be in a particular sector. For example, an investor in recycling that is seeking to contribute to the circular economy may want data and evidence that the facilities in which they invest also have strong records of worker safety and job quality.
To generate a holistic picture for each investment, shared standards and best practices will be key, as will the degree of transparency into the quality of an investor’s ESG and impact management practices.
Independent verification can play an important role in continuing to drive convergence and the adoption of best practices across ESG and impact management disciplines.
By marrying convergence with accountability, independent verification will increase market trust among key stakeholders (e.g., investors, allocators, companies, policymakers and regulators) and move us closer to a future where impact—total net impact—is managed with at least the same rigor as financial risk and return.
Christina Leijonhufvud is the CEO of BlueMark, Tideline’s new verification business. She manages all aspects of business strategy, new product development, and external relations, and has directly led over 20 impact verification assignments across investor types and asset classes.
This piece was originally published in ImpactAlpha.
Every commercial market that has successfully reached mainstream consumers and investors shares two qualities: First, a common set of standards and best practices. And second, a mechanism for holding market participants accountable to those standards.
This is true of the organic food market, which only took off when governments began regulating “organic” labeling to give consumers confidence in the quality and source of their produce. It’s also true of the automobile market, which didn’t become a dominant form of transportation until car manufacturers and industry associations agreed on fuel standards and safety protocols.
And it’s true of credit ratings, which gave investment professionals a reliable way to evaluate the creditworthiness of companies and governments, thereby unlocking capital to help businesses grow and countries prosper.
This story is now repeating itself in the impact investing market, which is poised to scale sustainably thanks to the introduction of new standards and impact verification requirements.
The lack of a reliable accountability mechanism has frequently been cited by impact investors as one of the biggest challenges facing the market. According to the GIIN’s ‘2020 Annual Impact Investor Survey,’ the top three industry challenges over the next five years are ‘impact-washing’ (66%), an inability to demonstrate impact results (35%) and an inability to compare impact results with peers (34%). Each of these challenges can be addressed through well-designed independent impact verification.
The evolution of impact investing
Impact investors have no shortage of standards, frameworks, and principles that provide guidance for navigating this rapidly growing industry.
Standard-setting started with impact measurement (i.e., measuring social, environmental and economic impacts according to industry frameworks like the U.N. Sustainable Development Goals). More recently, the focus has turned to the broader concept of impact management, the incorporation of impact considerations into each step of the investment process, from crafting a robust impact thesis to engaging with portfolio companies to help them maximize positive impact outcomes and mitigate negative ones.
There exists a literal alphabet soup of standard-setters in the impact investing field – B Lab, GRI, IMP, IRIS+, PRI, SASB, TCFD, and UNDP, to name a few. Each of these organizations has sought to fill a gap in the impact investing industry, with the over-arching goal of catalyzing the flow of private capital towards solutions to societal problems.
However, until April 2019, the market was missing a way to hold impact investors accountable to a single shared standard. That’s when the International Finance Corp., or IFC and 60 impact investors came together in to introduce the Operating Principles for Impact Management, or “OPIM” or, simply, “the Impact Principles.” These nine principles were created to “provide a framework for investors to ensure that impact considerations are purposefully integrated throughout the investment life cycle.”
One year later, more than 100 impact investing organizations representing more than $300 billion in impact assets under management—from private equity and wealth management firms to foundations and development finance institutions—have signed onto the Impact Principles and committed to manage any investments labeled as “impact” according to a shared set of best practices.
The Impact Principles are unique from previous industry standards in that they require all signatories to independently verify and disclose their alignment with each of the Principles. This verification requirement is a game-changer for the impact investing industry.
When designing our verification methodology, we saw the potential to bring three important benefits to the impact investment market:
- Accountability. Verification provides a mechanism for evaluating whether impact investors’ practices and performance are aligned to accepted market standards, ensuring greater transparency and credibility across the market;
- Discipline. Verification encourages impact investors to take steps to adopt industry best practices, continuously raising the bar for performance across the industry;
- Comparability. Verification establishes benchmarks and ratings that allow stakeholders, whether asset owners, intermediaries, or beneficiaries, to compare different approaches to impact investing on a consistent basis.
To maximize these benefits and help scale and mainstream the practice of impact investing, Tideline in 2020 launched BlueMark, an independent business providing impact verification services to investors and companies.
One of these services is a standardized methodology to assess the degree of investor alignment with these Principles. To date, we have completed 20 independent verifications for impact investors managing nearly $85 billion in combined impact assets, and recently published a report, Making the Mark, to share our initial findings.
We discovered that while each impact investor has a different strategy and impact management process, they all share a commitment to learning about best practices and common challenges. Verification is an essential part of that learning process, providing impact investors with an opportunity to self-reflect about where they excel and where they have room for improvement. At the same time, the public disclosure mandated by the Impact Principles provides a way for impact investors to benchmark their practices against others in the industry.
The power of impact verification
Independent verification is more important now than ever. The COVID-19 crisis has exposed and exacerbated the fragile, inequitable, and unsustainable nature of our social, economic, and environmental systems. The pandemic has provided a precious opportunity to rethink the role of private capital in shaping a better world and building a more sustainable and inclusive society.
Impact investing can and must play a part in this transformation. But we need more than good intentions. We need more than “impact” labels and philanthropic initiatives. We need a mechanism to give the market confidence that intentions are backed up by practices, outcomes are backed up by evidence, and impact labels actually mean something.
Verification represents the best defense against rampant impact-washing, and also the best weapon for scaling the impact investing industry with integrity. If we all work together and use this tool wisely, we can realize the ambitious vision to mainstream the use of private capital to meet the sustainability challenges of our time.
Christina Leijonhufvud became CEO of BlueMark, Tideline’s new verification business, in January 2020, leading all aspects of the business strategy, new product development, and external relations. Christina has directly led over 30 verification assignments across investor types and asset classes.