Investor's Guide to Impact PDF

Florian Heeb Julian Kölbel CSP Center for Sustainable Finance & Private Wealth The Investor’s Guide to Impact Evidence-based advice for investors who want to change the world “Investors can play a crucial role in helping to solv...

Florian Heeb Julian Kölbel CSP Center for Sustainable Finance & Private Wealth The Investor’s Guide to Impact Evidence-based advice for investors who want to change the world “Investors can play a crucial role in helping to solve the global challenges we are facing. However, to unlock this potential we need to be clear about how investors can drive real change. This is the core of our work and this guide.” Falko Paetzold Assistant Professor Social Finance at EBS University Managing Director at CSP, University of Zurich About CSP – The Center for Sustainable Finance and Private Wealth About the Authors Contents CSP is a research and teaching unit at the Department of Banking and Finance of the University of Zurich in Switzerland. CSP engages Executive Summary 4 in multidisciplinary research to explore fundamental issues and current dynamics in sustainable finance and uses the insights from About This Guide 6 its research to advance the understanding of sustainable finance Florian Heeb is a researcher at CSP. within the private wealth ecosystem. The mission of CSP is to Florian holds a master's degree in activate private wealth and sustainable finance, at scale, as a environmental science from ETH Zurich. What is Investor Impact? 7 substantial driver for sustainable development. Before joining CSP, Florian worked in the executive management of South The Mechanisms of Investor Impact 12 Pole, a leading provider of sustainability Contact financing solutions, where he built Applying the Mechanisms to Sustainable Investing Products 28 We are always glad to receive feedback on our work or to engage in up and managed a global team of discussions on how to optimize impact. Please get in touch with sustainability experts. Florian via [email protected] How to put this Guide Into Action 34 Vision and Outlook 36 Disclaimer In this report, we use examples of financial products to illustrate the mechanisms of investor impact. In no way do we provide any advice Sources and Further Reading 38 for or against investing in any of these products, and we have no Julian Kölbel is a postdoc serving as the commercial relationship with any of them. This guide is based on the Head of Research and BMW Foundation peer-reviewed paper: Kölbel, J., Heeb, F., Paetzold, F., Busch, T. (2020). Fellow at CSP. He holds a PhD in “Can Sustainable Investing Save the World? Reviewing the Management & Economics from ETH Mechanisms of Investor Impact,” Organization & Environment. Zurich and prior to joining CSP, worked at MIT Sloan's Sustainability Initiative. Julian also serves as a member of the investment committee of the Abendrot pension fund. MORE INFORMATION AT www.csp.uzh.ch 3  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) Executive Summary HOW CAN I HAVE INVESTOR IMPACT? Investor impact can mean enabling green companies with a net-positive impact to grow faster or encouraging “brown” companies with negative (or less than optimal) impact to improve. It can also include influencing other investors by This is a guide for investors who want to change the world. being part of a movement. Thus, based on the available evidence, we make three recommendations on how you can maximize your impact as an investor: It supports investors in developing an evidence-based impact strategy for their entire portfolio. Here is a summary of our 1 key messages and recommendations. Enable impactful companies to grow. WHAT IS INVESTOR IMPACT? Typical asset classes: private equity, private debt, and venture capital Investors have impact, whether they mean to or not. The challenge is to separate the impact of the Allocate capital to young impactful companies in inefficient financial By investing in corporations, investors might principally company on the world from the impact of your markets, as much as your risk-bearing capacity allows. Ensure the seek a financial return, but they are implicitly and investment, in other words, to recognize two “additionality” of your investments by choosing companies that really explicitly also participating in the impact of their distinct components of impact: need your capital and cannot easily get sufficient funding from other companies on employees, communities, and the planet. investors. Increasingly, investors are embracing that role, Consider investing in companies that require flexible or concessionary desiring to create change in the world through their financing to scale their positive impacts. This will broaden your range of investments. But understanding the social and options, as many impactful companies cannot grow with financing environmental impact of an investment is not as easy as provided at commercial terms. simply investing in the most responsible company you When selecting fund managers, consider their capabilities to boost the can find. Your investor impact isn’t the impact of the Investor impact is the Company impact is growth of companies with non-financial support (e.g., their management companies in your portfolio. Rather, it is the change change in company the change in the skills, reputations or networks). you induce through your investment in the impact of impact caused by world caused by 2 those companies. investment activities. company activities. Encourage improvement. Typical asset classes: public equity and debt Vote your shares and engage with the management of all of your publicly