In this blog, we will delve into the foundations of impact investing, debunk common misconceptions, explore its applicability in secondary markets, and provide evidence-backed insights into this growing investment approach.
Impact investing is an investment strategy that seeks to generate positive social and environmental impacts alongside financial returns. It goes beyond traditional investment criteria by actively considering the social and environmental performance of companies and projects. The goal is to create measurable, positive outcomes while maintaining financial sustainability.
Impact investing is distinct from charity or philanthropy in that it seeks to generate both financial returns and measurable social and environmental benefits. Unlike traditional charitable giving, impact investments are made with the intention of creating positive change while also generating financial gains. This approach is exemplified by organizations like Acumen, which invests in businesses addressing social challenges while seeking financial sustainability. Research supports the differentiation between impact investing and philanthropy. For example, a study by Godechot et al. (2021) highlights the distinctive characteristics and motivations of impact investors compared to philanthropic donors.
ESG (Environmental, Social, and Governance) investing involves integrating environmental, social, and governance factors into investment decisions. It considers how companies manage their impact on the environment, treat their employees and stakeholders, and maintain strong governance structures. ESG investing aims to align investments with sustainability goals and drive positive change through responsible investing practices. It primarily focuses on risk management and generating long-term financial returns. Example: ESG investing involves selecting companies with strong ESG performance and excluding those with poor ESG practices from investment portfolios. For instance, an investor may choose to invest in a renewable energy company that prioritizes sustainable practices and emission reductions.
Impact investing, on the other hand, goes beyond ESG considerations. It aims to generate measurable positive social and environmental impacts alongside financial returns. Impact investors actively seek investments that address specific social or environmental challenges, focusing on sectors such as clean energy, affordable housing, education, healthcare, and poverty alleviation. The intention is to make a tangible difference in targeted areas by allocating capital to projects and businesses with a clear social or environmental mission. Godechot et al. (2021) conducted a study exploring the motivations and characteristics of impact investors. Their research reveals that impact investors prioritize measurable impact alongside financial returns, actively seeking investments aligned with their values and social objectives.
Example: An impact investor may invest in a social enterprise that provides job training and employment opportunities for disadvantaged communities. The investment aims to create positive social impact by improving the lives of individuals and promoting economic empowerment.
More specifically, it is the intentionality and additionally of investments which enable impact to be real:
One key difference between ESG investing and impact investing lies in the intentionality of the investments made. Impact investing explicitly seeks to generate measurable social or environmental impact alongside financial returns. It involves intentional allocation of capital towards projects, companies, or funds that have a clear social or environmental mission. On the other hand, ESG investing focuses on integrating environmental, social, and governance factors into investment decisions without necessarily targeting specific impact outcomes.
An impact investor may invest in a microfinance institution that provides access to financial services for underserved populations, aiming to alleviate poverty and promote economic empowerment. In contrast, an ESG investor may consider investing in a company that has strong diversity and inclusion policies but without a specific focus on poverty alleviation. Emerson et al. (2014) argue that impact investing requires a higher level of intentionality compared to ESG investing. They emphasize the need for investors to articulate explicit social or environmental goals and actively seek investments aligned with those goals (source: ImpactAlpha, **https://impactalpha.com/wp-content/uploads/2014/08/The-Impact-Reporting-and-Investment-Standards.pdf**).
AdditionalityAnother distinguishing factor is the concept of additionality, which refers to the extent to which an investment generates an impact that would not have occurred otherwise. Impact investing prioritises investments that create positive social or environmental outcomes beyond what would have been achieved through traditional market forces alone. ESG investing, while considering sustainability factors, does not necessarily focus on generating additional impact.
An impact investor may invest in a renewable energy project in a developing country, contributing to the expansion of clean energy sources and reducing greenhouse gas emissions. The investment creates additionality by supporting the project's development and implementation, which might not have happened without the investor's involvement. Scholtens and Sievänen (2013) discuss additionality as a critical component of impact investing, emphasising the importance of investments that go beyond business as usual to create positive societal change(Journal of Business Ethics)
Impact investing in secondary markets has gained attention in recent years as investors seek to align their financial goals with positive social and environmental outcomes. However, achieving measurable impact in these markets presents unique challenges due to their characteristics, such as liquidity, speculation, and diverse shareholders.
Let's delve deeper into the challenges and explore how impact investors navigate these complexities:
Despite these challenges, impact investors have made strides in secondary markets. They collaborate with other stakeholders, including non-governmental organisations, research institutions, and market regulators, to advocate for improved sustainability reporting and encourage companies to adopt responsible business practices (UNPRI, 2021).
In conclusion, impact investing and ESG investing differ in terms of intentionality and additionality. Impact investing seeks intentional allocation of capital to generate measurable impact alongside financial returns, while ESG investing integrates sustainability factors without necessarily targeting specific impact outcomes. While achieving direct impact in secondary markets is challenging, impact investors can still contribute indirectly by engaging with companies and advocating for responsible business practices.