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ESG Focus: Impact To Join Risk and Return At The Hip

ESG Focus | Jun 30 2020

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

The Responsible Investment Association of Australia's most recent report on impact investment augurs major changes to fundamental investment principles, and to government policies and investment flows over the next decade.

By Sarah Mills

-Impact investing to join risk and return as a third paradigm
-Government policy and funds to play a key role
-Trajectory for 2020 and beyond

The Responsible Investment Association of Australia has published its Benchmarking Impact 2020 report.

The survey of 125 investment groups shows that impact ESG investment (as opposed to best-in-class investment) is experiencing strong growth.

But more on the numbers later. What was interesting about this report is that it also outlines the likely path and role for impact investing in Australia, and the world.

Impact investing the third paradigm

The report's executive summary starts with an interesting quote:

2020 is like no other, with the global COVID-19 pandemic impacting communities and economies worldwide, on the back of Australia’s most devastating bushfire season in history. These events have brought the interdependencies between our society, environment and economy into sharp focus, and reaffirms the relevance of impact as the third paradigm of investing, alongside risk and return.”

This is a big call. To rank impact investing alongside risk and return as an investment driver suggests a complete rewrite of the way in which the world views investment, and a commitment from the most powerful levels of society.

From a political perspective, this is consistent with conservative aims to outsource traditional government social functions to the private sector, and an attempt to fill the social gap that has emerged over the past 30 years as a result of unfettered capital flows. This is a trend that is likely to continue globally.

As the survey states: “Impact investing has emerged as a powerful strategy for investors to intentionally direct capital towards economic, social and environmental outcomes and is at the forefront of this growing awareness and shift in thinking.

“The impact investing community is championing innovative approaches that demonstrate how capital can be directed towards delivery of measurable positive social and environmental outcomes.

“It is leading the development of market infrastructure, including development of a shared language, frameworks and tools for measuring and managing impact more comprehensively and consistently.”

These sentiments also align with the stated determination of governments and big business to underpin the fourth industrial revolution with sustainability. 

Australia’s impact investing respondents and stakeholders

The RIAA Benchmarking Impact report was funded by AMP Capital and the Department of the Prime Minister and Cabinet, and was conducted by the Deakin Business School.

It surveys 125 respondents across several investment categories and explores motivations, intentions and perceived roadblocks.

The report positions itself as a guide for major institutional investors and other investing bodies:

This report is prepared for investors, asset managers, intermediaries, advisers, enterprises, not-for-profit organisations, government agencies and others who have a stake in and/or seek to better understand the impact investment market in Australia. 

“It can help investors understand aggregate performance figures and trends and provide insights into the interests, experiences and challenges of other investors in the Australian market.”

Government policy for impact investing

Survey respondents agreed that government should play a key enabling role through initiatives and tax incentives, providing capacity building for impact businesses, clarifying fiduciary duty to include consideration of impact and improve impact reporting and measurement by providing access to government data.

The Commonwealth Government has several measures in place to support the development of the domestic social impact investment market.

 In 2017, it published a social impact investing discussion paper and the Australian Government Principles for Social Impact Investing.

Since the 2017-18 Budget, the Commonwealth has announced $57m in initiatives. This is relatively small fry but is expected to increase at the next budget in October and may well form part of the government’s covid-19 response.

According to the survey, initiatives include:

• $22.3 million over 10 years to partner with state and territory governments on social impact investing projects; 

• $8 million over four years towards a Sector Readiness Fund to grow the social impact investing market by providing capability-building grants to impact businesses looking to become investment ready; 

• $6.7 million over four years to build the capacity of the Australian social impact investing sector to measure its outcomes and impacts; 

• $15.7 million over three years to fund the co-design, implementation and evaluation of three payment-by-outcomes funding trials in the social services sector; and

• $5 million to establish a Social Impact Investing Taskforce to provide evidence-informed recommendations on a strategy for the Commonwealth’s role in the social impact investing market – in particular, how social impact investing can provide solutions to address entrenched disadvantage and some of society’s most intractable social problems.

Much of the above funding appears to be preparatory funding for the management infrastructure to channel further government funds flows over the next decade.

Industry’s response to government policy

Industry is positioning itself to align with government policy. In 2019, it established the Australian Sustainable Finance Initiative (ASFI) in 2019, a collaboration of Australia’s major banks, superannuation funds, insurance companies, financial sector peak bodies, civil society and academia. 

According to the RIAA report: “ASFI intends to develop a Sustainable Finance Roadmap in 2020 to recommend pathways, policies and frameworks to enable the financial services sector to contribute more systematically to the transition to a more resilient and sustainable economy and to help Australia meet its commitments in relation to the SDGs (Sustainable Development Goals), the Paris Agreement and the Sendai Framework for Disaster Risk Reduction. “

State government policy in this area is fledgling and varied.

The RIAA survey notes that the UN Sustainable Development Goals are the most widely used framework for measuring and communicating impact.

Nuts and bolts: Market posts strong growth

According to RIAA, the Australian impact investment market tripled in the two years to December 31, 2019 to nearly $20bn, with the number of products available increasing to 111.

This compares to the global market of US$502bn, according to the Global Impact Investing Network.

Overall, including impact investment, the total responsible-investment market in Australia grew 13% in 2018 to $980bn, or 44% of professionally managed assets under management.

The RIAA expects that demand for impact investments from Australian investors over the next five years could increase at least five-fold to $100bn (4% of assets under management from 0.7% now), given respondents expected they would allocate five times their current funding to the category over that period.