traded equities. You can either interact with companies personally, get a service provider to do it for you, or select a bank or asset manager who does it. Whichever route you choose, the keys are to focus on realistic but meaningful improvements and to track outcomes. What Is Investor Impact? Screen your public equity and debt holdings for transparent ESG criteria. Screening out companies that lag behind on widely accepted business norms (e.g., no child labor and setting climate goals) is more likely to cause companies to improve than screening out entire industries. INVESTOR IMPACT COMPANY IMPACT Focus on specific issues that are supported by a large coalition of Is the change in company impact caused Is the change in the world caused investors and demand changes that companies can implement at by investment activities by company activities reasonable cost. 3 I nfluence the public discourse by being vocal about what you do. Be vocal about your investment decisions and why you made them. This can be a signal to other investors and to society at large. Enable Growth Products & Services If you are divesting from harmful industries, communicate this publicly. Encourage Improvement Operations Divestment may support broader political or cultural change, but only when it is done publicly. INVESTOR COMPANY WORLD Enter coalitions with like-minded investors to join forces. 4 5  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) About This Guide What Is Investor Impact? This guide provides practical advice on how to have impact as an investor, Investor impact is the change that you cause in a company’s impact. based on a synthesis of academic research. Three key insights explain why. The impact of an investment is not as clear-cut as the an impact at the margins, if at all. To truly get at what More and more, investors want to drive positive and synthesized the available evidence in order to offer prospectuses of sustainable investing products make it difference you made, you need to consider three insights change with their investments. This has brought new these practical recommendations on how to maximize seem. That’s because it’s not accurate to simply claim a that, when considered in turn, help to explain where perspectives to investing and new products and services your impact as an investor with an evidence-based company’s impact as your own. A company might be and how your investment can do the most good. to the sector. Indeed, as more financial institutions investment strategy. doing well by doing good, but your investment only had promise impact in their offerings – from ESG ratings Importantly, while there are already many agencies to impact investing funds to shareholder resources that focus on assessing the impact of investee advocacy groups – investors are finding companies, this guide is focused on the impact of the INSIGHT #1: it challenging to evaluate which strategies truly deliver investor herself. Thus, we aligned the guide as much as Impact is change in the real world that is caused by your activities on their promises. possible with an emerging framework established by This guide supports impact-driven investors in the Impact Management Project (IMP), a broadly The idea of impact boils down to two things. First, something needs to change. Second, this change must be due to developing an investment strategy that accomplishes supported initiative to manage and measure the impact your activity, and not due to something or somebody else. Our simple definition for impact is this: Impact is the real-world change. Changing the world through of investments. change in a specific social or environmental parameter that is caused by an activity. investing is complex and has been studied by many academic researchers. We’ve reviewed existing research,1 C  hange: Having impact requires that something  Causality: Having impact requires that an observed examined the mechanisms researchers have identified, changes in the real world. There are many things you change is caused by your activities, and not by other might want to change, for example, has there been a factors. It’s crucial to think about what would have reduction of greenhouse gas emissions? Or an happened in absence of your activity (i.e., the This guide makes several contributions to complement existing tools and approaches: increase in the number of people with access to “counterfactual”). Would the amount of people with safe drinking water? To measure impact, you need access to safe drinking water have increased anyhow? 1 We clearly define investor impact, along with a rationale for why investors who want to change the world should focus on it. to observe whether a set parameter is changing over time. Your impact is the change going beyond what would have happened even without your actions. This aspect of causality is also referred to as 2 We detail a framework to qualitatively assess different mechanisms for investor impact, and “additionality” or “contribution.” their requirements and limitations, based on the evidence. 