An A to Z of impact investments
Investors far too often consider impact investing and ESG (Environmental, Social and Governance) investing as being synonymous. There are similarities between the two investment styles, but they should not be conflated. Impact investing is characterised by having a dual mandate. Investors aim to provide a positive and measurable social and/or environmental impact whilst also generating robust financial returns. As such, investments within an impact mandate aim to solve the world’s problems.
Measuring impact investing usually requires some reference to the Sustainable Development Goals (SDGs) as established by the United Nations. The SDGs, which were adopted in 2015, are a set of interconnected goals to achieve a better and more sustainable future for all. Within each goal, there are a set of specific targets. In total there are 17 SDGs with a total of 169 targets.
ESG investing, however, is an investment style that zooms in on the negative aspects of investing. It is looking at how a specific company is run – the different practices they carry out and how that affects returns. For example, does the company in question do the right things when it comes to the environment?
ESG is therefore simply an additional tool to enhance financial analysis. The ESG analysis will aim to identify ESG-related risks and opportunities and, in doing so, it will aim to achieve a better financial return. ESG investors do not aim to solve the world’s problems in the same way that impact investors try to. As such, there is usually no reference to the SDGs when referring to ESG investing. We therefore place ESG investing at the least stringent end of the spectrum of responsible investing.
Impact investing can create a greater positive impact than ESG investing. A growing number of investors are thus looking at this space. In fact, over the last couple of years, the demand for impact investing has increased substantially. The millennial generation play a part here, given their greater focus on positive social and environmental change. In order to achieve this, they are choosing to become more active with their investments. Asset managers are taking note and have begun to integrate impact within a range of their products across various asset classes.
Across these asset classes there are various impact investment solutions, themes and opportunities that could be attractive from a financial sense, but more importantly are able to generate a positive impact. Here is an A to Z of potential opportunities within the impact investing space now and for the years to come.
Agriculture: The agricultural industry accounts for a large amount of carbon emissions, behind only energy, transport and manufacturing/construction. Investing in this area and improving the sustainability of agriculture (whether that is land, machinery or data-driven) has the potential to have the biggest positive impact on the environment. This can be through more sustainable and more efficient methods of agricultural production or improving data collection to better forecast weather patterns etc. Moreover, with deforestation slowing, farmland supply will be even more constrained. Farmland prices will rise substantially and efficiency will need to improve.
Biodiversity: This is the variety of life on earth at all levels, from genes to ecosystems, plants and animals, and the abundance of it is essential for the survival of the planet. Insects and bees pollinate crops, healthy soil prevents landslides, flooding etc. and many medicinal drugs are found in nature. It is therefore imperative that species extinction does not rise substantially. Companies that are trying to fix these issues include planet-friendly farming practices, businesses that are supportive of nature, and those creating a more circular economy. These tend to be more focused on technology and innovation. There are also product innovations, for instance rhino bonds, which aim to increase the populations of black rhinos. This could be the first of many wildlife conservation offerings.
Climate Change: This is perhaps the most advanced in terms of attracting investors. There has been a wide range of climate change products being launched and this is the area of impact that companies seem to be most focused on, and for good reason. Climate change can result in a whole host of other issues – melting glaciers, rising sea levels, and changing weather patterns such as more frequent weather disasters, all of which can impact people’s livelihood as well as animals and the places they live. Investing to diminish the effects of climate change will typically mean investing in companies that are low or zero emitting, or companies that are looking at cleaner energy.
Diversity: Diversity is getting much more airtime these days, with respect to both investment teams and portfolio companies. This is because gender, ethnic and cultural diversity can lead to better investment decisions. According to research by McKinsey, companies that come in the top quartile for gender or ethnic and cultural diversity are more likely to outperform on earnings. Research like this is likely to encourage more investment into diverse companies, which in turn will encourage companies to increase diversity, creating the positive impact over time.
Education: Globally, over 250 million children are out of school. There is a clear need to invest in education to reduce this problem, and there are many ways to do so, such as increasing school funding, increasing education service delivery or even encouraging innovation in teaching/learning methods. Technology is also an area which could enhance the education process and bring it to a larger number of people, particularly in the developing world. However, this is a long-term investment, especially on the impact side where it is likely to take years to see the benefits and even then, it can be difficult to measure success.
Food: By 2050, the dietary needs of an estimated 10 billion people will need to be serviced, which will no doubt require the provision of healthier and more sustainable food. There are three key themes that can create the most impact. Veganism and plant-based diets will help to alleviate the negative climate and environmental impacts associated with the production of meat. Efficient (precision, vertical, hydroponic, aquaponic etc.) farming can increase the quantity and quality of crops through technology while agricultural science is a more innovative solution, where companies focus on seed science (gene editing and breeding technologies).
