CPD: Investing for Impact – how to help your clients cut through the noise

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With growing awareness around the threats posed by climate change investors are increasingly targeting climate action through their investments.

When your clients embark on impact investing, this is done with the idea of achieving positive social or environmental outcomes alongside a financial return. Impact investing involves intentionally targeting investments which make positive contributions to selected social or environmental areas as well as avoiding investments that cause harm to them. Examples include climate action or gender equality.

This has two key implications for your clients’ portfolios:

  • it potentially provides significant growth opportunities in areas with increasing global demand
  • it creates skews relative to traditional portfolios.

In this paper we discuss how impact-oriented strategies can target growth opportunities and manage the associated risks.

For those clients that are genuinely seeking to invest for impact, they will be conscious of the number of products that purport to be impactful but look very similar to traditional portfolios on a look-through basis. We discuss how “greenwashing” can be identified and avoided.

Finally, we discuss some of the ways a financial adviser can engage with their clients to reach the best outcome in terms of both positive impact and financial return.

Opportunities

When looking to invest for impact, it is common to find products oriented around the United Nations Sustainable Development Goals (SDGs). The SDGs were implemented in 2015 as part of the 2030 Agenda for Sustainable Development, which aims to stimulate action in areas of critical importance for people and the planet by 2030. Products that invest for impact will typically focus on specific SDGs and this focus needs to be aligned with your clients’ objectives. This paper will focus on two impact areas that are widely sought after by clients – Climate Action (SDG 13) and Gender Equality (SDG 5).

Climate Action (SDG 13):

The United Nations believes that climate change is the defining issue of our time[1]. SDG 13 aims to “take urgent action to combat climate change and its impacts”[2]. More specifically, this goal supports the United Nations Paris Agreement, which seeks to hold “the increase in global average temperature to well below 2°C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5°C above pre-industrial levels”[3].

With growing awareness around the threats posed by climate change, investors are increasingly targeting climate action through their investments. Typically, managers can address these demands in two ways – at a general level and through targeted investments:

  1. At a general level, managers can support climate action by screening each industry, region or asset class for companies with the lowest carbon emissions and the strongest net zero alignment to include in the portfolio.
  2. At a targeted level, managers can focus on specific investments in climate solutions such as renewable energy, clean technology, forestry and timber and biogas.

With governments and communities pushing to address the climate crisis, these two approaches not only create positive impact but also have clear investment logic: investments that contribute to the climate crisis will be at risk and investments that provide solutions to the climate crisis should perform well.

Recently, in ‘Carbon Might Be Your Company’s Biggest Financial Liability’, the Harvard Business Review concluded that a global carbon price is inevitable and that, whilst the price of carbon is still near zero in many markets, economic models suggest that a global price of US$50-$100 per ton of carbon dioxide (CO2) emitted is likely in the near term and would be expected to rise from there[4]. This means that many companies have hidden liabilities on their books, with high emitting companies at risk of financial distress.

Consider ExxonMobil, who recently had three board members replaced by a small activist investor because they failed to recognise the substantial changes they needed to make in the context of a global energy transition. When put under the microscope, it is clear why investors were so infuriated by this oversight. In 2020, ExxonMobil emitted 112 metric tonnes of CO2-equivalent and other greenhouse gas equivalents (such as methane). At a carbon price of US$100/tonne, that equates to an annual liability of over US$11 billion for a company that has earned only US$8 billion on average over the past five years. Put simply, the push for climate action means that high emitting companies are at risk of financial disaster.

The targeted approach, on the other hand, seeks financial return by investing in climate solutions that have a clear runway for growth. The ‘World Energy Outlook – 2021’ published by the International Energy Agency found that, to successfully transition to a net zero global economy by 2050, renewable energy capacity and generation would need to grow to more than 30 times its current levels in the next nine years, equivalent to an annualised growth rate of 46.5%. With governments and communities becoming increasingly committed to net zero, this growth seems inevitable. In addition to renewable energy, this trend extends to all parts of the climate solutions landscape. For example, the report also found that electric vehicle sales would need to grow to around nine times their current levels by 2030, equivalent to an annualised growth rate of 29.2%. This presents a clear opportunity to create a positive impact whilst experiencing high growth by targeting investments in climate solutions.

Gender Equality (SDG 5):

SDG 5 aims to ‘achieve gender equality and empower all women and girls’.[5] A key focus of this goal is to address the current gender imbalance in the economy, with women accounting for just 28.2% of the workforce in managerial positions globally in 2021. Clients wanting to make a positive impact in this area can invest in products that focus on female participation in executive leadership. Once again, managers can address these client demands in their portfolios at a general level and through targeted investments:

  1. At a general level, managers can screen each industry, region or asset class for companies with the highest female participation rates in senior management and board positions.
  2. At a targeted level, managers can invest specifically into funds that apply a bottom-up gender equality For example, there are female leaders venture capital funds and female economic empowerment bond funds that invest in companies with female founders and CEOs.

