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ESG Focus: The Impact Horizon

ESG Focus | Jun 09 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:

ESG Focus: The Impact Horizon 

Having examined the concept of additionality, FNArena now checks out the impact horizon – the distant fields where additionality and impact-producing companies graze.

  • Capitalism’s next phase
  • The impact horizon
  • The green transition, the developing world and circularity
  • Checking out stocks with impact

By Sarah Mills

In the previous article in this series (link below), we examined the concept of additionality and key concepts such as the distinction between ESG and impact investment; active investment; degree of impact; and social value. 

Now, to quote Star Trek, we boldly go where few have gone before – the impact horizon.

Star Trek’s title sequence is a perfect example to describe the spirit and nature of impact investing, and the Star Ship Enterprise a great analogy for the corporate enterprise in the impact market. 

Additionality refers to “adding” value from a predefined baseline and generally in accordance with the United Nations Sustainability Development Goals (SDGs). 

To do that, impact investors, very much like the Star Ship Enterprise crew, scour the world for impact and value-creating opportunities, before bringing that information back to the mother-planet (in this case the capital markets) to mobilise capital and resources in their direction.

Unlike the Star Ship Enterprise, which appears to be run by the government, the most significant impact investment is expected to take place in the private markets before being brought back for carriage by the public markets.

But first, a quick recap on additionality and impact 

Impact investing, traditionally viewed almost as an asset class, is now viewed as lens through which all investment is cast, and it is a filter for the sustainability premium.

In many respects, impacting investing turns traditional financial wisdom on its head. It's about counting outcomes more than outputs.

Keeping outcomes front and centre in assessing prospects, alongside risk and reward, is critical.

Given additionality and impact boil down to outcomes, “intentionality” on behalf of investors becomes a key term. Degree of impact, long-term investment timeframes, and flexibility are also key terms.

Impact investing is active – exclusion screens don’t count and fall under ESG investing.

Additionality and impact are often interchangeable but there is a difference. 

Not all impact is considered “additional” in that investing by its very definition creates impact. Not all that is “additional” is impactful in that something new does not by definition create impact.

Additionality is defined by a number of factors such as degree of impact, social value, degree of innovation, solution-orientation, distance from the pack, and “newness” (the best way to describe this might be an example of building infrastructure in developing economies where none previously existed).

Or: “To boldly go where no man [or woman] has gone before”.

The concept turns much of traditional investment wisdom on its head – in particular, risk-reward balances, with impact now joining risk and reward at the hip to create a three-sided investment see-saw. 

Financial fundamentals remain universal but financial outcomes shift according to the new risk-reward balances, and the altered subsidy environment; and timeframes are critical given rapid change can unseat the most solid financial fundamentals.

Running with the pack carries greater risk; failing to contribute to socially beneficial change (which includes the environment) carries risk; and innovation, often perceived as a threat to established industries, is to be encouraged and rewarded – at least that’s what it says in the press release.

To succeed, companies will have to innovate and restructure their business models, creating closed-loop systems, and most likely invest in developing markets where the burgeoning middle class and younger demographics will pick up the demand slack from flagging Western demand. 

In other words, they have to find ways to fire new demand, and these endeavours are in part to be funded by an increase in resource efficiency, which also comes at a cost.

Capitalism’s next phase

Over the past 30 years, power has been transfered from the government to the private sector. 

The transition is an acceleration of this. 

Governments denuded of funds and corrupted beyond redemption have no power to protect the environment or improve social value – both of which are essential to securing the future of capitalist enterprise (or any government for that matter).

The markets are now expected to improve health and social outcomes as that becomes a cost of doing business in a true user-pays model. 

People devoid of money and health don’t buy many products and companies need resources as much as any human.

And solving social and environmental problems will free up young consumer demographics to consume, creating new markets as Western demand fades, keeping the capitalist machine alive.

In a way, it is the capitalist machine seeking greener pastures. Having exhausted the low-hanging fruit in the West with its relative security and legal systems, it is going to have to forage further afield.

So private interests via the capitalist machinery are usurping, or reclaiming these roles in what appears to be a modern version of feudalism (no government in history has been able to ignore the society in which it operates).

As the world industrialises, population and demand pressures on existing resources represent an ever-present threat to existing markets and global stability. 

Extracting greater value from and protecting and rehabilitating existing resources will be critical for a sustainable future for all companies.

Existing industries are much less likely to be protected from innovation than in the past. 

Disruption will become more the norm rather than the exception. 

Barriers to entry in many industries are likely to be dismantled, meaning more companies (but certainly not all) will have to compete on a slightly more even playing field. 

