Impact investment is growing rapidly. Why? What are the developments? And how does this business model contribute to the transition to a sustainable and inclusive society? In 6 articles, we highlight the developments, opportunities and risks of Purpose & Impact investment. This is the sixth article.
By Martin de Jong and Anne Rademaker. This article was previously published at: Portal Sustainable Finance.
Using Environmental Social Governance (“ESG”) disclosures only to comply with regulations is a missed opportunity. Why not position ESG more strategically? This supports a company’s purpose and sustainability strategy. Moreover, it creates a better ESG rating, which is relevant to investors. Positioning ESG at the core of a company automatically creates long-term value and creates the need for better ESG performance. Impact measurement and valuation make this possible by creating quantitative, comparable information rather than simply “ticking boxes.
ESG investing needs impact measurement
ESG disclosure has long been seen as “compliance. Companies’ Investor Relations departments had to “check the box,” since finances, strategy and prospects were investors’ main concerns. And yes, this is still the case, but times are changing. Employees are demanding a purpose with social impact, customers are punishing brands that don’t act well, regulations are being introduced globally on all ESG topics, and many other developments show that ESG must be at the core of companies. Especially since ESG investing has now become mainstream among institutional investors. With that, ESG disclosure is becoming a strategic issue for the company. This is the time to move forward and use ESG disclosure as an opportunity rather than compliance or even a risk (see Article 2 of this series). In this article, we explore the next phase of ESG investing and how impact measurement and valuation fit into ESG assessment.
ESG: From a ‘tick box’ activity to a core business competency
In August 2020, the CFA Institute published a draft standard for disclosure of ESG performance of investment products, recognizing the need for it. It is just one of many developments over the past 2-3 years that indicate financial markets are seeing the value of ESG disclosures. There are a number of problems with ESG disclosures, perhaps the most important of which is the focus on intent rather than output or outcome. Companies publish their ESG policies, thus setting the check mark. Most companies quantify and publish their sustainability outcomes, sometimes even linking them to strategic and operational goals. This is output reporting, but usually only covers part of the ESG scope. There is a growing need for outcome reporting and, moreover, impact measurement, as Harvard professor George Serafeim puts it.
The Harvard Business Review published an article by Prof. George Serafeim on ESG integration in its September/October 2020 edition. Based on academic research, his Harvard team discovered that there is a need for ESG integration within companies to take advantage of ESG opportunities. They identified 5 recommendations around ESG:
- Implementing strategic ESG practices;
- Creating accountability structures for ESG;
- Connecting corporate purpose with ESG;
- Decentralize to implement ESG strategy;
- Being transparent and reporting on ESG performance.
The need for impact measurement
ESG focuses on minimizing the harm a company does to society and being transparent about it. ESG is also investor-focused, a way for a company to share their environmental and social efforts in a “standardized” way. Within companies, ESG is often part of the Sustainability department, which shares ownership with the compliance team. Professor George Serafeim’s plea is to truly integrate ESG into organizations. So strategic ESG is not just about minimizing environmental damage, but about building a purpose and strategy to optimize the positive impact a company has on society.
This call for strategic ESG seems to be part of a broader discussion about corporate transformation toward more sustainable efforts, CSR, shared value and purpose-based business. But the difference is the financial angle. For investors, ESG and the ESG rating is the only “objective” way to ensure that their investments meet current standards for how companies operate or should operate. As previous articles in this series have shown, there is a limitation to this method of ESG rating because it is primarily qualitative information. ESG must be quantified to truly manage and benchmark a company’s performance. Impact measurement and valuation of ESG data will help drive quantification.
What is impact measurement and valuation?
Measuring a company’s social impact and valuing that measurement to put impact into perspective can help capture the intangible and understand the Economic, Natural, Social and Human value a company creates and extracts from society. It helps identify risks in the value chain and provides a way to build a purpose-based strategy. In short, Impact valuation: measures the positive and negative impact a company has on society to optimize its connection to society.
In corporate reporting, the IRCC six capitals model is a widely used model to clarify a company’s environmental and social impacts and its impact. Traditional ESG reporting focuses on business operations. Over the years, the scope of ESG reporting has expanded to include more (up to six) capitals and more broadly by including Input and Output of the company. In practice, a company’s most relevant impact is not quantified, but only reported qualitatively. And as ESG begins to become mainstream for companies and investors, this is a missed opportunity. Strategic ESG needs impact measurement and valuation to share with investors the true social impact of a company’s activities.
Problems in quantifying ESG performance
We believe impact measurement and valuation are important to move ESG from compliance to strategy. This promotes alignment between corporate and global agendas (more in Article 3). Moreover, this is important for investors to truly assess a company’s value. By using big data, an ESG rating agency can determine which industries have positive environmental and social impacts. But within an industry, it becomes difficult, especially with a large number of potential investments. In the classic ESG approach, compliance was enough. But as we have shown in previous articles in this series, ESG has become a differentiator and even a strategic decision-making tool for an investor.
However, impact measurement and valuation are not always the answer. The difficulty lies in the calculation and benchmarking of impact itself (interesting discussions at the Harvard Idea Lab). Since impact measurement is new to the world, the techniques available and the application of those techniques (and standards) are also new. It seems that the E (environment) is the easiest. CO2 emissions, even in scope 3, are pretty solid. One can calculate and start valuing it. Comparing impact and avoided environmental impacts is already fodder for discussion. Comparing one company’s e-impact to another builds on this discussion. KPIs such as carbon efficiency per asset or product are used, but if some of a company’s operations are outsourced, while a comparator company performs those operations itself, the comparison is already difficult to make. Once social elements are added to impact measurement, direct and indirect (for example, the environmental, social and economic impact of working from home as part of Vodafone’s product offering), impact measurement and valuation cannot be used within ESG assessment by investors. It’s just not objective enough.
When a company publishes impact measurement and valuation as part of their ESG performance, it provides two insights:
- That company understands;
- The measurement will be applicable for future benchmarking of that company.
ESG is moving toward a more strategic approach. Not only is better corporate performance driving this, but large investors (such as Blackrock) expect it. To understand a company’s ESG performance, these large investors are looking for new ways to assess it. In addition to more and better ESG data, we also see investor knowledge growing rapidly. Former CSOs and sustainability directors are being hired by investors and therefore the (internal) knowledge is growing. This requires a more solid way to be transparent about ESG performance. Impact measurement and valuation is the answer to this call and leads to ESG investing with impact measurement.
About the authors:
Martin de Jong is founder of Empact, impact consultancy and works for (international) clients in the field of Societal Strategy, ESG and Impact Valuation. He is former Director Societal Value VodafoneZiggo and Sustainable Business Manager Vodafone PLC. He is a guest lecturer at several universities on sustainable business.
Anne Rademaker is founder of Rademaker Consulting and works with strategic partners (both public and private) to accelerate the transition to a global circular economy. Anne works with Martin for Empact’s ESG & Impact clients. She is a former Senior Consultant at EY with extensive knowledge in Finance, Risk and Process management.