ESG Focus: Counting On Additionality

ESG Focus | May 26 2021

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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:

Counting On Additionality

As the world awaits the formal adoption of the EU taxonomy this month, and the passage of trillions of dollars into green investments, FNArena homes in on the concept of additionality.

-Additionality and impact key to sustainability premium
-The critical distinction between ESG investing and investing for additionality
-All eyes on the impact horizon – where to invest?

By Sarah Mills

US President Joe Biden in April announced an acceleration in US emissions reduction targets, heralding the funneling of trillions of dollars through the global economy for the sole purpose of creating a sustainable future.

But as we reported in previous articles, green-washing and eco-fraud are already commonplace and the transition investment period has barely begun.

Even among credible companies and investments that are worthy of transition funding, some will be more sustainable than others, but most importantly, some will have more impact than others: and this is where the real treasure lies.

At its most basic, impact equals additionality; but not all impact is created equal. 

Additionality, in its purest form, refers to impact that would not otherwise have occurred were it not for this investment – we expound on this below.

The test of additionality is being touted as one way of sorting the wheat from the chaff when assessing environmental and social projects given it helps determine a company’s prospects for yielding the coveted “sustainability premium”. 

The concept also poses specific challenges for passive investors, also discussed below.

In today’s world, there is a risk in not adding value, which many investors have not considered.

Circularity is another litmus test, which we will examine in a separate article, but it also is an avenue to additionality.

Defining additionality

To get the ball rolling, we have started with the Wikipedia definition of additionality, and the Stanford Social Innovation Review’s (SSIR) definition of impact investing.

The Wikipedia definition is as follows:

“Additionality is the property of an activity being additional. It is a determination of whether an intervention has an effect, when the intervention is compared to a baseline. ‘Interventions' can take a variety of forms, but often include economic incentives.

“The notion of ‘additionality’ tends to be of great importance to traditionalist impact investors: to be impactful, investments should pass the ‘but for’ test: it would not have happened, but for our investment.”

The SSIR argues that the “but for” implies “financial sacrifice”, and believes it is only likely to be found in smaller, imperfect markets – hence mainly private markets or IPO markets:

“If an impact investor is not willing to make a financial sacrifice, what can he contribute that the market wouldn’t do anyway?” asks the SSIR. 

“We believe that in publicly traded large cap markets, the answer is nothing: even quite large individual investments will not affect the equilibrium of these essentially perfect markets.”

“With this core concept in mind, we define the practice of ‘impact investing’ capaciously, as:

“… actively placing capital in enterprises that generate social or environmental goods, services, or ancillary benefits (such as creating jobs), with expected financial returns ranging from the highly concessionary to above market.” 

The Business Dictionary defines additionality as the:

 “Extent to which a new input (action or item) adds to the existing inputs (instead of replacing any of them) and results in a greater aggregate.”

Additionality is not for the passive investor

The adverb “actively” in the SSIR definition is critical and applies to both additionality and impact investment.

Impact investors are innately active. This is because the very definition of additionality is to “add value”, not passively screen out risk. 

As a result, most definitions of additionality exclude negative investment screens because this is a passive strategy.

So funds using only negative screens fail the impact litmus test at the first hurdle.

Negative screens may have provided a good first brush three years ago, but they won’t cut the mustard going forward.

At first glance, this appears to shaping up as a problem for passive investors broadly. 

Passive investors tend to favour public markets and large liquid exchange-traded funds.

Even sustainability indices, as discussed in the previous article on additionality, would likely fail the additionality test.

So under these definitions, upside is reduced while risk rises.

Reiterating the above: in the brave new investment world, there is a growing risk to not adding value.

If the test of additionality cannot be applied to existing investments, then public-market investors are left largely scouring the IPO market for opportunities.

So for example, if a solar project was going to be built regardless of your investment, theoretically that doesn’t count as additionality, given another investor would have built it and no more environmental impact than not taking action.

As a result, much of the genuine impact activity is occurring in the private market, leaving largely table scraps for many public-market investors.

A battle brewing over application of definitions

The above definition of additionality is, to most eyes, extremely broad and open to interpretation. 

As FNArena reported in the previous article in this series, pure impact investors focus heavily on additionality: yielding a change that would not otherwise have occurred were it not for the investment.

Such investors would argue that the bulk of transitioning investment would have occurred regardless, due to either regulation, or competitive pressure.

Transition investors, however, prefer a loser prescription, claiming that transition is itself an impact.

Gita Rao, of the MIT Sloan finance faculty summarises this argument as follows:

“In a sense, the term ‘impact investing’ is an oxymoron, because all investing is inherently impactful: you are investing with a specific objective.

