How investing with impact is gaining ground among sustainability advocates

Impact investing, a small but fast-growing segment of the investment industry, is responsible investing in its purest form. Rather than tilting a portfolio to the least bad energy provider or the most equitably managed tobacco company, impact funds invest only in companies or projects that offer a tangible, measurable impact in areas of importance to society and/or the environment, whether this be in terms of carbon emissions, improving biodiversity, providing clean water or creating sustainable jobs.

With many types of responsible investing, the impact is unclear. The investor hopes that investing in a clean energy company will reduce carbon emissions, but they have no absolute proof. An investment manager may commit to engagement with the management team of a company that damages the climate or the environment in the hope of changing their behaviour, but progress may be measurable over decades rather than months. Impact investing is different; the investor can see the specific social or environmental impact as clearly as their financial return.

In recent years impact investing has become an increasingly important and influential element of the responsible investment sector. In 2022 the Global Impact Investing Network (GIIN) estimated that more than 3,300 organisations managed $1,164 billion in impact investments.

From SFDR to the Sustainable Development Goals

Since then, the European Union has introduced its classification of funds with a sustainable purpose under Article 9 of the Sustainable Finance Disclosure Regulation (SFDR), which encompasses impact funds.

Impact investment strategies are often focused on the United Nations’ 17 Sustainable Development Goals.

Impact investment strategies are often focused on the United Nations’ 17 Sustainable Development Goals. Established in 2015, the UN framework for social and environmental good practice covers areas including eradicating poverty and hunger, health and well-being, education, gender equality, clean water and sanitation, affordable and clean energy, decent work… They also provide a structure for measuring and reporting on progress, and for holding companies to account.

Investors have been becoming increasingly aware of the difference they can make with the way they use their money. This has spurred burgeoning interest in the sustainable investment sector as a whole. Investment management groups have responded with a vast range of new products.

This can be bewildering, requiring investors to navigate myriad sustainable investment approaches along with their complex terminology. There has also been concern about greenwashing, in which funds badged by managers as sustainable exaggerate the environmental or social impact of their investments.

Do impact investments require financial sacrifice?

Against this backdrop, impact investing is an easier concept to grasp for many investors. With other types of responsible investment, they may still find themselves with stakes in fossil fuel extraction, processing or consumption, or in defence industries, wondering whether these really match their values. With impact investing, they can decide on which goals are important, such as carbon reduction, fairer wages or habitat conservation.

However, the question remains whether investors need to sacrifice financial returns to ensure that their investments are having a positive impact on the world. In recent months, the debate has been muddied by the war in Ukraine and the impact of economic sanctions against Russia. As a result, fossil fuel groups in particular have benefited from the soaring prices of oil and gas. This has benefited alternative energy providers too, especially those enjoying higher prices for their renewable electricity generation, but not to the same extent.

The question remains whether investors need to sacrifice financial returns to ensure that their investments are having a positive impact on the world. (…) Early data suggests that no trade-off is required for investors.

Impact investing is relatively new, especially at the present scale, and it can be complex to judge performance. However, early data suggests that no trade-off is required for investors. A GIIN report, Evidence on the Financial Performance of Impact Investments, examined various analytical studies on impact investing and concluded: “Impact investors seeking market rate returns can achieve them.

“Across various strategies and asset classes, top-quartile funds seeking market-rate returns perform at similar levels to peers in conventional markets. In many cases, median performance is also quite similar. As in conventional markets, however, performance varies from one fund to the next, thus indicating that fund manager selection is key to achieving strong returns. Generally, the range of fund returns in impact investing mirrors that in conventional investing.”

Raising the cost of financing carbon

It is clear that impact investors are likely to be exposed to various long-term structural trends, such as the more or less global focus on reducing carbon emissions, in many cases backed by government incentives to encourage the net zero transition.

The EU has already made significant commitments with the RepowerEU initiative and European Green Deal, while the US’s $1.2 trillion Inflation Reduction Act of 2022 included some $370bn for areas such as green infrastructure, energy efficiency, biodiversity and carbon-free transportation.

Meanwhile, bond investors and banks are increasingly differentiating between sustainable companies and those facing long-term challenges as a result of their environmental or social impact. There is evidence that it is becoming more difficult and expensive for companies that are not addressing their sustainability risks to borrow money – ultimately it could compromise their ability to do business altogether. This is likely to be reflected in long-term share price performance, at least for businesses listed on public markets.

Meeting the data challenge

Impact investing itself still faces a number of challenges. Disclosure by companies is imperfect, and it is not always easy for impact investors to obtain the data they need. While most companies compile reliable data on greenhouse gas emissions, substantially fewer make disclosures on risks to clean water from their activities or the impact on biodiversity. Some areas are easier to measure than others – while carbon emissions can be readily measured, social impact such as labour rights tends to be harder to quantify.

Nevertheless, the trend is toward improvement. The EU’s Corporate Sustainability Reporting Directive (CSRD) provides a framework for corporate disclosure, and impact investors themselves are exerting pressure on companies to provide more and better information. Every year more data is produced, providing easier comparisons and allowing impact to be measured more accurately.

The impact sector is still in its infancy, but it should become more sophisticated over the coming years. It has already struck a chord with investors, and more are likely to be drawn to the sector as measurement and reporting improve, especially if this confirms that there is no trade-off between financial return and an investor’s values. Indeed, it may prove to be the future of sustainable investment.

Impact investing is different from a portfolio targeting engagement with companies in transition: the investor can see the specific social or environmental impact as clearly as their financial return.