On the other hand, barriers to entry will rise in some respects, as companies are forced to pay living wages; but will fall in other respects, by inviting smart competitors who were previously unwilling to operate sweat shops. The bias remains in favour of big capital.

Avoiding the impact investment treadmill

The risk of obsolescence to investors is rising. 

New technology today may be obsolete tomorrow. The timeframes for introductions and rollouts are likely to narrow.

The health arena is a classic example. Much of the traditional pharmacological technology is soon to be replaced by frequency medicine. 

Frequencies have been being patented for decades now by big pharma and others, with a Harvard professor notably patenting a killer frequency for malaria as early as the noughties; and frequency is already being used in cancer treatments in Germany and around the world in various guises. 

This stands as a reminder that the transition and various industry disruptions on the horizon have been planned for decades; and those in the know have a significant jump on the technology rollout in this respect.

This is why “degree of impact” is so critical when investing for additionality. 

Playing safe is dangerous because the horse has already bolted and investors run a real risk of constantly chasing the money/innovation and being consigned to the investment treadmill. That is why some argue that it is safer to opt for greater impact over incremental impact.

For example, once circularity is initiated, then new innovations are generally considered less impactful and innovation shifts to improved efficiency within the circular system, creating ever-diminishing impact returns within that innovation cycle until the next phase of innovation.

Hence the new investor is constantly mining for efficiency-driven innovation.

It’s a bold new world and additionality is not lurking in the shallows.

On the flipside, impact funds are scouring the world for game-changing, disruptive innovation so there should be no shortage of opportunity, but how to distinguish between winners and losers?

We start with some examples in this article; and in our next article, in the absence of accounting methodologies (which will no doubt come) we outline methodologies that can help investors sort the wheat from the chaff.

The impact horizon

So, where can investors go that no man has gone before?

The green transition, the developing world and circularity currently sit at the top of a loose and interchangeable impact hierarchy.

The green transition.  Moving from a fossil-fuel based economy to a renewable economy is all additional – it is all new infrastructure.

Not much needs to be said about the green transition that hasn’t already been said.

But it is worth adding that green priorities feed into circularity and developing world priorities given they incentivise greater vertical integration and various forms of centralisation (which generally demands better work conditions and a reduction in labour arbitrage). 

The developing world is a no-brainer. Almost any successful investment in any industry from infrastructure to health to education will yield impact and be “additional”, while simultaneously aligning with the SDGs of supporting the developing world. 

But because so many contributions to the developing world have impact, again, it all boils down to degree.

There are significant risks in the developing world: weak securities markets affect liquidity and exit strategies, then there are the usual governance issues such as bribery, property rights and contract enforcement, poor governance and legal frameworks.

This often requires local engagement, on-the-ground expertise or personal connections, which generally are not available to most public market investors, illustrating again the clustering of opportunity in the private market and the longer term horizons required for impact investing.

Circularity is another.  It is additional in that it turns a scarce resource ideally into an inexhaustible resource, requiring infrastructure, technology and processes that did not exist previously, while simultaneously extracting hundreds of billions of dollars from waste, turning outputs into inputs.

Circularity boils down to degree and purity. 

For example, plastic recycling, from plastic to plastic is direct; from plastic to fuel to plastic is less direct, and of a lesser degree; although if all three operations are housed in the one complex, it is almost on par.

This raises two other aspects of circularity: vertical integration and location. 

The more vertically integrated businesses are, and the closer to end markets, the less energy is used in transport and distribution, and this will most likely determine which products are the most circular (again, it is a matter of degree). 

Health – a key SDG — is another, particularly for solutions to global plagues such as diabetes, and degenerative illnesses such as cancer and heart disease – which are reported to be likely favoured in early investment phases. 

Healthy, hopeful people are more productive; and with excess capital have the funds to consume products generated by the capitalist machinery. 

Health and living wages will also help create stability during the imminent period of extreme disruption.

Solutions to global problems also count as strongly additional. 

Examples include: cleaning the world’s waterways of pollution, ranging from plastic to nitrogen; technologies that offer quantum leaps in energy efficiency or agricultural production; transport (think flying cars, speed and underground and atmospheric travel); self sustaining cities; robotics; and communication (device implants and Internet of Things).

And there’s always space.

The big winners are likely to be those which are a combination of at least two, or all of the above areas of additionality. 

The more SDGs targeted with the one investment, the better. Biodiversity screens should also be used.

How to invest in impact markets

As mentioned above, most impact investing is expected to take place in the private markets through venture capital and impact funds but individuals may be able to participate through listed impact funds. 

