Everyone who works with investments has heard the word 'impact' with increasing frequency over the past year or two. In the latest column for Compliance Matters by experts from Guernsey's legal sector, Collas Crill Group Partner Wayne Atkinson discusses the merits of 'impact investing' from a regulatory point of view.
Investors are concentrating more and more on making investments with a positive social 'impact;' investments which not only offer profitable returns but also come with the added bonus of good ethical returns because of their sustainability, environmentally positive nature or the way in which they cause social change and well-being.
Even before the phrase ‘impact investing’ caught on, green, clean, social and ethical investments were all badges worn with pride.
A survey conducted last year by the Global Impact Investing Network (GIIN), an impact investment trade body, revealed cumulative impact investment of US$22.1 billion in 2016 by roughly 200 self-identified impact investors who made nearly 8,000 investments between them.
Those same 200 investors predicted that number increasing to $25.9 billion (£15.7 billion) this year and these peoply were simply the respondents to one survey. Rumour has it that the increase will be much, much steeper. GIIN considers an impact investment to be one "made into companies, organisations and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return."
The great pretenders
As a noted economic commentator called Kermit the Frog once taught us, however, it is not easy being green. In a world where investments are differentiated in the market place by virtue of a badge such as 'impact' or 'green,' it is inevitable that many people will want to wear that badge, some with less justification than others.
In the same way that many marketers are displaying some rather dubious 'tech' credentials, many investors are indulging in 'greenwashing' and equivalent forms of behaviour in the social investment arena. To put things very bluntly, one man's social housing provider may be another man's slum landlord.
If an investor were to lose money because he placed it in an investment fund that then invested in a way other than that suggested in its disclosure documents, he would expect to have a claim and would probably also expect that fund's regulator to take action. Investors who make impact investments are no doubt likely to feel similarly aggrieved if their monies are invested in less-than-ethical investments but it would be far harder for them to formulate claims on the argument that they have had their ethics infringed by breaches of investment policy than it would be for them to base claims around identifiable financial losses. Demand is therefore growing in some circles for some form of a ‘stick’ (with which 'non-impactful' impact managers might be hit) to balance out the economic ‘carrot’ that investors dangle when they are looking for impact opportunities.
ROI and social impact
In terms of measuring the effects of purely charitable actions, economists and statisticians are increasingly able to measure and compare organisations' 'impacts.' Websites such as GiveWell are now able to offer comparisons between various charities and show investors where they would can obtain the biggest ‘bangs for their bucks.’ But those are charities. In the impact investment sector, investors are having to gauge two other things: return on investment and social impact.
In circumstances where an investment manager is required to put a certain proportion of a portfolio towards 'impactful,' green or ethical investments it is ony natural for him to want to obtain the highest returns possible. These investments may or may not also offer the greatest social return but surely if they are to deserve the name of 'impact investments' they should offer a de minimis level of impact. This begs a question: is it even possible to define and quantify an investment's impact? If so, should we regulate funds that wear such a badge to ensure that they reach their lofty goals?
If we can set minimum requirements, the obvious next question would be who should determine whether an investment meets this de minimis level; is this a matter for self-certification or for external auditors? Once we have decided on that, what happens if an investment fails to meet expectations in terms of 'impact,' either because a project fails to meet expectations or because an external event causes the investment to change?
Fund regulation - is it the answer?
More and more funds and fund promoters are claiming to be making some form of 'impact' and various regulators have considered whether to regulate such entities for this specific purpose. Funds have always been categorised in a number of different ways. Some of their categorisations come from portfolio composition and very specific restrictions on investments, notably those that surround Undertakings for the Collective Investment of Transferable Securities or UCITS. Others come from certification by someone whose expertise is recognised by target investors; for example a scholar of Shariah law.
Regulatory restrictions on the composition of portfolios are problematic, especially in such a complex area. Regulators can rarely keep up with the marketplace and are unlikely to be able to assess investments' social impact well; besides, they have plenty of other jobs to do.