Investors identified the major brake on investment as the lack of social impact investment opportunities. There is some expectation that government policy and budget support should be used to build this market.

Impact investing yields solid returns

The survey says 93% of impact investors believed their financial expectations were being met or exceeded by these investments, which returned a weighted average annualised return of 5.3% across products in different asset classes. About 75% of investors expected competitive or above market-rate returns. 

Only 25% of investors were willing to accept below market rates of return and only 1% of investors targeted capital preservation.

Despite the overriding financial prerequisite, impact remained the primary motivation for investment (76%) followed by mission alignment (60%) and financial returns (35%).

Investors happy with their impact

The survey says that 93% of respondents also believed the resulting impact from their investments had met their expectations. 

The majority of impact investment products were overwhelmingly directed towards conservation, environment and agriculture ($16.8bn or 84%).

Green investment trumps social investment

About 87% of available products target environmental outcomes – green bonds and environmentally focused investment. 

The survey notes a rapid scaling of the green bond and environmental markets as a result of financial performance and strong product development.

Social investment on the rise 

Nevertheless, the number of products targeting social outcomes jumped tenfold to $2.5bn from $250m.

The weighted average annualised returns (net of fees) between January 1, 2018, and December 31, 2019, ranged between 3.5% for private debt and 11.3% for public equity. Green Social Sustainability Bonds (GSSs) averaged 5.1% and real assets returned 7.4% and Social Impact Bonds (SIBs) returned 3.9%.

Financial returns on impact investments targeting environmental impacts were 5.5% on a weighted average basis for 2018-2019, outpacing investments targeting social outcomes at 4.4%.

Much of the social impact investment comprised asset-based housing investment and AUD-denominated impact investment in developing nations.

Global comparisons

The global impact investing market hit US$502bn in 2018, with more than 13,000 deals being managed across 1,340 organisations globally, according to the Global Impact Investment Network’s (GIIN) ninth annual impact investor survey.

The market is expected to reach US$1trn by 2024 – a very “impactful’ figure.

According to the GIIN survey, two thirds of impact investing products are managed through specialist impact intermediaries. Two thirds of investors target market-rate returns, one third target concessional rates of return, with 15% of investors targeting returns that are capital preservation than market rate. 

The majority of investors (56%) target both social and environmental outcomes, 36% target only social objectives and 7% target only environmental objectives. Overall, investors are satisfied that the impact outcomes and financial performance of their impact investments are in line with their expectations. 

What impact-investors want

The RIAA report finds motivations of impact investors remain primarily financial, although impact is the first priority. While 24% cited ethical reasons, 76% expected competitive or above market rate returns on their investments.

Measurable impact, mission alignment and financial returns were cited as the leading motivators for allocating funds to impact investments.

Investors also called for more investable deals; and evidence and track record of social impact and financial performance.

Their main focus is on early-stage products such as seed capital/start-ups and venture-stage companies, however, there is a dearth of these products in the Australian market.

It is interesting to note that early-stage investments will likely be in hot demand by the broader market as the fourth industrial revolution roles out. 

Investments that have both a 4IR and sustainability profile should be in particularly high demand.

It is this lack of seed product, and reliable information and research, that are proving the main barriers to attracting new participants to the market, the survey finds.

For existing investors, the most important catalysts to investing more funds was reported to be investable deals, evidence of social impact, evidence of financial performance, or a longer track record.

Final sentiments: beneficiaries

The report closes with a section about how and whom its findings may benefit:

“ It can provide product manufacturers and deal makers with evidence that may support decision-making on product development.

“ It can provide asset consultants and wealth advisers insights on investor interest and demand that can assist in understanding their evolving needs. 

“It can also help asset managers by providing a benchmark from which to assess market activity and their own performance and investment strategies. 

“It can help for-purpose businesses seeking to understand the market dynamics of the impact investment market as a potential source of capital. 

“It can help inform government and other policy makers with data and insights that highlight potential areas for policy development.”

Trajectory for 2020 and beyond

Meanwhile, BetaShares reports that its three ethical exchange-traded funds attracted an increase in inflows in 2020, suggesting continued demand for ESG products this year. This year’s October budget should start to clarify government intentions and direction in this area.

The suggestions that product manufacturers and deal makers stand to benefit from impact investing was clearly articulated in the survey, and is also a strong indication of where funds and government subsidies are likely to flow in 2020 and beyond.

Investors can expect an expanding suite of products and opportunities and better impact measurement frameworks, in what is shaping up as an early mover’s market.

The focus is likely to grow to “impact at scale” on specific social and environmental solutions and early movers are likely to benefit. Scaling Impact by Impact Investing Australia is an early source of information on this.

At this stage, it appears highly likely that impact investment will prove profitable over the next five years, given underlying trends and intentions.

However, there is a growing debate about the efficacy of impact investing given investors are increasingly being primed for “investment opportunities” over solutions to problems.

Questions are already being asked about who decides the priorities for investment, and whether funding recipients are worthy; and so on. 

True impact investors will need to see genuine social and environmental change to justify their investments, as opposed to incremental and slightly abstract adjustments in figures such as CO2 levels. 

Similarly, governments will need to prove their stripes in allocating funds to businesses in an independent and impactful manner to avoid accusations of misdirection of taxpayer dollars.

Only the next five years will tell whether the social/environmental investment experiment has any hope of success. In the meantime, the funds will flow.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

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