Narrow definitions risk limiting the investment pool for positive social gains

Impact investments are on the rise. Research in 2018 by management consultants McKinsey found they are growing in popularity. McKinsey expects impact investments to reach more than USD300 billion in total assets under management by 2020. The sums are large but not enormous. To put this in context, USD300 billion is but a small fraction of the estimated USD2.9 trillion that private-equity firms will manage globally over the same period.

But what are impact investments? There is no universal definition. Part of the problem of definition is their long genesis. Over time, they have picked up a myriad of conceptual narratives. The Global Impact Investing Network (GIIN), arguably the leading impact investing organisation, acknowledges the challenge in its recent publication Roadmap for the Future of Impact Investing: Reshaping Financial Markets. For non-specialists trying to get to grips with this, GIIN admits: ‘This universe [of impact investors] lacks a commonly accepted or understood segmentation, creating confusion and opacity that constrains the deployment of investment capital.’

We think GIIN has identified two valid definitional needs: the need to clarify impact investing’s identity and the need to develop investable impact products. The relationship between these two needs – the ‘what’ and the ‘how’ – helps us view and understand impact investing.

While difficult to define precisely, professional investors commonly apply useful broad terms to impact investments. First, they can be considered a derived product such as a listed vehicle in capital markets where positive impacts are hard coded into the vehicle’s mandate. Second, they are also defined by the nature of the investment where specific sectors typically prevail, such as renewable energy. Third is how the investment is undertaken, where any positive outcome is sought, not limited by specific product, mandate or sectors.

While none of the above are mutually exclusive, as investors we need to reflect on how we are undertaking investments and whether we are applying the narrower view of impact investing as a product or as a subclass, or if we are applying it in far broader terms.

However narrow or broad the definition, one thing is clear: impact investors expect to generate financial returns on their investments while supporting positive environmental and/or social outcomes. This is not the same as environmental or social philanthropy.

A continuous process of reflecting and gaining clarity

Impact investing lies within the wider concept of sustainability/sustainable development and environmental, social and governance (ESG) practice. As a term, ESG is now well-established in the financial sector, synonymous with sustainability and sustainable development, which the respected Brundtland Report defines as “… development that meets the needs of the present without compromising the ability of future generations to meet their own needs ”.Good ESG practice is strategic and should be considered a core part of an investment business, and even more so if impact investing is included. But we must be careful if we advocate the use of the term ‘definition’ as it seems too hard-coded, given the complexity of the world. Instead we prefer to refer to ‘interpretations’ of impact investing, these being more flexible and accommodating.

Consider, for example, comparing a wind farm versus a gas thermal power plant investment. On the face of it the wind farm is clearly more sustainable and can be considered impact investing purely due to the nature of the asset, which generates power through a renewable resource (wind), while the gas thermal power plant is a non-renewable fossil fuel that produces climate changing CO2, which is clearly worse.

But what if the wind farm involves high bird and bat mortality of endangered species, large scale erosion in sensitive habitats, extensive resettlement of vulnerable communities which was poorly undertaken, disenfranchising those community members and also involved poor health and safety practices? Now consider a gas thermal power plant in which all ESG issues have been appropriately managed, developed at a site which is not in sensitive habitat, has little or no impact on fauna, is within the country’s agreed model of reducing its carbon emissions over time and is in a country that is in desperate need of power to prosper. Although not considered impact investing due to the nature of the asset, it is arguably better sustainable development.

The above hypothetical example brings out the challenges of definition and can often lead to arguments about pragmatism versus idealism. At the heart of this argument is that the most important, dearly-held human values are often the hardest to measure. Energy and environmental issues are essentially about physical conditions in the real world, and thus susceptible to quantification. Human rights issues are hard to quantify and compare: we know what a degree of temperature is (and it is uniform globally), but what is a degree of human freedom or choice?

The world is complex. We are not referring to the world as being ‘complicated’, but as made up of countless complex systems. Imagine developing a hard-coded definition as drawing the boundary lines of a box. One then places this box within these countless complex systems. First, this action is wholly anthropocentric and we have presumed to understand these complex systems (we are likely wrong); secondly, the hard-coded boundary lines of the box have created exclusion of everything not in the domain of the box. As we are unlikely to have fully understood the complexity we are working in, much of this exclusion will be unintentional and likely unhelpful. Simply put, many investors who could have had really practical, positive outcomes may be left out of the ‘Impact Investing’ capital resource pool.

Critically, each investor must reflect and gain clarity of how they undertake and understand (interpret) sustainable development and/or impact investing, how this should inform their strategy, and how this can be clearly articulated to their stakeholders. This allows for alignment on strategy and alignment of expectations with stakeholders.

Our real world example highlights how impact investing and sustainable development can be complex and messy. Clarity is the issue here. What is key is how your specific offering, your way of thinking and reporting, and ultimately your ESG and impact investing strategies are articulated clearly with your stakeholders. In considering this, investors should first reflect on the full landscape of sustainable development, and the full toolbox of ESG and how this can be applied to all investments rather than defaulting to a potentially narrow view of impact investing too quickly.

A key consideration is understanding your budget to support a determined strategy. Again, one is not arguing that one strategy is better than another, but that rigor is necessary in understanding, distinguishing, choosing among and executing any of these strategies that result from the interpretation(s) of impact investing you wish to adopt.Another consideration is where international ESG standards, guidelines and reporting frameworks find themselves in one’s view and interpretation of impact investing? How will you operationalise these frameworks to ensure that the broad foundation of good ESG practice underpins your investment strategy?

What we should avoid is a narrow focus on impact investing that is to the detriment of good ESG practice and sustainable development across the private equity market, where positive environmental and social outcomes can be delivered to more communities while investors make agreed returns on their capital.

Dean Alborough is Head of ESG at Old Mutual Alternative Investments and Scott Nadler is Principal and Founder of Nadler Strategy and a non-executive director of Ibis ESG Consulting.