3  e apply our framework to common types of sustainable investing products, with concrete evaluation W Figure 1: The impact of an activity is the change it criteria that investors can use to compare them. causes above what would have happened in absence of the activity. The guide concludes with a suggestion on how to turn insight into action, as well as with a recognition of knowledge gaps. Research on the impact of investing is ongoing, and the recommendations in this guide may change as new knowledge becomes available. For now, however, this guide provides the best advice we can give. e.g., Number of people with access to drinking water WHAT HAS HAPPENED BECAUSE OF THE ACTIVITY ACTIVITY IMPACT TARGET PARAMETER WHAT WOULD HAVE HAPPENED WITHOUT THE ACTIVITY TIME 6 7  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) INSIGHT #2: Your impact as an investor is GREEN COMPANY INVESTOR IMPACT = 0 BROWN COMPANY INVESTOR IMPACT = 50 the change in company impact that you cause. Investor Positive (Beneficial) Positive (Beneficial) 100 100 Impact = 0 If impact is change caused by your activities then, as COMPANY IMPACT COMPANY IMPACT an investor, you do not directly have an impact on Before After real-world outcomes such as global carbon emissions. Investment Investment But you may have an impact on a company, and that Before After company has an impact on the real world. Thus, it Negative (Harmful) Negative (Harmful) Investment Investment -50 is helpful to distinguish investor impact from company impact. -100 Investor Impact = 50 Investor impact is the Company impact is the Figure 3: Investor impact is about causing change – not about owning impactful companies. For example, investing in a company change in company impact change in a specific with a negative impact, and convincing it to improve (Brown Company) can result in a larger change than investing in a company that already has a net-positive impact (Green Company). that is caused by an parameter caused by investor’s activity. For company activities. example, enabling a For example, selling company to sell more products that reduce products that reduce carbon emissions. carbon emissions. A common fallacy for investors – in terms of impact Example: Does investing in pharmaceuticals goals – is to assume that the company impact of their make people healthier? holdings is synonymous with their own impact. This can be misleading. To see why, consider the example Unfortunately, investor impact and company impact are illustrated in Figure 3. often conflated. As an example, consider a self-proclaimed What Is Investor Impact? There is a green company with a net-positive company impact and a brown company with a net-negative “impact mutual fund” that invests in public companies that contribute to the 17 Sustainable Development Goals company impact. Only looking at company impact, (SDGs) as defined by the United Nations. One of the investing in the green company seems more attractive. fund’s top holdings is Gilead Sciences, one of the largest INVESTOR IMPACT COMPANY IMPACT However, if the green company has the same impact one pharmaceutical companies in the world. Gilead develops Is the change in company impact caused Is the change in the world caused year later, the investor impact was zero. When an and produces drugs for severe diseases, such as HIV. One by investment activities by company activities investment in the brown company causes the company might reasonably argue that the company has a positive to reduce its negative impact, the investor had impact, impact on SDG Goal 3, Good Health and Well-Being. even though the brown company is still far worse than the green company. So, to assess investor impact, The number of HIV patients treated with the drugs investors must look at the change in company impact produced by Gilead Sciences would be a reasonable they cause. measure of company impact. However, investors seeking impact should ask themselves, “If I invest in this fund, Enable Growth Products & Services will more HIV positive patients receive treatment?” Encourage Improvement Operations The answer is unlikely to be, “Yes,” given that Gilead can easily access capital to pursue the projects that INVESTOR COMPANY WORLD management decides to pursue. But the only way to really answer this question is to think through the mechanisms of investor impact. Figure 2: Investor impact is the change in company impact, caused by investment activities. 8 9  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) INSIGHT #3: Investors can change company impact by enabling impactful companies to grow or encouraging companies to improve. There are two fundamentally different types of investor impact. Investors can either enable the growth of impactful green companies or encourage the improvement of brown companies that have potential to improve. There are various mechanisms to achieve these types of impacts, but both types ultimately CHOOSING COMPANIES TO GROW CHOOSING COMPANIES TO IMPROVE result in an increase of company impact. If you want to enable growth, focus on companies that If your goal is to encourage improvement, you want to have significant positive impact on people and the focus on those companies that have the greatest planet. It would be counterproductive to help grow a potential for improvement. Rather than measuring the company that has some positive, but also lots of overall impact of the firm, you need reliable information negative, impact. Also, the positive impact of companies on specific environmental, social and governance (ESG) can differ by orders of magnitude, so picking the right criteria.2 This enables you to evaluate which companies ones is crucial. What you would look for is a robust have room to improve and whether companies are estimate of the overall level of a company’s impact. indeed improving. The challenge is to find criteria that ENABLING GROWTH ENCOURAGING IMPROVEMENT The Impact Management Project (IMP) provides a are actionable for the company, easily observable by Investors can have impact by enabling impactful Investors can have impact by encouraging broadly endorsed framework on how to assess the outsiders and widely adopted by investors. companies