Impact investing or the ultimate frontier in sustainable investing – Oxford/24 Report

This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.”

ABSTRACT

The lack of a standard definition of impact investing results in many interpretations of impact and that creates concerns in the market thorough greenwashing. The challenges to implement measurement of the impact, reporting it and proving additionality of these investments makes impact investing a very niche form of investment.   

Thus, transparency from funds on the specific role of sustainability in their investment process is key to ensure trust in the market and help scale it. 

Additionally, simplification in the amount of sustainability related rules is necessary so the focus moves away from excess disclosure requirements to incentives of investments. A simpler and more effective regulatory environment that facilitate innovation and encourage investment into sustainable solutions is what it is more needed.  

KEY WORDS 

Impact, additionality, measurable, sustainability, risk management, regulation, labelling, greenwashing, comparability, transparency, stewardship, engagement, metrics. 

CONTENT 

All investments have impact. While this means investors need to be very clear about the definition of impact investing in order to avoid greenwashing, it also means we need to be transparent and realistic in our approach. Today when we say impact investing, we mean positive impact investing. But the world will not reach the sustainable future targeted by impact investors without companies that are currently excluded. And we must also consider the negative externalities of positive impact investments – even positive impact solutions providers have negative externalities. Impact improvement, the delta, should be just as important as the focus on positive impact if we as a community are serious about encouraging change. 

In terms of assets under managenment, Impact investing registers a steady growth, at 14% CAGR over past five years (based on GIIN 2024 State of the Market Report) 

We have seen a number of favourable drivers for the growth of the impact investing market in recent years, where the overall trend we see is the gradual movement from ESG (risk management lens), to sustainability (shift towards how an investment can positively contribute), and then further to impact (targeting measurable, significant outcomes for society)   

Some of those drivers include:  

• Tangibility and urgency of solutions (and financing) needed in the market around e.g. climate change  

• Hand in hand, the promises that corporates have made around net zero  

• Wealth transfer to younger generations who tend to care more about the impact of their investments 

• Regulatory perspective, SFDR, SDR, CSRD which may drive some of that higher level of focus on impactful investments   

However, there is still a long way to go, as impact still only represents a small percentage of AUM. Some key calatysts that could help to attract flows:  

• Track record: Whilst the first generation of the large impact PE funds are starting to generate financial performance data (which shows impact funds generating returns comparable to other non-impact PE products), it will take time for the industry to build a longer-term track record, and also across different asset classes. If the concept of investing with a focus on the impact of a company’s products and services on society and the environment is going to break out of its current niche position within the portfolios of asset owners, it needs to deliver returns that are comparable with traditional global equity strategies through the cycle 

• Quality of impact management and impact comparability: it is important to improve the quality of impact measurement and management, so that investors can be reassured that the impact performance being reported is credible. The industry still needs more consistency and convergence in the market in terms of definitions and methodologies, to enable better comparability across offerings, which will help investors make more informed decisions.  

• Taking a more pragmatic approach can also help here. By being forward looking, focusing on companies that are important in the transition to the sustainable future or that have the potential for positive impact in the future, impact investors can broaden their investable universe. This can reduce the inherent style or sector bias in current impact strategies, reducing relative performance volatility and broadening the investment appeal of the concept. 

Emerging areas or segments in impact investing  

Significant investments in the climate space – around mitigation solutions (renewable energy, energy efficiency, electrification etc.); infra investments that enable the energy transition is also very topical 

Looking more broadly at environmental and sustainability solutions that are needed, how we safeguard planetary boundaries will become an increasing area of focus, e.g. solutions that help us reduce the reliance on production of fossil-based materials such as plastic, or those that reduce our production of chemicals harmful to the environment. 

In terms of types of asset classes – whilst a lot of impact investing is in PE / VC in private markets, there is growing appetite of investors in impact private credit.  There will be increasing interest in how players deliver credible positive impact in this asset class, beyond sustainability-linked loans which has historically focused on footprint reduction (rather than positive impact, or ‘handprint’ contribution). 

Stewardship and engagement 

From the private markets perspective, depending on the type of investment, engagement can be done in different ways. So for example, for impact private credit, focusing on embedding impact requirements into the loan documentation upfront, and in addition, some practicioners are starting to develop impact-linked loans where appropriate, where discounts to interest rates are linked to the company’s achievement of specific impact KPIs. Impact PE sponsors, or PE sponsors who have appetite to move into the impact space, are interested in working with impact-specific credit funds, because there is alignment in terms of impact objectives, and it is often a helpful recognition of the impact PE investments are generating if an impact private credit fund were to choose to be a co-investor. 

