On the Way to Impact Investment: Mind the Gap between Theory and Practice

ESG Impact August 1, 2021

Overview

This paper:

  • Reviews some of the most prominent impact management and measurement frameworks developed by leading institutions around the world with the aim of identifying a baseline for what constitutes impact investment;
  • Compares the current state of “impact-branded” investment practices by listed equity investors to the criteria identified in the baseline, in order to assess the level of misalignment in the interpretation of impact in theory versus practice;
  • Identifies the Sustainable Development Goals (SDGs) as a useful framework for assessing the impact of companies, which is confirmed by increased investor adoption;
  • Concludes with recommendations on how the investment community – including investors, regulators, financial service providers, and non-profit organizations – can address this issue; and
  • Sets the stage for further exploration of the societal value associated with the different SDGs and SDG-aligned impact from companies.

Impact investment and why we need it

Despite significant regulatory evolution and increase in financial flows as indicated by the growth in assets managed in accordance with the Principles for Responsible Investment (PRI)1, many of the critical environmental and social challenges facing the world have become even more acute and have led to systemic risks emerging. The most mainstream sustainable investment (SI) practice of ESG (environmental, social, and governance) integration has been defined by the CFA Institute and PRI2 as “the explicit and systematic inclusion of environmental, social and governance factors in investment analysis and investment decisions”. However, the way in which it is being practiced has been deemed insufficient to deliver answers of the right magnitude to the issues at stake by many observers, NGOs, regulators, and investors themselves.

There are numerous interlinked systemic issues that the global community is far from resolving – climate change and wealth inequality being just two examples.

Human-induced warming reached approximately 1-degree above pre-industrial levels in 2017, increasing at 0.2-degree per decade.3 An annual reduction of over 7% in greenhouse gas emissions (GHG) is required to stay within the 1.5-degree pathway, set by the Intergovernmental Panel on Climate Change (IPCC) as the upper limit for preventing the worst impacts of climate change.4 However, global greenhouse gas (GHG) emissions have risen by 1.5% per year over the last decade (2010–2020). Importantly, according to the IPCC, mitigation and adaptation options consistent with 1.5-degrees pathways are associated with multiple synergies across the SDGs.5

In the United States, the average income of households in the top fifth of income distribution was 16.6 times as large as those at the bottom in 2019, compared to 10.3 times in 1975.6 More importantly, financial wealth inequality – which affects income inequality through the capital income generated by wealth – is sharper than the income gap and is growing more rapidly.7 In 2017 the three wealthiest people in the United States owned more wealth than the bottom half of the population combined, while over 19 percent, had zero or negative net worth.8 Even these figures underestimate wealth concentration, as the growing use of offshore tax havens, domestic tax loopholes allowing much of this wealth to not be considered “taxable income” unless assets are sold and gains realized, and legal trusts has enabled concealing of assets more than ever before.9 For example, according to a June 2021 analysis, United States’ wealthiest executives paid USD 13.6 billion in federal income taxes in a period when their collective net worth increased by USD 401 billion.10 A similar pattern is repeated throughout Europe, if less pronounced.11

The “Tragedy of the Horizon” illustrated in former Governor of the Bank of England Mark Carney’s seminal speech back in 201512 demonstrates why investors must now take into account what is known elsewhere as “double materiality” – namely, the financial impact of sustainability issues on a company’s financial performance, as well as the company’s impact on society and the environment (beyond the impact on the company itself) through its operations, products and services. As the SI market matures, financial institutions are looking beyond risk and opportunity to focus on the real-world outcomes of their investments.

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1. PRI 2020. Annual report
2. CFA Institute and PRI 2018. Guidance and case studies for ESG integration
3. IPCC, 2021. Special Report – Global Warming of 1.5°C
4. UNFCCC 2020. Cut Global Emissions by 7.6 Percent Every Year for Next Decade to Meet 1.5°C Paris Target – UN Report
5. Ibid.
6. Congressional Research Service, 2021. The U.S. Income Distribution: Trends and Issues
7. Pew Research Center 2020. Trends in income and wealth inequality
8. Institute for Policy Studies 2017. Billionaire bonanza
9. Ibid.
10. The New York Times 2021. Wealthiest Executives Paid Little to Nothing in Federal Income Taxes, Report Says; FT 2021. US investigates leak of records showing billionaires pay little tax
11. Piketty, T. and Saez, E., 2014. Inequality in the long run. Science, 344(6186), pp.838–843.
12. Bank of England, 2015. Breaking the Tragedy of the Horizon – Mark Carney

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