to grow. For example, an investment in a companies to improve their company impact. For impact of companies. This framework differentiates ESG rating agencies provide information that can be start-up that has found a way to make solar panels example, investors may encourage a large between five dimensions of company impact: What, Who, used to identify improvement potential. The more more efficient could have a big impact if the company manufacturer of snacks to stop using palm oil How Much, Contribution and Risk. The Contribution detailed and industry-specific indicators used by the is struggling to raise the capital it needs to scale. linked to deforestation. dimension is crucial: If a company does not cause any rating agencies offer suitably comparable criteria on, for change above what would happen anyhow, all other example, a company’s greenhouse gas emission dimensions become obsolete. intensity in comparison to industry peers, or the While our guide puts a strong emphasis on investor impact, it is important to look at company impact as The Global Impact Investing Network’s (GIIN’s) company’s revenues coming from SDG-aligned product well. But depending on whether you intend to enable growth or encourage improvement, you might look IRIS+ offers a comprehensive catalogue of indicators categories. Controversy assessments published by data at company impact in different ways. Here, we explain how company impact is relevant and point to that can be used to assess company impact. In addition, providers are an additional data source that can several tools that go into more depth. several providers offer databases on company impact. complement the company’s own disclosures. A recent report by the DVAF, the Association of Investment Professionals in Germany, provides a useful overview of these databases. 10 11  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) The Mechanisms of Investor Impact There are different mechanisms of investor impact. We assess the effectiveness of each mechanism based on available evidence and identify key requirements and limitations. LEVELS OF EVIDENCE There’s more than one way to make a difference through In the section that follows, we look at the effectiveness of Theories about investor impact abound, so we The academic research, as described in Table 2, cuts your investments. Our starting point is the Impact the different mechanisms of investor impact. For each compiled as much evidence as we could to separate through some uncertainty. However, evidence levels Management Project (IMP)’s classification of four mechanism, we give a concrete example, discuss the theory from reality. We reviewed academic studies that vary. We found convincing empirical evidence for mechanisms of impact (see Table 1), which we’ve existing academic evidence for its effectiveness, and have investigated the effectiveness of different investor some mechanisms but not all of them. Investors should mapped to current academic research and modified review its key requirements and limitations, as impact mechanisms and placed them within the IMP consider the level of empiricism behind a given modestly. To be sure, we also use some different summarized in Table 3. classification. Assessing how much impact you will mechanism for achieving investor impact as they wording than the IMP.3 have with an investment is prone to uncertainty. gauge confidence in their own potential impact. Investor Impact Mechanism (based on IMP classification) Description Evidence Level Description Grow new/undersupplied capital Allocating capital to impactful companies whose A: Scientific consensus Systematic reviews of the empirical evidence document a scientific consensus on markets growth is limited by access to financing. effectiveness of the mechanism. Provide flexible capital Allocating capital to impactful companies that require B: Empirical evidence Empirical studies show that the mechanism has been effective in specific settings. Yet, it flexible financing conditions to grow. remains unclear how far these findings can be generalized. Engage actively Provide non-financial Provide resources beyond capital that enhance the C: Model-based prediction Economic models predict that the mechanism should be effective under certain support growth of impactful companies (e.g., know-how, assumptions. reputation, network). D: Narrative There are narratives that rationalize why the mechanism could be effective. Shareholder engagement Encouraging management to improve as an active owner (e.g., management dialogue, voting). Table 2: Classification of the level of evidence for the different mechanisms of investor impact. Signal that impact matters Market signals Sending price signals to the entire market that encourage improvement (e.g., screening based on ESG criteria). REQUIREMENTS AND LIMITATIONS Each mechanism is dependent on specific conditions – the requirements and limitations in Table 3. Evidence of impact Non-market signals Sending signals to society at large that influence the is dependent on those requirements and limitations; there is only support for the impact potential of an investment if public discourse on pressing challenges. the requirements are met and the limitations do not apply. Table 1: The mechanisms of investor impact. 