Grid infrastructure: The energy transition and any realistic path to a decarbonised economy will require a significant increase in spending on the electric grid, and it will need to happen sooner rather than later. As we are quickly integrating more renewable energy into the economy, the grid and grid technology will need to be developed to enable the movement of affordable and reliable electricity to where it is needed the most. This is especially the case in developing nations where power systems will need to be rapidly expanded to meet growing electricity demand and support economic growth.
Hydrogen: A world with zero carbon emissions will need a lot of hydrogen, but what is important is the method in which the hydrogen is produced. Right now, most of the hydrogen is grey, where it is produced by heating fossil fuels, which emits greenhouse gases. Blue hydrogen is the next most popular because it involves producing hydrogen in the same way (so no additional costs) with the greenhouse gases stored underground. However, the technology of carbon capture and storage is not yet achievable at scale. This is why green hydrogen, where energy from renewable sources (solar or wind) separates hydrogen from water, will be needed to decarbonise the world. The potential next step is purple/red hydrogen, which involves the use of various forms of nuclear power.
Infrastructure: Traditional infrastructure probably has a more harmful impact on the environment – think airports, toll roads etc. However, infrastructure in the form of renewable energy i.e. solar panels and wind farms will of course benefit society. Moreover, the new wave of infrastructure in digital assets is also likely to have a positive impact on society. This can include the grid infrastructure but also things like data centres, fibre and towers, which all result in better and more easily available access to the internet and telecommunications. Not only does infrastructure provide these benefits; it can also provide more jobs, of which a large proportion can be higher-skilled.
Job creation: This has been a metric that is always talked about, especially in private equity, infrastructure and property. These are asset classes where companies are either in their growth stage or in need of development or construction work, which naturally means more workers are needed. However, investing specifically with job creation in mind means more than just looking at the absolute number of jobs. There should be more of a focus on high quality jobs, good working conditions, jobs in underserved communities or certain groups of people or to prevent certain issues like recidivism. There are specific projects out there that aim to achieve this, but these metrics should at least be considered in traditional investments.
Keeping people healthy: Okay, this is a bit of a cop-out. Hydrogen made better sense for H, but I couldn’t leave out healthcare, especially given we’re still in a global pandemic. An ageing population in the developed world will need more healthcare while the growing middle class in the developing world will demand greater access to healthcare. A lot of interesting things are already happening in the world of medicine and healthcare from gene and cell therapy to AI & bionics and robotic surgeries. Asides from actual treatments and cures, more will need to be done on the mental health side, healthcare affordability and accessibility, as well as promoting active lifestyles and healthy diets.
Lithium: The main reason to gain exposure to this commodity is because of its use in batteries. Lithium-ion batteries are favoured in electric vehicles and consumer electronics because of lithium’s high efficiency. It is also essential for energy storage solutions. As such, the demand for lithium is only going one way. However, acquiring lithium occurs through either mining or extraction from brine water, which are both unsustainable and have adverse environmental effects. More innovative solutions such as extraction of lithium from seawater are where the interesting investment opportunities are.
Microfinance: The world bank estimates that 2.5 billion adults are financially excluded worldwide. This is where microfinance can help. It is a form of finance where banking services are provided to low-income individuals or groups who would otherwise struggle to get access to finance, particularly in developing markets like Asia, Africa and Latin America. Investing in this area would usually involve a Microfinance Investment Vehicle, which pools assets together and then provide loans to microfinance institutions, which in turn provide loans or micro-credits to individuals, small businesses or small projects in need of financing.
Nuclear: There are plenty of sources of energy that are clean – solar, wind, hydro, hydrogen, but if we are serious about our aspirations to eliminate carbon emissions within the next 20-30 years, then nuclear energy is probably the only realistic solution, given the unreliability of renewable energy sources. In fact, earlier this year, the EU Commission presented a new climate act which labels nuclear (and gas) as green. This move suggests that the EU is seeking to mobilise private investments in activities that are needed to achieve climate neutrality by 2050. This is likely to drive demand for uranium while supply becomes constrained.
Oceans and water: The oceans are getting polluted by both people and businesses. Water is quickly becoming a scarcity and clean water is becoming hard to come by. This needs to reverse, or at the very least slow down, if oceans are to remain in good condition with clean water accessible to everybody. This can be done through investments in sustainable fisheries, aquaculture, water purification technologies and water-reducing production processes e.g. efficient farming. Even investments in companies that are looking to provide water to a greater proportion of people in the less developed world.
