Stockholm (NordSIP) According to Kommuninvest, the Swedish Local Government Funding Agency, it released a record SEK 10 billion in green bonds last year. The market for green bonds continues its upward surge and is well on its way to becoming a mainstream product – particularly now that even insurance companies have begun to purchase them.
Below, Head of Lombard Odier’s Impact Office Bertrand Gacon outlines his views from the investment perspective in an original op-Ed. He discusses why investors now increasingly demand a real and positive ESG impact in their portfolios alongside low risk and high returns, and conveys his expectations that “Impact Investment” is on the verge of moving from the margins to mainstream investment.
Why Impact Is the Third Dimension of Investing
Investors know about return and they know about risk – in all its forms, from price volatility to “ESG” risks. But growing numbers are recognizing a Third Dimension of investing: Impact
By Bertrand Gacon, Head of Impact Office, Lombard Odier
By now, most investors recognize that it pays to take into account the environmental, social and governance factors that affect the companies they invest in. From the oil shock of the 1970s, through the accounting scandals at Enron and Parmalat, the global banking crisis of 2007-09, the Macondo oil-well disaster, and recent vehicle emissions-testing controversies, “ESG” failures have had devastating financial consequences for companies and brands previously considered robust and sustainable.
Investing with ESG factors in mind may have started out as “ethical” or “mission-based” investing, a century ago. But as mainstream investors became more cognizant of risk during the 1950s and 60s, and especially of “grey” and “black swan” risks during the 1990s and 2000s, it was natural that they should recognize ESG factors among those risks. They learned to interrogate the concept of business sustainability more thoroughly, because it was clear that damage to the environment, society or the economy that was hidden one day could devastate their portfolios the next.
Are we measuring processes or outcomes?
Nonetheless, these investors remain concerned primarily with business processes rather than the real impact their products are having on the planet and on society. This is problematic, because by focusing on the internal processes of companies, investors measure only a fraction of the global impact of that company.
A little reflection makes it obvious that high scores in an ESG analysis do not necessarily imply high beneficial outcomes for the environment and society – and therefore portfolio performance. Tesla, for example, which is revolutionizing both the automotive and the battery industries with its electric vehicle innovations, has a relatively poor ESG score in most models simply because it is an immature, fast-growing company that has yet to formalize its governance, code of ethics, certification standards, and other processes. By contrast, a company like Total also scores well in ESG models – it gets an 86 in our model versus just 56 for Tesla, for example – despite the fact that its core product is a leading contributor to greenhouse gas emissions.
We are big believers in ESG analysis, and have been doing it for 20 years. But we also think we have found a way to augment our ESG analysis by looking at the genuine impact criteria that are at the heart of another style of investing that evolved through the 1990s, which sought out “social enterprises” established explicitly to make the world better and more sustainable, while delivering good returns to portfolios.
Labeled “Impact Investing”, this led investors into smaller, often private investments, partly because it is easier to see the beneficial impact of a private equity stake in a small chain of sports facilities in deprived neighborhoods, than to see it in a 1% shareholding in a multinational engineering conglomerate that has a division making wind turbines; and partly because an investment of private capital represents a genuine addition of resources to a company, whereas buying public equities merely represents a financial interest changing hands.
But therein lies another problem: classic impact investing will always be a worthwhile-but-niche activity, whereas mainstream investing in the world’s larger companies has the potential to deliver beneficial outcomes that are much more significant – in scale, if not in depth.
Integrating outcomes into mainstream analysis
The solution, of course, is to integrate some of the key performance indicators that impact investors use – the carbon intensity, water intensity and social returns of products and services, for example – into mainstream ESG analysis. We believe it helps if investors try to keep track of the direction of movement on ESG factors within a company, too. It’s positive if a company signs the Carbon Disclosure Project (CDP), for sure; but it should get a better score once it starts to change its fleet of salespeople’s cars to hybrid models, and the best score when it can demonstrate a tangible reduction in greenhouse gas emissions as a result. This is the only way to pick up on “greenwashing” that doesn’t follow-through with actions that will generate beneficial outcomes (and remove real risks to the company and investor portfolios).
The Third Dimension
The current terminology around extra-financial risks and opportunities in investment – “sustainable”, “responsible”, “ESG” and “impact” investing – have been useful for defining and differentiating approaches as the concepts were coming of age. But how they have come of age, we believe the complementarity of these approaches, and particularly the potential to bring an impact mindset to ESG analysis, is the more important point to convey.
It’s a point recognized by more and more investors who are demanding the integration of key impact performance indicators into fundamental ESG analysis. As such, we expect impact to move from the margins of responsible investing to the heart of mainstream investing, and “impact” to become the dominant terminology. It is part of, but augments, the traditional understanding of return and risk that governs all parts of a portfolio. This is why we call for impact to be recognized as the Third Dimension of Investing.
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