12 13  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) Investor Impact Mechanism (based on IMP classification) Type of Change Evidence Level Requirements Limitations Typical Asset Classes Grow new/ Enabling Growth B: Empirical Evidence Investments in companies with net-positive Not suited for investments in large, Private markets: undersupplied impact established companies, which have Private equity capital markets Companies' growth is limited by external sufficient access to external Private debt financing conditions. This is more likely: financing Venture capital – For small and young companies – For companies with mainly intangible assets – In immature financial markets Provide flexible Enabling Growth B: Empirical Evidence Investments in companies with net-positive Not suited for companies that have capital impact sufficient access to philanthropic or Companies' growth depends on access to commercial capital flexible capital Engage actively Provide non-financial Enabling Growth B: Empirical Evidence Investments in companies with net-positive Only suited for early-stage support impact. investments, where investors can Investors with know-how, reputations or directly influence the company networks that help companies grow faster Shareholder engagement Encouraging Improvement B: Empirical Evidence Focus on meaningful improvements that Limited to incremental Public markets: companies can achieve at reasonable cost improvements; unlikely to Public equity Investor with strong influence on a company. transform industries Public debt Influence increases with: – The number of shares held by investor – The cultural proximity with the company – Size and reputation of the investor Signal that impact Market signals Encouraging Improvement C: Model-Based Prediction Transparent ESG criteria that companies Effect unlikely for industry exclusion matters can meet at reasonable cost Disagreement on how to measure ESG Substantial portion of the market criteria screening out or underweighting firms that don’t meet the ESG criteria Non-market signals Growth or improvement D: Narrative High level of public visibility of signals Impact is difficult to evaluate as it is indirect and depends on political action or cultural change Table 3: The mechanisms of investor impact. For each mechanism the table lists the level of evidence for its effectiveness as well as the key requirements and limitations. 14 15  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) EVIDENCE LEVEL: B. EMPIRICAL EVIDENCE A large body of literature shows that investors can promote the growth of Grow New or companies under the right circumstances. Many studies make use of unexpected shocks Undersupplied in capital supply to a sample of companies. These studies identify the circumstances Markets where such shocks affect corporate investment and growth – and under which circumstances they do not. Allocate capital to impactful companies whose growth is REQUIREMENTS: 1. Investee companies need to have a net- limited by access to financing. positive company impact so that a company’s growth results in greater Investors can make a difference by enabling the growth positive impact. of impactful companies. One way to do that is to invest 2. Investee companies’ growth needs to be in profitable companies whose business models limited by access to external financing. contribute to solving the world’s problems, but whose This is more likely for small and young growth is constrained by limited access to external companies, for companies with a lot of financing. This kind of impact is directly caused by an intangible assets, or for those in immature investor’s capital allocation decisions and is often financial markets, such as in developing referred to as additionality. Investors may even create this countries. This does not mean that every additionality without making concessions on risk- young company in a developing country is adjusted returns. restricted in its growth; investors would The mechanism is effective if the capital provided to a want to assess conditions on a case by company causes the company to grow faster than it case basis. would have without this capital. The mechanism thus Example: Bill Gates investing in Impossible Foods only works for companies that are restricted in their LIMITATIONS: growth by their access to external financing. There is no empirical support for investors’ Meat production is a major source of greenhouse gas This example shows that investments have the highest capital allocation influencing the growth of emissions and the subject of ethical concerns. In 2011 potential to enable impactful growth where financial large, established companies. These Stanford biochemistry professor Patrick O. Brown started markets have the highest frictions – for example, due to companies usually have sufficient access to Impossible Foods to tackle this challenge. In 2013, Bill the high level of information asymmetries and capital markets and are more constrained in Gates invested 25 million US dollars in Impossible Foods – uncertainty of investments in early-stage start-ups. But their growth by product demand and at a time when the prospects of the company were still it’s also important to consider that not every start-up is competition than by access to capital. This is extremely uncertain. Besides relishing the prospect of a limited in its growth by access to capital. By now why the mechanism is oriented toward handsome gain should Impossible Foods complete an Impossible Foods has demonstrated its potential and growing new/undersupplied markets. initial public offering or IPO as expected in 2020, Gates many investors stand ready to invest additional capital. arguably made a vital contribution to Impossible Food’s TYPICAL ASSET CLASSES: impact by enabling its rapid initial growth. Private equity Private debt The venture is now experiencing commercial success and Venture capital has had an impact on carbon emissions and animal welfare. When Burger King rolled out an Impossible Burger across the United States in 2019, artificial meat entered the mainstream. 