"E" and "S"
Increasingly, investors are demanding that their investments not only generate strong financial returns, but also make a positive impact on people and the planet. In fact, there’s a growing body of evidence demonstrating the importance of non-financial factors on financial returns. Chris Kuchanny explains how to integrate Environmental and Social (“E and S”) factors into your investment decisions, and how this can support stronger long-term financial returns.
Once an investor decides that they want their investments to be more impactful, they need to take action. But what to do? It's key to determine, up front, which factors you want your investments to improve, i.e., your impact investment objectives. To help with this determination, you may want to review the SDGs - a globally recognised and supported framework - and decide to align with one or more of the 17 goals and 169 sub targets. Alternatively, you could focus exclusively on high-level environmental impact, such as carbon reduction targets; or social impact, such as poverty reduction; or educational improvement. Whatever the decision, it’s key to know where you want to focus your impact, as there is a wide and growing universe of opportunities out there, and it can quickly become overwhelming without clear, predetermined focus. The next step is implementation, and some of the most salient factors are considered below:
Integrating environmental and social impact considerations into your investment decisions is the simplest way to portray “Impact Investment”. To be an impactful investor, you need to apply an impact lens to the entire investment cycle. This includes screening, due diligence, investment selection and exit criteria. All investment decisions can and should consider E and S effects. This is summarised in the ESG Integration Framework developed by the CFA and PRI, which defines three integration levels: Portfolio, Security and Research (see Figure 1 below).
Impact integration requires measuring, monitoring, evaluating, and reporting impact factors most relevant to your investment objectives. Such efforts should focus on relevance and materiality, i.e., the factors most likely to materially impact your impact objectives. To highlight the point, it would likely be wasted effort to establish a detailed reporting process for a financial EdTech strategy’s impact on oceanic life (as important as this factor is).
Additionally, ensuring robust data sources is key to implementing a successful impact integration strategy.
Compliance and Alignment
It’s worth taking time to understand the regulatory landscape. To market and operate as a Sustainable, ESG, or Impact investment manager requires compliance with a growing range of regulations. Europe is leading the way, with the Sustainable Finance Disclosure Regulation (“SFDR”). The key here is whether a product is defined as:
a) Article 6 – no sustainability scope; or
b) Article 8 – E and S characteristics (light green); or
c) Article 9 – fully integrated sustainable objectives (dark green).
An important aspect of SFDR is that it requires all managers to disclose sustainability risks under Article 6, even when they are not promoting ESG products – ensuring impact factors cannot be ignored. This highlights the importance of investors educating themselves on impact issues, and the direction of travel, towards mandatorily higher impact reporting standards.
Another related consideration is the bodies and standards investment managers choose to align with. This can be a complex and confusing area, with an alphabet soup of options, including PRI, IRIS+, SASB, GHG, IMP, GSG, TCFD, and many others. In the first instance, this can be kept simple, by ensuring alignment with the most recognised industry bodies and well-established standards. It is also important to assess how aligned are operating practices of the investment manager with industry best practice, such as B-Corps certification.
Lastly, it is important to align performance targets with impact investment objectives. This does not replace traditional financial return targets and incentives, but adds an additional hurdle based on non-financial performance. Linking investment manager fees and staff remuneration to impact targets is an important step to ensure impact integration is genuine, and incentives are aligned.
So, after reading this, you may be questioning if impact integration is worth the effort? I believe the answer is a resounding “yes”! Not least, to meet the overwhelming demand stemming from client preferences, with numerous studies demonstrating that the majority of customers consider sustainability and impact factors in their purchases. This is increasingly influencing investment decisions and contributing to the rapid growth in the impact investment market.
In fact, impactful professional investment managers are more successful, with a significant survivor bias. Morningstar found that, on average, 77% of ESG funds still existed after 10 years, compared with only 46% for traditional funds. When coupled with the growing requirements of non-financial reporting regulations, this not only makes impact integration worth doing, but something that is likely to become mandatory. And it points to the likelihood that early adopters of impact investment will reap significant rewards, including greater E and S impact, larger, more enduring investment businesses, and better performing portfolios. Surely, that is worth the effort?