Property: There are two ways in which impact can be achieved in property markets. One is on the climate front given that buildings are a significant contributor to carbon emissions. To combat emissions, properties should be reducing energy consumption, improving energy efficiency, using renewable energy as well as the whole construction process becoming more efficient and environmentally friendly. Secondly is through sustainable cities and communities. The quality of the build and surroundings are key to the safeness of the community, and this comes in the form of streetscape, transport, connectivity, amenities etc.
Quant: This one isn’t strictly impact investing, but given the rise in quantitative strategies in traditional equity and credit funds, there is no reason why this can’t happen for impact funds, at least for public equities and credit. There is probably not enough data to plug into quant models yet, but as data standards increase and transparency improves, impact strategies do have the potential to be quant-driven.
Renewable energy: This is nothing new. Renewable energy accounts for a large part of total energy production in many countries around the world. The main forms of renewable energy are solar, wind and hydropower. While they are clean sources of energy, they are unreliable and there is also the lack of storage solutions at scale. Investing in these renewable sources can be attractive, particularly if you take on the development or construction risk. Further opportunities can be found in technological developments such as skybrators, algae solar panels or storage solutions.
Social and affordable housing: A lack of readily available social and affordable housing remains a problem in many countries, particularly in the UK. Increasing rental payments and falls in affordability is contributing to increasing homelessness. Social and affordable housing aims to solve this by providing accommodation to individuals with low incomes or with particular needs at affordable rates. Investing in these types of properties still provide exposure to the housing market and any reduction in rents can be alleviated by purchasing properties at bulk discount rates or, for registered providers, obtaining government subsidies.
Timberland and forestry: This involves the ownership of freehold land, for instance a forest on which commercial timber is produced and harvested i.e. the sale of a crop in a sustainable manner. To mention the obvious, trees contribute to offsetting carbon emissions, thus playing a key role in global decarbonisation. Also, timber is considered the most sustainable building material in construction and further, wood pellets from timber are not only renewable but are also one of the most eco-friendly forms of wood fuel available.
Utilities: This definitely isn’t the first sector you think of when it comes to impact. It’s not a sector with a low carbon footprint. However, capital that is invested with utility companies could directly go towards projects that provide a positive impact. Capital can be allocated to building new wind and solar facilities or service the distribution of electricity. It can even play a significant role in water management – that is by supplying clean and safe water globally, sewage treatment plants, desalination plants and more generally through the water cycle (from the production and distribution of drinking water to treating wastewater).
Vehicles: Plans to become carbon neutral in the next few decades will mean there has to be a number of changes in the energy space. One of the most important will be accelerating the transition to zero emission vehicles. This comes in the form of electric vehicles and the movement away from combustion engines. It’s not just Tesla involved in this area. All traditional carmakers are getting involved and adapting to the movement to electrification. Exposure to this theme can come through electric vehicle manufacturers or along the value chain for example materials such as semiconductor chips, batteries, lithium etc. Investments into new technologies for next gen electric (better battery technology) or self-driving vehicles could also be opportunities to exploit.
Waste: Plastics in the oceans, landfills everywhere, excessive food waste and fast fashion. These are just some of the issues we face, all of which contribute massively to pollution. The impact play here is to aim to invest in companies that promote the creation of a zero-waste economy. This could mean investing in the likes of efficient packaging companies or sustainable fashion companies, or other businesses where there is an emphasis on reducing, reusing and recycling waste.
XX (female) empowerment: This has been a problem for centuries, and it still is today. Women tend not to get an equal right to their male counterparts when it comes to education, economy, politics, jobs, salaries and many other activities. While this has been improving in recent years, there is still a long way to go. To promote this, investments can be made in in female-led businesses, companies looking to improve female health and education accessibility or even investing with an eye to engage companies on increasing female representation on company boards.
Younger generations: They are the ones who will be driving growth in the economy, particularly focusing on impact solutions through a better understanding of technology. Investing in the youth, through education, or even in businesses built up by younger entrepreneurs could therefore result in greater impact than traditional entrepreneurs who may not be as adaptive to impact and sustainability in the same way.
Zero carbon: Companies are now thinking about carbon neutrality, where they will offset as much carbon as they emit. However, they will need to take the next step and go zero, whereby, as the term suggests, there will be no carbon emissions whatsoever. While this is still a long way away, the work must start now. Significant investments will be needed in current and new clean technologies, and away from fossil fuels. Also, in the meantime, the likelihood of carbon permit prices to increase (which regulators can achieve by limiting supply) will encourage more companies to move to zero carbon exposure more quickly.
28 April 2022