If the sustainable investment trinomial = (risk/return) + impact
Then impact = ESG Alpha?
The premise of sustainable investments
Investment professionals decompose risks to realize a financial return on invested capital. Sustainable investment capital increasingly requires proof that positive impact is achieved alongside a positive financial return. Once transparent impact metrics are adopted by investors, they’ll initiate a rotation in portfolios that takes them from “impact-negative” to “impact-positive” investments.
This impact-oriented rotation is meant to generate alpha for investors within the areas of environmental, social and governance (ESG).
Impact is hot.
“Put simply, impact is the measure of the advantage of an motion for people and the planet.” — Sir Ronald Cohen,
by Sir Ronald Cohen became certainly one of the “Best Books 2020 – Business” by As founding father of Apax Partners, Cohen isn’t any stranger to leveraging risk to generate attractive returns for investors. Since 1981, Apax Partners has been synonymous with global enterprise capital and personal equity.
Today, as chair of the Global Steering Group on Impact Investment, Cohen is committed to the worldwide introduction of a standardized accounting method for measuring impact – Impact-Weighted Accounting (IWA).
“Asset owners are increasingly demanding impact reporting from their asset managers.” —
The award with the distinguished 2020 Graham and Dodd Scroll to the award “Public opinion and the worth of corporate sustainability,“” by George Serafeim. Serafeim describes a long-short ESG strategy focused on public sentiment that has generated “significant positive alpha.” Public sentiment within the ESG space might be an indicator of perceived impact.
So what’s the formula for the sustainable investment trinomial?
1. Quantify risks
Investment managers routinely calculate the “risk-adjusted return” of their portfolios. The Sharpe ratio uses price volatility – the portfolio standard deviation – as a quantitative measure of risk. However, this risk proxy is simply valid if the info series is often distributed. Beware of black swans! By the way in which, what time period did you select?
SASB — Sustainability Accounting Standards Board — publishes industry-specific accounting standards and related technical metrics for sustainability risks and opportunities which are prone to be financially material to investors. Climate risks, carbon risks, cyber risks, reputational risks, regulatory risks, stranded assets and lack of societal capability risk, and lots of, many other sustainability risks add to the list of risks that investment professionals manage.
So, before you realize that a part of your wealth is lost, discover concerning the financially material sustainability risks lurking in your portfolio.
2. Input return
The term “return” can be difficult to define. Over what time period? Gross or net? Minus what? All costs and charges or just a few of them? How should currencies be handled?
GIPS is a voluntary standard that has been constantly revised since its introduction, but has not yet been adopted across the industry.
So how is the financial return in your private investment portfolio reported? What sustainability risks are you financing to realize this return?
3. Measure impact
Serafeim and his team at Harvard Business School published a series of documents detailing the quantitative methodology behind Impact-Weighted Accounting (IWA)Through the transparency of open source, IWA eliminates the potential for impact washing.
SAS, GRIAnd the Global Impact Investing Network (GIIN) have long-standing principles and metrics for sustainability reporting. Together with these organizations, IWA is taking its foundational work a step further by monetizing these metrics as a part of the Impact Management Project.
Using publicly available data, IWA translates all sorts of social and environmental impacts into comparable, decision-relevant currency units which are intuitively comprehensible for business leaders and investors. Importantly, IWA shows financial and impact performance in the identical accounts, enabling using existing financial and business evaluation tools to evaluate company performance.
For example, let’s compare the environmental impacts of Coca-Cola and PepsiCo’s competing operations using the IWA. PepsiCo reported revenue of $64 billion and net income of $12 billion for 2018, double that of Coca-Cola, which reported $31.8 billion and $6 billion, respectively.
The IWA estimates the negative environmental impact of PepsiCo’s operations in 2018 at $1.8 billion, such as Coca-Cola’s $1.7 billion. In each cases, these costs are almost entirely attributable to inefficient water use, in accordance with the IWA study.Environmental impacts of firms: data complement.“If the negative environmental impacts of Coca-Cola’s operations were accounted for as an expense, the company’s net profit would decrease by 28% in 2018.”
Consider the impact on employment. How would labor be managed if it were classified as an asset relatively than an expense in financial accounting? Companies spend money on and maintain assets to generate high-quality income. Expenses should not like that; they’re simply costs that must be reduced where possible.
Does the standard of the wages and advantages an organization pays create value for society? And is that this also a logical consequence: do low wages and a high dependence on temporary staff deprive society of value?
IWA transparently monetizes the impacts of an organization’s employment practices. Likewise, IWA’s Product Impact Methodology quantifies in financial terms the social and environmental impacts brought on by, amongst other things, the inherent quality – or lack thereof – of an organization’s products, increased availability to underserved populations, and product safety.
Diploma
Over a dozen multinational corporations and global institutional investors use the IWA methodology today. These market participants share the goal of developing transparent, comparable and decision-relevant impact metrics. Asset owners can use Impact-Weighted Accounts as a tool for manager selection and monitoring to make sure their allocations are aligned with impact.
Impact-weighted accounting is the missing ingredient for an impact economy. Its introduction will trigger a rotation in portfolios away from “impact negative” and towards “impact positive”. This impact-oriented rotation should unlock ESG alpha for investors.
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Photo credit: ©Getty Images / Carles Navarro Parcerisas