There is evidence that these approaches have strong investment potential alongside the positive impact they create. In their 2018 ‘Delivering through Diversity’ report, McKinsey & Company showed that companies in the top quartile for gender diversity in executive leadership were 21% more likely to experience above-average profitability and 27% more likely to experience above-average long-term value creation than companies in the bottom quartile.6

This means that, for clients who wish to create a positive impact towards gender equality, they have opportunities to achieve through their investments while also experiencing strong financial returns.

Risks

For clients wanting to make a positive impact with their investments, managers will have to target assets that have a positive contribution to their chosen impact areas and exclude assets that have a negative contribution. For example, climate solutions-focused managers might target investments in renewable energy and exclude investments in the fossil fuel energy sector.

These impact considerations create skews in your clients’ portfolios relative to the broad market. It is important that managers are aware of these risks and understand how they can be mitigated without compromising your clients’ impact goals.

For example, the Apostle People and Planet Domestic and Global Equity strategies – which have a focus on gender equality and climate action, amongst other impactful goals – follow an investment selection process that includes:

  • full exclusion of negative impact areas from the investible universe, such as fossil fuels
  • bottom-up investment selection based on measurable contribution to positive social and environmental goals
  • top-down carbon and gender lens applied across the portfolio to ensure aggregate impact goals are met.

As a result of this process, the remaining universe has the following skews relative to the broad market:

To mitigate these skews, Apostle takes multiple risk management and risk substitution steps to construct a portfolio with strong impact qualities whilst also having minimal active risk relative to the broad market index.

Risk management

When applying a top-down carbon and gender lens, Apostle includes companies with the best climate action and gender equality scores. Unlike managers who take an absolute approach, this approach manages risk by ensuring the portfolio has a strong level of market exposure whilst only including best-in-class companies based on these goals, leading to a positive impact portfolio with low active risk.

After selecting companies based on this approach, Apostle optimises portfolio allocations to minimise tracking error. This leads to a portfolio with systematic risk in line with the market, allowing company-specific risk to be the key driver of active return, which is directly linked to the ethical and impact selection process.

Risk substitution

For fully excluded areas such as fossil fuel energy, these risks cannot be managed. Instead, they can be substituted with correlated assets that replicate the exposure to some extent. For example, renewable energy can be used to substitute traditional energy as these two areas are often correlated based on market demand cycles. This means that exposure to renewable energy can help mitigate the risk created by the full exclusion of fossil fuel energy.

In short, an impact-focused approach has embedded risks as it creates active positions relative to the broad market. When seeking products that are suitable for your clients, it is important to identify a manager’s level of understanding of the level of these risks and the actions they take to mitigate them.

Greenwashing

In a recent report, the Responsible Investment Association Australasia (RIAA) revealed that 86% of Australians expect their superannuation or other investments to be invested responsibly and ethically. Furthermore, 62% of Australians believe ethical or responsible investing performs better in the long term, which is up from only 29% in 2017. This surge in demand has spurred countless new product offerings focusing on ESG (environmental, social and governance), ethical and impact considerations. To keep up with this trend, however, many managers have moved into this space without sufficient capabilities or expertise, creating the potential for them to overstate the extent to which their practices are environmentally friendly, sustainable or ethical. This is referred to as ‘greenwashing’.

There is growing unease amongst clients about the risks of greenwashing, but help is at hand for financial advisers wanting to identify truly ethical or impactful products for their clients. Regulators from around the world are directing their efforts towards uncovering greenwashing and creating frameworks that prevent its occurrence. For example, the Australian Securities and Investments Commission is currently conducting a review of responsible investment products with the Sustainable Finance Task Force, which was established by the International Organization of Securities Commissions (IOSCO) to improve the completeness, consistency and comparability of sustainability reporting.

A key issue they are tackling is the lack of clarity around the labelling of products and the lack of a single generally accepted taxonomy in this area. One set of rules addressing this is the Sustainable Finance Disclosure Regulation (SFDR), which categorises products in Europe according to their level of impact considerations. For example, they define ‘article 8’ products as those that promote environmental or social characteristics, whereas ‘article 9’ products have sustainable investment as their objective and are required to explain exactly how their products are achieving these objectives. This is a developing framework and the European Commission has indicated that it will be more consolidated by early 2022.

While frameworks like this are still under development, there are key questions you can ask managers to ensure they are truly investing for impact:

  1. Is a sustainability lens applied at all stages of the investment process?
  2. What measures are they using to assess each investment?
  3. Do they measure their contribution to the targeted social or environmental goals and report on these measurements to clients?
  4. Do they have an action plan for longer term goals such as net zero and report on their progress against these goals?
  5. Are they engaging with portfolio companies on impact-related issues and reporting on these stewardship activities to clients?
  6. Do they demonstrate sustainable practices and values at the corporate level as well as in their portfolios? For example, does the manager themselves have a plan for net zero?