16 17  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) EVIDENCE LEVEL: B. EMPIRICAL EVIDENCE A range of empirical studies shows that flexible capital provided by governments, Provide multi-lateral agencies and philanthropies have enhanced companies’ investment and Flexible Capital growth. Several studies argue that private investors can promote impactful growth by providing similarly flexible capital. Allocate capital to impactful companies that require flexible REQUIREMENTS: 1. Investee companies need to have a net- financing conditions to grow. positive company impact so that a company’s growth results in greater, Growth may also be constrained not by access to positive impact. capital per se, but rather by access to capital at the right 2. The investee companies need to be limited price. Some impactful companies cannot grow with in their growth by a lack of access to financing provided at commercial terms, so investors flexible capital. This requires two things. might provide them growth capital with flexible First, a company needs to have sufficient conditions. Companies whose business models resolve opportunities to grow, given the right externalities not priced by the market (think cleaning financing. Second, flexible capital makes a up pollution where polluters don’t have to pay) or that difference only if a company is unable to focus on bottom-of-the-pyramid customers instead of grow with market-rate financing. more profitable market segments are less attractive to capital markets. LIMITATIONS: There are different ways investors can offer beneficial The main drawback of this mechanism is that Example: Root Capital financing the Musasa Coffee Cooperative financing. For example, they can accept below-market investors may need to compromise on risk- risk-adjusted returns, take subordinated debt or equity adjusted return compared to non-flexible Most smallholder coffee farmers in rural Africa sell their This example shows that capital allocation may have positions, or accept longer terms before exit. Investors investment opportunities. This may not be an raw beans to local intermediaries and receive only a the strongest effects where financial markets are offering flexible capital can also help companies steer option for all investors – either due to their fraction of the coffee’s value-add. Connecting farmers weakest – and that investors may need to be able to clear of mission drift by lowering the pressure that capital financial preferences or due to requirements directly to global specialty coffee markets can increase make a cut in their risk-adjusted return expectations markets often impose on growing companies related to their fiduciary duty. the farmers' revenues and thereby substantially improve to reach these places. to sacrifice impact for income. The additionality of a their living conditions. Yet, producing for global markets flexible investment, i.e., whether it has a causal effect TYPICAL ASSET CLASSES: requires large production volumes and expensive on growth, needs to be assessed on a case-by-case Private equity equipment and machinery, representing substantial basis. For example, it is important to make sure that the Private debt upfront capital expenditures. This is a crucial hurdle for investment is not crowding out other sources of Direct investments most smallholder farmers, as they do not have access to capital, including philanthropic capital or other impact- commercial sources of credit. oriented investors. The nonprofit social investment fund Root Capital covers this gap and provides loans to coffee farmer cooperatives, like the Musasa Coffee Cooperative in Rwanda. Since Root Capital's initial investment in 2004, the number of farmers exporting their coffee over the Musasa Cooperative has grown more than fivefold. The loans provided by Root Capital generate positive returns. However, these are below the market rate for comparable commercial investments. 18 19  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) EVIDENCE LEVEL: B. EMPIRICAL EVIDENCE Several empirical studies looking at private equity or venture capital funds show that Providing non-financial support by fund managers can affect the performance of investee Non-Financial companies. However, there is a relatively high level of variation among the results of Support these studies. A set of qualitative studies shows that both investors and entrepreneurs attribute considerable importance to non- Provide resources beyond financial support. capital that enhance the REQUIREMENTS: growth of impactful companies. 1. Investee companies need to have a net- positive company impact so that a Investors commonly support early-stage companies with company’s growth results in greater, more than their checkbooks. Indeed, enhancing the positive impact. growth of portfolio companies by providing non- 2. To provide effective non-financial support, financial support is a key value proposition for many an investor needs to offer resources traditional venture capital and private equity firms. besides capital that help portfolio They may share their expertise as board members and companies grow faster. This includes help to improve governance structures. They may also governance or management know-how, a directly provide management support or technical strong reputation, or an extensive network assistance. Also, by using their reputations and that helps the company cut regulatory red networks, investors can enhance companies’ ability to tape, find additional