For other asset classes, engagement approach adapts accordingly, e.g. for indirect PE fund investments, one practical approach could be selecting impact PE fund managers who have high quality impact practices, and then engaging with them on impact measurement and management aspects, reporting best practices, and trying to facilitate convergence on specific methodological topics across partners where possible.  

Some important benefits of stewardship are not only gaining valuable insights into the issuer’s strategy, governance, and management practices, but it can also use its influence to encourage a focus on long-term, sustainable value creation and to drive positive impact. It requires continuous follow up, monitoring and if required, escalation. Changes that we are seeking from a governance, strategy or disclosure perspective are often not quick wins. Need to have clear objectives when engaging and be able to articulate progress to investors. 

In public equities, to have an additional investor impact, we need to see active and deep engagement with companies to encourage and accelerate change. While in private markets investors may claim an impact through capital allocation, additionality is less demonstrable in public markets and additional active ownership is required. Even through engagement however, investor impact remains very hard to measure and report. Regulation and asset owner demand is focused on simplicity, but simplicity in impact metrics risks missing nuance, reducing the critical relevance and materiality of the KPIs provided. Measuring impact remains a key challenge in the space.  

Potential issues and debates with impact investing 

One of the most important issues found around impact investing is the lack of a standard definition in the market. 

Asset managers/investors need to be very clear and concrete in its definition, investment approach, philosophy and process, otherwise could result in greenwashing and/or be value destructive. So multiple definitions translate into multiple approaches to impact investing. From Integration to Impact: there are multiple shades of sustainable investing. Therefore, fund labelling could be misleading.  

There is a general view that impact investing involves aligning investments with sustainability or ethical preferences, but it does not mean there is a sacrifice on performance and returns.  

Complexity of the impact investments can be confusing for clients when. Every firm has a slightly different approach to impact investing with different scopes, calculation methodologies and definitions.  This could be due to overlapping issues and the fact that impact can be quite subjective. For example, having a positive impact could lead to negative impacts for other areas within ESG. Such as closing coal plants which could have negative social impacts for local communities if that is the main income stream. 

In addition, Fund labelling regimes coming such as SDR, SFDR v2, ESMA guidelines and AMAS in Switzerland which all have varying approaches. Trying to run an impact strategy which is compliant with overlapping regulations in different jurisdictions can be difficult.  

This is a constantly evolving area so staying up to date with regulatory development is crucial. If investors are not compliant with certain regulations or obtaining certain labels, firms run the risk of being screened out by clients.  

Complete transparency is key to navigate in this environment. Investors need to be extremely clear what the investment approach is, the impact metrics that are considered and how this is calculated. 

Difficult to implement properly. 

The precise definition of Impact Investing means investing to achieve positive social and environmental impacts – thus it requires measuring and reporting against these impacts demonstrating the intentionality of investor and underlying asset/investee and demonstrating the investor contribution. While impact investing is perceived as the ultimate goal for many ESG investors, it is also the most difficult to implement. 

 Assessing holistically the positive and negative effects of a company or project on people and the planet is a challenging exercise. Among others, it needs to consider the multiple sustainability dimensions, which may be measured using different indicators, and are sometimes contradictory. 

Proving additionality is extremely difficult particularly in public markets, that is why it is generally perceived that impact investing is more of the remit of private markets.  

Excessive and complex amount of sustainability related regulations focused on disclosure requirements, impact measurement, metrics reporting can become an impediment to attract investment in the field. A regulatory environment that fosters technological innovation and provide incentives to invest in sustainable solutions is necessary. This would attract interest from any investor, not just an impact investor, which will really help mobilize capital.   

CONCLUSIONS AND PROPOSALS 

The challenges to implement measurement of the impact, reporting it and proving additionality of these investments makes impact investing a very niche form of investment. However there is a steady gowth in terms of assets under management and some catalysts that can help to attract inflows. 

Transparency from funds on the specific role of sustainability in their investment process is key to ensure trust in the market and help scale it. A simpler and more effective regulatory environment could facilitate innovation and encourage investment into sustainable solutions. 

Stewardship and engagement are key in this segment in order to add value, generate change and encourage a focus on long-term, sustainable value creation and to drive positive impact. 

AUTHORS

Oxford/24 Final Report:

This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.” Held at Jesus College, Oxford on September 18th, 19th, and 20th, 2024, the Congress brought together world leaders in finance, regulation, and sustainability. This comprehensive report consolidates key insights from the event, offering strategic recommendations to financial institutions and regulators on transitioning to a low-carbon economy and reaching net-zero greenhouse gas emissions by 2050. 

The full report can be found at: https://bit.ly/oxf24-report