“That's why my course is titled ‘Social Impact Investing', because we're focusing on the impact that investing has beyond financial return. In addition to financial return, you're hoping to generate an environmental or other impact.”

A battle is brewing between these two camps for the world’s green funds.

In particular, between those who believe the term additionality should be applied to “transition” initiatives by brown companies and existing majors; as opposed to new green initiatives.

In Germany, this problem was largely solved by government compensation for brown coal and nuclear companies.

In the rest of the world, this appears to be being left to market judgment.

Basically, it is a minefield. Some believe additionality should only apply to new projects – which tend to be the province of the private market, favouring fund managers.

Blackrock for example recently launched a partnership with Temasek, called Decarbonisation Partners, that plans to launch several late-stage venture capital and early-growth private equity investment funds that will focus on advancing decarbonisation solutions.

Some analysts are openly sceptical of non-additional projects being brought to bond markets.

“If you want to reduce your own carbon footprint, you’re not going to ask your mortgage provider to give you a discount for doing it,” Jonathan Butler, co-head of global high-yield at PGIM advises The Wall Street Journal.

“This is effectively just a backdoor way of private equity reducing their margins [on borrowing costs].

Despite the purists, and despite the fact that much of the initial investment will be in private markets, many successful projects will find there way to the IPO market.

But given there will be so much activity occurring behind the veil, it will be difficult to know whether a technology is already obsolete.

Breaking it down – the difference between ESG investing and impact investing

Brown companies and crowd transitioners do not strictly qualify as “additional”, but rather fall under the broader category of ESG investing.

MIT Sloan makes this distinction:

“There is a distinction between impact investing and ESG-based investing. Investing for impact is often described as investing with a ‘double bottom line’ — that is, financial return and a clear, well-articulated set of impact goals, often, but not always, aligned with the United Nation Development Programme’s 17 sustainable development goals (SDGs).”

The broad consensus is that brown transitioning companies are less likely to yield a sustainability premium in a transitioning world, although much depends on the will of big capital, corruption and government regulation. 

Across the broader market, existing majors that transition along with the crowd are more likely to hold their value but are vulnerable none-the-less. 

Those that that are first-movers and continue to successfully innovate are forecast to outpace their peers.

Those that introduce successful, novel proprietary technology and processes (impact and additionality) should attract a sustainability premium.

Those that successfully introduce technology or processes or knowledge that changes the world (the game-changers), should prove the big winners.

One key term is that of social value

The UK Treasury has this to say on the subject:

“Additionality is a real increase in social value that would not have occurred in the absence of the intervention being appraised. 

“Leading asset owners and asset managers have already expressed clear preferences for projects that provide additionality in the form of funding for low-carbon projects that would not otherwise have been funded. 

“In addition, any form of project funding for a traditional green bond gains credibility in the marketplace only when the issuer has demonstrated that project commitments support a coherent energy transition plan and a credible sustainable finance framework.”

The latter paragraph does cut transitioners some slack, and companies are likely to test these limits.

Another key term is quantitative

Not all impact is equal and one of the greatest variables here is that of degree.

Investors want to know not just if a corporation is having an impact, but how much impact.

Investors are likely to pursue alternative goals if the expected impact in one area is too low. 

This may completely alter the manner in which capital has flowed in the past; hence recent pronouncements that impact is to join risk and reward at the hip.

Efforts to quantify the degree of impact are relatively nascent.

Determining the magnitude of enterprise impact demands an assessment of costs and social benefits, but the whole area is poorly defined and some groups of investors have a considerable advantage in this respect over others.

The introduction of reporting standards will at least guide the market as to which social and environmental benefits are regarded as countable but will they guide to relative value?

As it stands, it appears the UN Sustainable Development Goals represent the guiding principles and the global reporting standards (once created) will reveal the specific targets and relative value of these targets to the powers that be.

But it seems it will it be left to the market (perhaps guided by regulators and their information distribution channels/media) to guess the rest – in particular, the hierarchy of social and environmental value, and degree of impact.

For example, climate change is the king of the castle, but at some stage (for example, when the transition is irreversible) it may be dethroned by a rival such as biodiversity or circularity, and investors will find themselves chasing the money.

Additionality, impact, and degree of impact are variables in this mix, as is circularity. 

By applying these principles across a broad range of social and environmental priorities, investors can gain a more diversified protected path than simply chasing the money. 

Yet impact investing is fraught

They say the road to hell is paved with good intentions, and it is hard to imagine an area to which this applies more than impact investment.

