The impact measurement revolution
It is increasingly clear that to meet the challenges of the climate emergency and address social problems, good intentions are not enough. Against this backdrop, the latest frontier in responsible investment is impact investing. This is investing to produce a tangible goal, such as lower emissions, labour reforms or clean water. Today, the market for investments designed to create a positive social or environmental outcome is $715bn in size and rising fast.
For charities, there is a growing body of evidence that this approach can not only boost financial performance, but also enable them to align their investments with their charitable aims.
It can help expand their mission: a child welfare charity can invest in companies which are tackling child labour, environmental charities can ensure that their investments help reduce carbon emissions or encourage biodiversity. Impact investment is a way for a charity to deliver more than it could through its day to day activities.
The Charity Commission’s guidance on this area for financial investments is being revised but they are waiting for the outcome of two High Court cases due any minute which will update the case law. The Charities (Protection & Social Investment) Act 2016 widened the options for charities to use their assets in a way to further their aims and make some financial return through programme related investment and mixed motive investment.
Understanding impact investment
It is impossible to deal with the scale and severity of the social and environmental challenges faced globally without harnessing the resources of the private sector. As shareholders – and as allocators of capital – charities can exert powerful influence on companies’ behaviour. They can pour money into enterprises creating measurable impact, while draining resources from those companies creating environmental or social harm.
The old model, which put shareholder primacy at the top of the tree, has not encouraged this behaviour. If anything, it encouraged wasteful use of natural resources or human capital in pursuit of profit above everything else. To create the change needed, a wholesale redesign of the capitalist system is required, from one of shareholder primacy to one of stakeholder primacy. Charities should be at the forefront of this shift.
It means that shareholders, customers, employees, the environment and wider society all become part of an organisation’s purpose. For organisations, being able to demonstrate real positive impact both qualitatively and quantitatively will be a major differentiator. It will influence the extent to which they can attract capital, and the cost of that capital.
It is also likely to see new types of enterprise emerge, led by entrepreneurs with different priorities. These are likely to be able to attract capital, scale up and deploy resources much faster and further than before, and thus achieve much more impact. Those which can’t show positive impact will face higher costs and will be left behind. The charity sector will be no different. New types of charities will emerge with new objectives. It is a new environment, for which trustees need to be ready.
The systematic reporting of positive and negative environmental and social impact is a starting point to harness market forces and create enduring change. Investors and regulators are increasingly starting to demand more granular data. This measurement is where the revolution starts. All public and private organisations including charities will ultimately need to be included in this transformation.
The impact sector is still small, but has accelerated recently, growing more than three-fold in just two years, according to the Global Impact Investing Network (GIIN). With new capital, the sector has evolved, spreading from the high net worth/philanthropist market to institutional and then retail investors.
Defining and measuring impact
The term “impact investing” is still relatively new, coined in 2007. The philosophical premise is relatively straightforward - to balance financial returns and positive social or environmental impact. Impact investors will consider a company's commitment to corporate social responsibility and how it interacts with society as a whole.
However, there are some obvious challenges. A system of measurement and reporting has had to be constructed from scratch. This is still work in progress and it will take time to get it right, but policymakers, regulators and accounting institutions are working to define and cost exactly what constitutes environmental and social impact, both good and bad, and how this can be incorporated into the accounting standards of each organisation.
To date, we have seen the EU taxonomy (list of environmentally sustainable activities), the EU Sustainable Finance Disclosure Regulation (SFDR) and the G20’s Taskforce on Climate Related Financial Disclosures (TCFD), all of which are helping to create a framework that allows for greater measurement of impact. In the UK, the government has pledged that TCFD reporting will be mandatory across the country by 2024/5; and for larger entities (FCA rules) the mandatory reporting starts from 1 January 2021.
While the early iterations of SFDR were watered down, regulators are unlikely to defer indefinitely and more stringent disclosure and reporting rules are expected shortly. The EU already has its environmental taxonomy, which is due to come into effect later this year, which gives it a good framework for similar efforts on measurement on social issues.
Amit Bouri, GIIN chief executive, wrote earlier this year: “In 2010, most [investors] used their own systems to track impact outcomes. Now, almost all are aligning around a core group of [impact measurement and management] systems.” The GIIN has developed its own IRIS+ system, which provides data to gauge whether investments achieve their social and environmental goals.