investors or access raise additional capital or gain initial customers. new customers. LIMITATIONS: Example: Owl Ventures helping ed-tech companies to scale Non-financial support is unlikely to further the growth of large, established companies With many students forced to learn at home, the The example shows that investors can help impactful with dispersed ownership. So far, there is no COVID-19 crisis has put education technology (ed-tech) companies grow using more than their capital. However, evidence of the effectiveness of non-financial into the spotlight. Silicon Valley-based Owl Ventures is it also shows that doing so requires fund managers who support other than for early-stage venture one of the largest venture capital funds focusing on ed- have unique non-financial resources that are of value to capital investments and private equity tech. It has invested in companies such as Remind, an the companies they invest in. portfolios. For large companies with online platform facilitating communication among dispersed ownership, investors may still students, teachers and parents, which has seen demand encourage management to improve their ESG spike during the COVID-19 crisis. practices (see next mechanism: Shareholder Engagement). However, they are unlikely to Thanks to its relatively narrow focus, Owl Ventures affect growth. has built substantial sector and technology expertise. This enables the fund to support its investee companies TYPICAL ASSET CLASSES: to scale, for example, by helping investees gain access Private equity to customers and talent as well as by helping them Venture capital navigate the complex procurement processes associated with serving public sector customers like schools and universities. 20 21  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) EVIDENCE LEVEL: B. EMPIRICAL EVIDENCE Several empirical studies show that shareholder engagement has resulted in Shareholder improvements of ESG practices. Shareholder engagement in these studies consists of a Engagement specific request and a continued dialogue with management over a period of about six months to three years. The studies establish Be an active owner and causality by contrasting engaged firms with encourage management comparable firms that have not been engaged. Effectiveness is measured as the to improve. success rate of engagement requests. Investors may use their privileged position and access REQUIREMENTS: to influence the companies they are invested in. There 1. Shareholder engagement needs to focus on are various forms of engagement, ranging from voting practices that result in meaningful at shareholder meetings, to dialogue with improvements of company impact but management, to activist strategies such as exerting have, at the same time, reasonable public pressure and taking board seats. As an impact implementation costs – in other words, mechanism, the objective is to improve a firm’s “low-hanging impact fruits.” Studies environmental or social performance, by clearly suggest that engagement is less successful expressing shareholders’ expectations, or by providing when the requested changes are too knowledge and expertise. demanding or costly. 2. Shareholder engagement hinges on investor influence. Unsurprisingly, the chances of success are higher if an investor Example: Hermes engaging Sinopec on climate change holds a larger share of the company. Also, the ability of an engaging investor to build Methane is a potent greenhouse gas; its effect on global Hermes EOS’s engagement and Sinopec’s methane- up a relationship with the company warming is 28 times stronger than that of CO2 over the reduction program are an example of the impact matters. It helps when the engaging course of a century. In oil and gas production, methane potential of shareholder engagement. On the other hand, investor is culturally close to the company leaks are common, even though technical measures to the mechanism may promote incremental improvements and when large and internationally reduce such leaks are available. that have substantial impact, but it is unlikely to renowned investors support engagement. transform businesses fundamentally: Sinopec is still Asset manager Hermes EOS provides shareholder producing just as much oil and gas. LIMITATIONS: engagement services. In 2014, Hermes EOS initiated a Shareholder engagement is unlikely to dialog with the management of Sinopec, a large Chinese transform industries because it is only oil and gas company. Since then, Sinopec has introduced a promising when targeted at low-cost methane-reduction program, among other initiatives. improvements. Thus, fundamentally According to Sinopec, the program saved an equivalent of problematic industries will continue to be roughly 3 million tons of CO2 emissions in 2017. This is an problematic while improving at the margin. impressive figure; it corresponds roughly to the annual On the other hand, small improvements at CO2 emissions of the Bahamas. large corporations quickly add up to substantial progress. There is plenty of low-hanging fruit in many industries, and engagement is a good approach to harvest them. TYPICAL ASSET CLASSES: Public equity, increasingly also public debt 22 23  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) EVIDENCE LEVEL: C. MODEL-BASED PREDICTION There is relatively scarce evidence for the impact of this mechanism so far. Several theoretical Market models predict that the price effect of market signals could incentivize improvements. While Signals parts of this mechanism have been empirically verified, it remains unclear whether the pricing effects are relevant in