by Kim Wonnacott November 19, 2020
While investors’ knowledge about Responsible Investing has generally improved over the past few years, the increasing diversity of thought in the market has created new layers of confusion. Overall, investors are better equipped to grasp the distinctions between Environmental, Social and Governance (ESG) and impact investing, but remain rather perplexed about the differences between sustainable and impact investing, often mixing one with the other. From a distance, sustainable and impact investing appear quite similar. A closer look, however, reveals meaningful differences.
The muddling of definitions isn’t all that surprising considering that sustainability and impact investing has only recently joined the mainstream Responsible Investment spectrum. Both approaches have come to the fore as they cater to investors’ growing appetite for investments that help to combat environmental issues and improve social outcomes. As reported in the most recent Global Sustainable Investment Review, sustainability-focused and impact strategies were the fastest growing areas of Responsible Investment between 2016 and 2018, with AUMs growing at 269% and 79% respectively.
Admittedly, this is from a low base, but the latest survey from the Global Impact Investor Network (GIIN) indicates that growth has been sustained for impact strategies, with the impact market estimated to have grown from $502 billion to $715 billion between 2019 and 2020, or +42%.
The sombre reality of COVID-19 seems to have galvanised even more interest in both types of investments. Although investors have been drawn in by their relative resilience in recent months, the severity of the outbreak has also led to a greater appreciation of the vital role played by company employees, and has shone a light on the breadth and depth of global inequality – prompting a refocus on our communities and the health of our people and planet.
Yet, how do we differentiate between sustainable and impact investing?
Despite the Investment Association’s (IA) best efforts to flesh out a legible ‘Responsible Investment’ framework last year , confusion remains stubbornly entrenched and wariness around terminology has not convincingly lifted.
As per the IA’s definition, sustainability refers to investments that fulfil certain sustainability criteria and/or deliver specific and measurable sustainability outcomes. The IA identifies three types of sustainability funds: ‘themed’, ‘best-in-class’ and ‘positive tilts’.
Impact, meanwhile, (endorsing the GIIN’s definition) is described as investments made with the intention to generate positive, measurable, social and environmental impact alongside financial returns.
Sustainability-focused and impact funds have a lot in common…
In contrast with ESG funds, whose emphasis is really on strong operational practices, both sustainability-focused and impact funds go a step further by focusing on economic activities (products and services) that deliver positive outcomes. As such, they often invest in similar sectors such as renewable energy, green technology, clean water, education and healthcare, to name a few.
…but the similarities stop there
Impact investing isn’t ‘better’ than sustainable investing, it is simply more demanding, with a stricter set of rules. Hence, for investors and fund managers, it means fishing from a shallower pond of potential investment candidates.
In addition to financial returns, which generally constitute the primary objective of sustainability-focused funds, impact funds seek to deliver on an ‘impact objective’ as well. To evidence the meeting that impact objective, managers of impact funds have an obligation to measure the positive outcomes that have been achieved, and report on these at least once a year. These are onerous requirements, but are essential to maintain the integrity of the impact investing approach.
Another hallmark of impact investing is ‘intention’; the positive impact a company delivers cannot be accidental. There has to be a genuine intent to engage in activities that directly contribute to making the world a better place. Many sustainability stocks lack this essential sense of ‘positive purpose’ or intention and, therefore, do not qualify as impact stocks.
‘Additionality’ is another determining tenet of impact investing. In simple terms, this means that the given impact would not have been achieved if a specific company did not exist. Looking at it the other way, many commoditised solar equipment makers, for example, might be sustainable, but would not reach that additionality threshold as they are easily substituted. Conversely, companies pioneering technological breakthroughs, such as low-cost gene sequencing methods or next generation energy-efficiency simulation software, would qualify as additional.
The principle of ‘materiality’ also weeds out certain sustainable stocks from impact portfolios. The activity or products delivering impact must represent the bulk of a company’s revenue, or it will fail the impact materiality test.
Last but not least, the ‘affordability’ or access factor, is exceptionally important in distinguishing between impact and sustainability. Take the area of education as an example. Educating wealthy students in the US would be unlikely to count as impact. By contrast, providing affordable, quality education to under-served young people in Brazil probably would. In the same vein, evidencing affordability and access is also critical for impact investments in sectors such as healthcare and financials.
Inevitably, the more stringent set of rules imposed on impact investors means that there are a number of popular sustainable stocks that would not be found in impact portfolios. These may be good companies with sustainable business models, but they just don’t pass the test when it comes to creating measurable impact. While the popularity of sustainability-focused and impact funds is greatly welcomed, and indicative of a thriving Responsible Investment ecosystem, this growth needs to be accompanied by full transparency and a clear explanation of their different attributes. This is the only way investors can make informed choices, and ensure the fund management industry remains true to its goal of providing genuine sustainability-focused and impact strategies.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.