Impact investments carry two risks: the usual financial risks that any company faces, and impact failure.

The prerequisite for impact and additionality is success.

Investors (or regulators) may be prepared to sacrifice financial return for impact, but there is no guarantee their investment will yield the impact they seek. 

Also, subsidising microfinance and community development institutions have been both positive and harmful in different circumstances, which could lead to unforeseen policy changes.

Also, as some analysts point out, additionality is a term that is relative to its baseline. However, the baseline of carbon offsets, for example, can be entirely hypothetical, as it is precisely what is being avoided, says the CFA Institute Magazine.

Another risk in the ESG environment is that of government subsidies, which we know will be flowing thick and fast.

Subsidies can mask an enterprise’s inefficiencies and crowd out healthy competition. 

IEEFA recently wrote of a recent green issuance by Indonesian power company PNL which was really just a disguised working capital shortage – there was zero impact, or additionality.

Fossil fuel companies are another example. The most heavily subsidised industry in the world for decades, it took a decree from on high to loosen its grip on the global economy. 

They will continue to be the recipients of distorting subsidies for some time, and the game of musical chairs continues.

The argument in favour of high impact

Many analysts agree the path to accessing the sustainability premium is to lean heavily on the side of impact.

Head of Responsible Investment at Zurich Insurance Company, Manuel Lewin, on behalf of the Cambridge Sustainable Investment Leadership (CISL) Group, notes that its very definition shifts the focus to more innovative financial instruments.

It favours smaller transactions and social and environmental issues that can be narrowly defined.

Nordea’s Jacob Michaelson agrees noting that meeting the European Commissions objectives in particular will require innovation.

The European taxonomy is expected to be formally adopted this month.

A matter of faith? Enter the G in ESG

There appears to be a notion that impact investing based on conviction, or faith, is more likely to yield greater social and environmental returns than investing for financial return (partly given the latter is more estimable in public markets than in new ventures).

This harks back to the “Who Cares Wins” mantra of the early architects of the global transition in the 1990s, but leaves most investors’ heads spinning. Most investors prefer to punt on a combination of the two.

This is why governance – the oft overlooked member of the ESG trilogy – in the form of oversight, transparency and disclosure will be crucial to the green bond and sustainability issuance market; and equity markets going forward.

Summary and closing observations

The greater the impact and additionality; the greater the sustainability premium.

For example, if a project was to be built regardless of investment then the “impact” quotient is reduced and hence the likely premium.

Analysts suggest sticking to triple bottom line: ESG, additionality and circularity; and screening for biodiversity and SDG goals.

MIT Investment Conference panelist Quyen Tran, a sustainable investment strategist at Wellington Management Co, looks for three attributes in companies for its Global Impact portfolio:

– Materiality (meaning a prospective firm’s core products or services – rather than its operations – must solve a problem that falls under one of three global impact themes: life essentials; human empowerment; and environment);

– Additionality (meaning the company provides a product or service that a competitor or government entity isn’t providing, thereby advancing rather than simply maintaining social or environmental goals);

– Measurability (which provides a way for investors to ensure the company continues to meet or exceed the investors’ impact goals); and

– Scalability – the company has to be able to grow.

Transition investments broadly fall under the ESG umbrella rather than the additionality umbrella.

As such, it is unlikely that impact will be yielded from fossil fuels in the existing political climate, given the world is transitioning. 

One exception may be in the field of carbon capture, utilisation and storage (CCUS) which, while dubious, appears to have received the nod of big capital (Morgan Stanley estimates it will become a US$2.5trn industry).

However, as mentioned in previous articles, given the industry’s lack of commercial viability CCUS may be simply a disguised fossil-fuel subsidy. 

We will discuss carbon capture storage and its various application in more detail in our series on renewables.

Globally, major diversified miners such as BHP Group ((BHP)) and Rio Tinto ((RIO)) have offloaded their coal holdings. 

Their focus now is the race to introduce genuine impact within their operations to give them a competitive edge as both a fund recipient and a more sustainable organisation.

Post 2025, when much of the groundwork has been laid for the transition, sustainability of resources companies is likely to come into focus.

The impact horizon

In FNArena’s next article on additionality, we explore the impact horizon: the distant field where roams that rare beast: the elusive impact opportunity.

For example, investment in the developing world, almost by definition, delivers impact, as the infrastructure did not exist previously – in health, manufacturing, education and so on.

Circularity offers opportunities to create impact, as does health, and solving global problems such as plastic pollution.

We also break down the components of enterprise impact. 

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