practice and whether the Send price signals that mechanism actually drives companies to encourage improvement implement reforms. to the entire market. REQUIREMENTS: 1. A focus on ESG criteria that companies can Investors can send signals to the entire market (not meet at reasonable cost holds more promise only to the companies they are invested in) by allocating than demanding fundamental changes, capital toward companies with positive impacts and because it’s not clear that the scale of withholding it from companies with negative impacts. incentives is large enough to drive wholesale While this may not necessarily affect the growth of changes to a company’s practices. companies, it may create share price incentives for 2. Influencing the market will require a companies to improve. When green investors tilt their considerable fraction of the market to use the investments toward green companies, the valuations of same criteria, and exclude (or substantially green companies may go up, and the valuations of underweight) companies that do not meet brown companies may go down. As a result, managers the criteria. While it’s hard to know what this of brown companies would have an incentive to fraction needs to be to produce a meaningful implement changes to become green. This mechanism is effect, most models point to meeting a at the heart of the most popular sustainable investing minimum threshold of green investors before Example: Vanguard ETF screening out ESG sinners approaches, such as ESG integration, best-in-class there is any meaningful impact. screening, norms-based or conduct-based screening, The ESG International Stock ETF offered by the investment If many other funds are implementing the same screen, and industry exclusion. LIMITATIONS: company Vanguard invests passively in a wide range of the stock prices of excluded companies should decrease There is no evidence that industry exclusions international equities. The portfolio excludes several to some extent. If the decrease is noticeable, managers of incentivize improvement. The cost for a firm to industries, such as tobacco and fossil fuels, and it also excluded companies may consider signing the UN Global change its industry or core business model is excludes companies that do not fulfill the standards of Compact to increase their share prices. Yet, even when likely to be prohibitive compared to share price the UN Global Compact, a public commitment to adhere the decrease is substantial, it is unlikely that tobacco movements caused by sustainable investors. to 10 principles of good business conduct. companies will stop selling cigarettes to avoid the screen. Thus, the case for norms-based/conduct-based exclusions or best-in-class approaches (see The fund itself makes no statement about the impact of Applying the Mechanisms to Sustainable its investment policies on companies. A key difficulty is Investment Products) seems more promising. that the fund's impact depends on whether other funds Disagreement among investors about the apply the same screen. selection and measurement of ESG criteria dilutes the effect of this mechanism. Given that there is ample divergence among ESG ratings, and different investment products implement a wide range of different screens, disagreement is likely to be relevant whenever this mechanism is used. TYPICAL ASSET CLASSES: Public equity Public debt 24 25  The Investor’s Guide to Impact University of Zurich Department of Banking and Finance Center for Sustainable Finance and Private Wealth (CSP) EVIDENCE LEVEL: D. NARRATIVE There is no scientific evidence for the effectiveness of non-market signals to date. Non-Market There are, however, compelling narratives. For example, the divest fossil fuel movement, Signals argues that by stigmatizing the fossil fuel industry, divestment paves the way for political and cultural change. Send signals to society that influence the public discourse REQUIREMENTS: 1. Non-market signals need publicity. Thus, to on pressing challenges. spur political or cultural responses, divestment decisions must be publicly Investors can also send signals that do not directly announced. They are also much more affect financial markets but may influence public newsworthy when undertaken by a agenda-setting or business culture. Investors can signal reputable institution or famous individuals. that they value company impact in ways that do not have direct asset pricing implications. This includes LIMITATIONS: stigmatization (publicly stating opposition to certain Non-market signals depend on political action companies or industries) and benchmark effects (the fact or cultural change to ultimately achieve impact. that companies tend to want to look good in ESG The signals need to be translated into actions, rankings for reputational reasons). Although non- political or otherwise, that have a tangible effect market signals do not have a direct influence on on companies. However, due to their indirect companies, they may indirectly support systemic nature, such effects are difficult to verify. change, for example, by supporting political processes and governmental regulation. TYPICAL ASSET CLASSES: Public equity Public debt Example: Stanford’s coal divestment In 2014, Stanford University announced the decision to Stanford’s coal divestment shows that excluding entire divest coal companies from its endowment of over 20 industries does not create impact through capital billion US dollars. The University took this stance markets. Rather, divestment may have an impact if it following persistent student activism and protests. While manages to gain visibility and