In 2019, the International Finance Corporation, the private sector division of the World Bank, launched a framework called the Operating Principles for Impact Management. The IFC principles are more stringent than the GIIN rules, largely because the information has to be vetted by an external auditor.
The Harvard Impact-Weighted Accounting standard has also had a significant impact. On launch, Harvard said: “The mission of the Impact-Weighted Accounts Project is to drive the creation of financial accounts that reflect a company’s financial, social, and environmental performance. Our ambition is to create accounting statements that transparently capture external impacts in a way that drives investor and managerial decision making.”
Broadening of measurement
Measurement is broadening out. Early on, the environment has taken centre stage. It is relatively easy to report on carbon output, to set targets for reduction and to see whether those targets are being met. The same is true on biodiversity or water targets, though these are at an earlier stage of reporting and measurement.
However, the “S” (social) in ESG is becoming more important. As the Covid-19 pandemic hit, citizens became more tolerant of government intrusion into their lives. Expectations have changed, and this is likely to accelerate social impact measurement too. This is still in its infancy in the UK and there are challenges around disclosure – can companies measure the social diversity of their staff, for example? What measurements can be put in place to judge wellbeing?
That said, there is progress in this area, and it is likely to be a major focus over the next 12 months. The EU has already published a first draft of a social taxonomy. Progress may be slow, but this change is coming.
The impact for companies
In the longer term, as these frameworks become more widely used, the “impact” of an organisation will have a greater bearing on its value. With standard rules agreed across the globe and accounts weighted in a standardised way, within a decade all investors and all projects could be routinely screened against risk, return and impact. The aim is to galvanise companies into more responsible behaviour.
GIIN’s Bouri has said: “We cannot unsee what this past year has revealed. There will be no miracle cure, no silver bullet for the economic and social recovery ahead. Instead, to truly address the underlying problems exposed by the pandemic, we need to tackle our systemic gaps from more than one direction.”
On the other hand, it becomes more difficult for non-compliant companies to raise capital. Increasingly, more assets will be managed under the impact umbrella and companies will be judged on their social and environmental impact. This is ultimately likely to be reflected in share prices. . If a company’s impact is clear, it will be more difficult for investors, particularly those that need to answer to other stakeholders, to be conspicuously committing capital to companies with a negative or social impact.
This is likely to accelerate a process already taking place, whereby “bad” companies with poor impact scores are likely to see a higher cost of capital. This will make them less competitive and less able to invest to achieve wholesale change. For charity investors, there is not just an ethical argument for prioritising companies with good impact, but also a financial one.
A more sophisticated measurement of impact will go some way to addressing the pernicious problem of greenwashing. It should help ensure that governments and companies deliver on their promises. It is clear to many responsible investors that those companies with large, well resourced investor relations team are adept at delivering the highest ESG scores. With impact measurement, it is far more difficult to greenwash a company’s output. As impact reporting becomes more important, companies have fewer places to hide.
Trustees preparing now
As a trustee, you need to be aware that this is coming. Charities have been at the forefront in terms of reporting impact and therefore the measures being put in place should not be unfamiliar. Increasingly companies are reporting in a more sophisticated and granular way, which makes it easier for charities and their advisers to quantify the impact of their portfolio.
Equally, there is plenty of information on impact investment. The TCFD website is a useful source of information about governance. The Charities Commission revised its Charity Governance Code in 2020. We see standards going up across the sector.
That said, charities may also need to be prepared for bad news. Impact scores for publicly quoted companies in their portfolios may not be as hoped. It is worth remembering that we are only in the foothills of this new way of viewing corporate purpose. For companies, their willingness to engage, and to address areas of weak performance may be every bit as important as their initial scores. In the early days, impact scores are about quantifying the extent of a problem, rather than trying to achieve the lowest score possible.
This is an exciting new dawn in investment. Suitability and diversification requirements will not change but for charities it will become easier to make the same impact with their investment portfolio as they make with their day to day activities. It will be easier to blend the goals of the charity within an investment portfolio. It will not happen overnight, but the change will be profound.