If the answer to any of these questions is no, the manager in question may not be suitable for clients wishing to invest for impact.

The simplest way to ensure a manager is not greenwashing is to focus on the reporting elements of their product. Impact-focused products should focus on specific social and/or environmental goals and set out the measurable targets and timelines for these goals. They should then measure the impact of their portfolio and constantly assess their progress towards these goals. For example, the Apostle People and Planet Diversified Fund has four target impact areas, one of which is Climate Action (SDG 13), where Apostle is working towards a net zero portfolio by 2040 or earlier. They provide regular client reporting on the portfolio’s carbon footprint and assess it against the portfolio’s net zero pathway. This reporting eliminates risk of greenwashing as clients can see the measurable impact being created by their investments.

Having the conversation with clients

The responsible and ethical investment universe can be complex with terminology and a framework such as the one devised by RIAA can assist in understanding the differences between the various approaches.

Within this universe, there is no clear right or wrong as each client will have their own set of financial and non-financial values upon which their portfolio will be based. When having the conversation around pursuing ethical and impact investment goals, financial advisers must understand two key things about their clients:

Investment philosophy

What is their philosophy around ethical and impact investing? If they want to create measurable outcomes for people and the planet, they may be better suited to an impact-focused approach. If they simply want to avoid negative impact by excluding ‘unethical’ areas, they may be better suited to a traditional, negatively screened portfolio.

Risk/return objectives

What is their preferred risk/return profile? If they are seeking growth and have a high risk tolerance, they may be suited to a full impact approach. If they seek a more conservative approach with low active risk relative to the broad market, they may prefer to hold a blended portfolio of impact and traditional investments.

Another conversation worth having with your clients is the pros and cons of either side. This paper previously outlined the risk associated with investing for impact as it creates portfolio skews and active risk relative to the broad market. However, avoiding these investments all together leaves your clients exposed to a large number of other risks that may lead to underperformance and volatility over the long-term. These risks include:

  • Investing in declining assets: By not considering the impact of their investments, your clients may be holding assets that are at risk of significant decline. For example, fossil fuel assets are at risk of becoming ‘stranded’ as the global energy transition progresses, meaning they may ultimately become
  • Missing opportunities in emerging assets: As the world pushes towards the SDGs, there are a number of areas primed for strong growth such as renewable energy and climate solutions. If your clients are not invested in these areas they miss out on these
  • Litigation: Investors have started taking legal action against their financial providers for not considering the impact of climate change in their portfolios (e.g. REST Super).
  • Being out of step with society: With growing amounts of capital being invested for impact, your clients are at risk of being out of step with societal norms and expectations and falling out of favour with large portions of the For example, the strongest advocates for impact investing are women and younger demographics, who account for a combined market segment that is too large to ignore.

Where to from here?

Momentum for impact investing is clear and growing. “Values” driven investors appear to no longer be satisfied with traditional, negatively screened, “ethical” portfolios and are increasingly interested in how their investments can achieve a financial return AND a social or environmental return. This movement is being noted across various demographics. Young investors tend to be more engaged with environmental and social issues and “investing with their conscience”, while older investors are turning their mind to the non-financial legacy they will leave behind.

Employing dual objectives – financial and non-financial objectives – introduces further deviations from conventional, non-impactful investment strategies but they are not insurmountable. However, “greenwashing” is a risk to be wary of. Whilst there appear to be a large number of impactful investing opportunities in the marketplace, advisers need to ensure that the stated goals of the client are reflected by the stated goals of the investment. Further, progress towards those goals needs to be measurable and investments need to be held to account for progress towards those goals. Ongoing and honest dialogue between client and adviser will help clarify both financial and non-financial goals and aide in their achievement.

 

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Sources:
THE 17 GOALS, Sustainable Development, un.org
Carbon Might Be Your Company’s Biggest Financial Liability, hbr.org
World Energy Outlook 2021 – Analysis,  IEA
Delivering growth through diversity in the workplace, McKinsey
What is “greenwashing” and what are its potential threats?, ASIC – Australian Securities and Investments Commission
References:
[1] https://www.un.org/en/global-issues/climate-change
[2] https://sdgs.un.org/goals/goal13
[3] https://unfccc.int/sites/default/files/english_paris_agreement.pdf
[4] https://hbr.org/2021/10/carbon-might-be-your-companys-biggest-financial-liability
[5] https://sdgs.un.org/goals/goal5
[6]https://www.mckinsey.com/~/media/mckinsey/business%20functions/organization/our%20insights/delivering%20through%20diversity/delivering-through-diversity_full-report.ashx

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