Otherwise, investors may be able to pick up table scraps in the market by investing in companies that innovate internally, and the odd IPO, and social impact and green bonds (SIBs), which we will cover in our article on bonds. 

A few examples of additionality 

Stressing that a desirable degree of additionality might not be delivered in the public markets, FNArena presents a few listed Australian companies below simply as examples of what additionality might look like.

Bluglass ((BLG)) is a stock that may create limited impact and additionality, assuming it is successful in creating its high-energy efficiency devices, in support of the green transition, but not circularity. 

Similarly, Strategic Elements’ ((SOR)) battery technology qualifies as slightly impactful for the green transition but not circularity (at this stage). It also invests in impact-creating private companies and by doing so, assuming the companies succeed, adds additionality and provides public market access to the impact market.

Waste companies such as Bingo Industries ((BIN)), which is set to be taken over by Macquarie Infrastructure ((MQG)), Pact Group ((PGH)) and Cleanaway Waste Management ((CWY)) are all candidates for circularity, but, given the world is going circular anyway, it could be argued that their future recycling attempts might fail the additionality test. 

To qualify for additionality, they would have to innovate themselves, or at a pinch be first movers to introduce innovative recycling technology produced by impact-creating companies in the private market (most likely) such as Australia’s plastic-to-fuel company Licella, for example. 

The unlisted Licella, meanwhile, doesn’t necessarily need to focus on recycling companies. 

It can team up with consumer goods companies, petrochemical companies, and nearly any company or industry with a plastic profile that wishes to obtain circularity. 

Many impactful companies are holding back from listing, given the risk it poses to being subsumed by one industry or one company, seeking to establish a broader distributive model, or to at least add significant value prior to listing.

Hazer Group ((HZR)) is commercialising a process that (put simply) can convert sewerage to cheap “clean” hydrogen.

If successful, the technology would qualify for additionality through circularity and its impact on a range of SDGs such as water, energy and waste. 

But it is a long way from profitability given the hydrogen economy is not expected to reach its stride for at least a decade, again emphasising the importance of longer investment timeframes in impact investing.

BHP Group ((BHP)) is installing a desalination plant in Chile for its copper mine. 

This counts as very minor impact given its minor contribution to the water SDG, and some social SDGs. But not circularity. It doesn’t really pass the additionality litmus test given desalination technology is well advanced. 

But if BHP proves a first mover with impactful technologies; or experiences success with its own R&D, in particular circular innovation, then it would have a higher additionality quotient. But again, because this disruption is part of the broader environment, again it is limited.

The company has set aside $400m over the next few years to address the task.

Archer Materials ((AXE)) is a clear contender for additionality. The company specialises in quantum computing which does yet not exist in the mass market for a number of reasons. 

Australia is considered a leader in quantum computing and global giants IBM, Microsoft and Google are all working with the local industry to crack quantum computing challenges. 

It is not a matter of if but when. 

Applications for the finance industry could be delivered in as few as three years, but the bulk of reward may yet lie a decade away, again stressing the importance of long-term investment horizons in the impact market. 

The technology is also expected to yield huge social and SDG value primarily through its powerful probability computing power (raising the spectre of Douglas Adams’ Hitchikers’ Guide to the Galaxy); assisting with climate calculations, carbon-capture simulations and energy optimisation for example.

There is no guarantee Archer Materials will win the race. Archer, with links to Sydney University, has several private and university sector competitors, with scientists at UNSW considered a front-runner, working on a silicon-based chip as opposed to Archer’s graphene-based chip.

There are many isolated problems in quantum computing and teams tend to focus on one area. 

One assumes the winners are likely to be subsumed by giants such as IBM, which is one reason big global tech companies with deep pockets are being well bid prior to the transition. These are derivative impact plays in the public market.

A broad brush approach

One way to guesstimate impactful sustainability innovation in the public markets might be to develop two lists – one for growth stocks and one for established stocks, given it is difficult to compare the two on impact measures given the different challenges, goals, functions and risk/reward profiles of these categories.

For each list, create a scorecard, checking how each company stacks up against green circularity and additionality/impact (green transition, health and global solutions).

Then cross check them with degree of impact and SDGs. Then run a biodiversity screen (this will become a big deal within five years).

The best performers from each category (growth or established) then progress to the usual financials, track-record and industry research tests. Perhaps some clear winners will emerge. 

But greater rigour is required.

Measuring impact is a fledgling area but for those prepared for a deeper dive, we explore early attempts to develop methodologies in the area in one of our next articles.

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