It is highly arguable whether or not a financial services regulator in, for instance, Guernsey, has, or should have, the expertise necessary to assess the social benefits of a micro-finance company in Africa. That is a job best left elsewhere with specialists. Of course, in transferring responsibility for confirming an investment's nature to an external professional monitor, the question then becomes one of who monitors the monitor.
One place where we have seen an attempt to mandate an investment's impact in this way is the London Stock Exchange's bond market. Here the front-line regulator has launched a number of what might be called 'impact segments,' offering issuers a flexible range of market models for ‘green bonds.’ According to the LSE model, green bonds have the same regulatory status as 'non-green' bonds.
Certification for green bonds
However, to get their green bonds admitted to the LSE’s dedicated green bond 'impact segments,' issuers are required to provide 'second opinion' documents that certify the nature of the bonds.
The London Stock Exchange does not dictate the choice of 'certification provider' but does set minimum criteria that the "third-party green-bond certifier" should meet in order for the instruments to be included in the relevant LSE green bond segment. The admission criteria that the exchange uses are aligned with Green Bond Principles developed by the International Capital Market Association. Every third-party reviewer ought to be:
- independent of the entity that issues the bond, its directors, senior managers and advisors;
- remunerated in a way that prevents any conflicts of interests arising as a result of the fee structure; and
- a specialist in the assessment of the bonds’ environmental objectives, with enough financial and market-specific expertise to assess the use of proceeds (with expertise demonstrable through either past experience or links with trade bodies) comprehensively.
This model has proved popular in the market place and at the end of November the total number of green bonds listed on the London Stock Exchange Group's markets was 59, with £14.3 billion (US$20.2 billion) raised. The LSE also offers Social Bond and Charitable Bond categories as well, again working with ICMA.
How to compare apples with apples
One issue that does remain, however, is that the rules are relatively non-prescriptive. There may still be considerable variance between the greenness of various offerings, so what does someone who wants to be dark green rather than light green do - compare bonds and the credentials of certifiers himself? As mentioned earlier, the green marketplace concentrates on a single issue (or cluster of issues) and is therefore likely to be easier to quantify than the broader concept of 'impact.'
B Lab, a US non-profit organisation, has tried to answer the question of whether funds have suitable 'impacts' not by setting a de minimis set of standards but by building up a rating system - GIIRS - which creates "a holistic picture of [a] fund and portfolio companies’ impact." This allows investors to compare one fund with another and do some 'benchmarking,' the better to root out funds that are failing to live up to their "social missions." It is, as one user described it, "a standardised way to compare apples with apples across different impact areas."
It may be that in future, in addition to being certified as ‘green’, ‘social’ or ‘impactful’ by an independent arbiter, a rating system like this is applied to almost all investments in much the same way that many investments today have S&P or Moody's ratings and the marketplace takes it from there. Perhaps these ratings would in and of themselves dictate that funds and their portfolios that reach a certain threshold on GIIRS or a similar system are good enough to belong to an impact sector. Perhaps, eventually, ethical AAA ratings might then be possible.
Although the current situation is something of a quagmire, with standards and terminology varying wildly and confusing the layman, it would appear that the marketplace itself is regulating people's idea of 'impact' through the mechanism of demand. In essence, this is a question of credibility in just the same way as a broader financial track record is.
Financial service regulators in various parts of the world might indeed attempt to create ‘an impact fund product.’ If so, they ought to do this on the LSE Green Bond model, with relatively simple, clearly-designed requirements for an independent certifier to meet.
An excessive overlay (too much stick, not enough carrot) beyond that may well stifle innovation in the marketplace and delay or reduce the injection of capital into projects that can use it to make the world a better place. One hopes that the various bodies in this field will continue to make progress and work towards a global standard of some kind; perhaps the GIIN will be just the tonic that the world's financial markets need.
An original version of this article first appeared in Compliance Matters, 27 March 2018.