Should investors care about impact?
A simple question with an obvious answer. Of course they should! Every investment has an impact.
This is not groundbreaking logic. Financial institutions and corporate actors directly and indirectly contribute to the conditions of our shared ecosystems. As long-term investors, how could we not care about the continuing viability of the issuers we invest in or the system in which they operate? If companies fail to account for the roles of all stakeholders — employees, customers, suppliers, communities and the environment — in the creation of economic value, they may ultimately lose their license to operate and everyone, investors included, will be the poorer for it.
Sustainable investing — simple in theory, confusing in practice
It’s often in the best interest of investors to be thinking about the impact issuers have on society and the environment. This is the basis of sustainable investing, and it’s elegantly simple in theory. In practice, it’s become a contentious and controversial topic over which the investment world has managed to tie itself in knots.
Politics has played a part. Sustainable investing, and in particular the consideration of environmental, social and governance issues (ESG), has been the topic of much political debate. But we can’t lay the blame entirely on political misapprehensions. The investment community has done a good job of confusing the issue on its own.
Our industry is inundated with a dizzying array of narratives around ESG, impact investing, sustainability and other related concepts. These narratives ultimately lead to the question of whether sustainability is about making better investment decisions or making a better world.
There doesn’t appear to be a right answer, or at least a complete one.
Perhaps this is because we’re asking the wrong questions. Humans are binary thinkers. It’s only natural for us to seek structured, measurable ways to approach complex problems. Yet my experience has been that complex problems require nuanced solutions. It’s inherently difficult to reconcile value creation with environmental and social preservation in an economic system that operates around short-term shareholder gains. This is at least in part a result of our industry’s excessive preoccupation with short-term financial results and the so-called “pacification” of capital. Not factored in are the social and environmental externalities detrimental to the world and the long-term economic viability of many business models.
What if we envision instead capital allocation as a tool to promote a system that prioritizes financial wellbeing while helping to build a shared prosperity and a healthy planet?
Challenges posed by the current approach to sustainability
We like to think this goal isn’t out of the reach of our collective remit. The recent movement around sustainability is driven at least in part by the recognition that we need to think about things differently. But before we can do this, we first need to reflect on the challenges that have come with how we approach sustainability today.
The first is around implementation. For many, sustainability is about merging certain investor values with financial objectives. Often, what ensues is a narrowing of the investment universe: Only invest in “good” ESG companies and ruthlessly exclude those deemed objectionable. This is problematic for a few reasons, not least because there is a difference between excusing yourself of something you don’t wish to partake in and actively pursuing change. This approach can also inflate the degree of impact being achieved, and risks equating portfolio impact with real economy change.
For example, in public markets, the vast majority of companies are net distributors of capital. They return far more through dividends and share buybacks than they extract through equity issues. In the secondary market, trading out of a high emitter into a lower emitter may help to reduce your portfolio’s carbon footprint and might make it “values aligned” in an attribution analysis, but it has zero bearing on the reduction of real-world CO2 emissions, past, present or future. Surely the real economy must lead and the portfolio statistics will follow. We don’t believe optimizing for carbon emissions at the portfolio level will have any impact on the real world.
Moreover, this approach often results in tradeoffs. As investors seeking financial returns, why would you devise a strategy that ignores critical components of the investment puzzle such as competition, supply and demand, profitability, capital intensity and valuation? A wind turbine manufacturer may play a critical part in the energy transition, but if barriers to entry are low or valuation is full, it may prove a terrible investment. Equally, if an oil company is cheap enough, regardless of the outlook for oil demand, it may be a great investment.
If you really wanted to create an impact in public markets, your best strategy might instead be to create a portfolio of the most-polluting companies and then agitate for change, but we suspect that this would deliver only a modest impact and poor financial returns and could raise issues in light of the investment manager’s fiduciary duty. Alternatively, there is scope to have a positive impact by investing in companies with an explicit social or environmental purpose, but only in the field of early-stage angel or venture investment, where companies constantly need fresh capital to survive and prosper.
The second challenge posed by the current approach to sustainability underpins the first: Most of the issues we’re trying to analyse are intangible in nature and can’t be synthesised. There’s a plethora of existing and emerging standards, metrics, frameworks and guidelines aimed at helping us measure ESG factors. But how can it possibly make sense to impose universal, predetermined templates on the investment community to assess the sustainability of every investment when so much of it is immeasurable?
For example, measuring a company’s staff turnover or wage disparity might give us an indication of its corporate culture, but would it present a complete picture of the employee, supplier and customer experience? Of course not. Intangible factors are by definition unquantifiable.