Think tank examines the causal link of investors on impact.
Investors seeking to create positive impact in the real world can lean on a new approach to identify ‘impact washing’ funds.
Think tank 2 Degrees Investing Initiative (2DII) is currently creating an impact investment framework, which will be released by the beginning of April for consultation.
It is drawing on the work of the Impact Management Project, a forum focused on impact measurement and reporting, and applies an evolving definition of how investments can generate real-world impact. Academics at the University of Zurich presented the idea in a 2020 publication titled ‘The Investor’s Guide to Impact’.
Klaus Hagedorn, Acting Head of Evidence for Impact at 2DII, explains that the definition focuses specifically on the impact of investors versus the impact of companies.
“If you want to claim impact, as a financial institution, you need to measure the actions that you implement; you need to track the changes that are happening in the real economy,” he says.
This means that unsupported marketing claims by asset managers, which claim without evidence or overstate a causal link in the real economy, are impact washing, adds Soline Ralite, Deputy Head of Impact at 2DII.
“As long as, when you read the claim, it’s likely that you understand that there is a causality between the product and the change in the real economy, [but] that there is no evidence to support that, we consider that it’s misleading,” she says.
Hard to trace
The new definition seeks asset managers to also openly acknowledge that their own real-world impact – compared to the one of a company – may be minimal or could be difficult to trace.
Meanwhile, a more obvious case of investor impact in the real world is provided by engagement strategies which are linked to a theory of change, explains Ralite. Other strong evidence for impact by financial institutions exists when companies receive either a cheaper loan or access to capital they otherwise would not have had, she adds.
Investor impact differs between asset classes. In terms of equities and other liquid markets, it is complex to prove the impact of decarbonising a portfolio in the real world, Ralite says.
If asset managers allocate large amounts in a green fund, it could impact the share price and cost of capital of the investee companies and support their growth; and if a large share of the market divests from high-carbon emitting companies, it could lead to their share prices falling and inhibit the firms’ polluting investment plans.
But while this potentially leads to impact in the real world, decarbonising portfolios cannot be seen as being equal with real-world decarbonisation, Ralite explains.
Without greater consensus on how to measure different types of impact, however, it can be easier to identify what isn’t investor impact than what is. 2DII plans to release case studies to clarify when investor strategies have the biggest impact in the physical world.
Evolving impact definition at EU level
Dominik Hatiar, Regulatory Policy Advisor at the European Fund and Asset Management Association (EFAMA), suggests greater distinction between investor and company impact is overdue.
“Investor impact reporting is essential to ensuring accountability for asset managers´ environmental claims. To improve the credibility of marketing impact statements, investors could benefit from a more precise distinction of company and investor impact,” he says.
But he adds that investor impact through the channel of capital allocation remains challenging to quantify and cautions against embedding it in legislation before academic consensus is reached.
“The only mechanism with empirical evidence of positive results is stewardship, and we believe this instrument should be encouraged in legislation,” he says.
Two different definitions of impact exist in EU legislation. The EU has recognised the new impact definition in the latest Ecolabel draft technical report for retail financial products, but not in the Sustainable Finance Disclosure Regulation (SFDR).
“The EU Ecolabel criterion 5 requires investors to report how their products use investor impact enhancement measures, such as capital allocation, environmental exclusions, engagement and measures taken to enhance investor impact. However, SFDR requires investors to report on the adverse impact of their investment decisions on the environment and society at company-level,” Hatiar explains.
He believes that the Ecolabel´s impact reporting adds “unnecessary complexity and costs to the product disclosures in SFDR”.
“Due to the SFDR inconsistency and the methodological challenges in measuring the impact of capital allocation, the Ecolabel should adopt a more flexible approach to investor impact reporting, using, for example, case studies,” he suggests.
Impact washing claims
A marketing claim is impact washing, according to the proposed investor impact definition, if a product claims to trigger a change in the real economy, but this cannot be supported by evidence or relates only to the company’s impact and not to the change caused by the financial institution.
2DII researched impact washing claims in line with the idea of real-world impact already in a report on EU retail funds in 2020.
The report wrote that the main inaccuracies are based on two types of uncertainties, sometimes combined.
This includes conflating the impact of certain economic activities of the investee companies with the impact of the investment strategy itself; and comparing an indicator associated with the companies in the portfolio (usually their carbon footprint) with the market average and presenting the difference as a reduction in the real economy, according to the report.
Green bond funds often combine two potentially misleading practices, the report said: A majority of the funds reviewed maintain an ambiguity between the ‘use of proceeds’ earmarked for green purposes by the bond issuer and the actual targeted financing of the activities; and in most cases, the wording also suggests that the instrument leads to additional investment in the earmarked green activities.
Hagedorn bemoans impact washing claims that sound impressive but are hard to substantiate, such as: “An investment of [US$]5 million in our fund allows you to reduce carbon emissions by 4200 tons, the equivalent of taking 1900 cars off the roads.”
“[Companies] still need to prove that high-carbon assets are taken from the grid,” he says.
Hagedorn concedes that at the moment there is no methodology that allows to quantify a single action by asset managers, adding also it is unclear if that will ever change.
Nevertheless, asset managers should communicate the truth and try to implement actions that have the highest chance to cause an impact, he adds.
Best-in-class impact cases
The distinction between impact by investor and impact by company remains a work in progress, but the direction of travel seems clear. For now, one way for asset managers to aim for impact are engagement strategies with a theory of change and supporting evidence, according to Ralite.
Will Pomroy, lead engager SDG Engagement and Small & Mid Cap Equities at Federated Hermes, explains that the asset manager develops an ‘engagement thesis’, the theory of change, for each company.
This thesis is directly tied to an investee company’s ability to contribute towards the attainment of the UN Sustainable Development Goals. It is, with three years in operation, in the relatively early stages of delivering real-world impact success, says Pomroy.
“In forming this thesis, we look at a company’s supply chain, including its relationships with and influence over its supply partners. We consider the company’s direct operations, including its resource efficiency and approach to its workforce. We also examine its products and services – do they have the potential to reach under-served markets or to develop product offerings supportive of a more circular economy?” he explains.
As an example Pomroy names Alliant Energy, a US utility company which is transitioning away from coal to renewable energy. The firm has given multi-year notice periods of closures to workers impacted from decommissioned coal plants and is working closely with individuals to find alternative employment, he says.
Bridges Fund Investment is another asset manager which applies the theory of change of the Impact Management Project.
Cristina Spiller, Associate at Bridges Fund Management, says: “[The theory of change] helps us understand the causal pathway to the outcomes we seek within our four impact themes.
“It enables us to analyse the short-, medium- and long-term effects of particular inputs and activities, so we can better understand the full impact potential of the asset and also the potential risks involved, both from a financial and impact perspective.”