What is Impact Investing?
The main idea of impact investing can be described in one phrase: “socially responsible investing”.
The goal of impact investing is to reduce the negative social effects of corporate activity by promoting businesses that benefit their communities and utilize clean technologies. Impact investing is a way to mitigate and discourage negative externalities—the negative costs of business activity that affect other parties wherein that cost is not reflected in the pricing of goods and services.
Impact investing is a form of socially responsible investing that is not only concerned with the minimization of social harm but the active production of social benefits.
In that sense, impact investing can be thought of as an extension of philanthropy.
However, impact investing differs from traditional philanthropy in its de-emphasis on personal donations and instead, an emphasis on advancing social solution through investments that also produce financial returns.
The central motivation of impact investing is to give back to society by investing in companies that promote developments and meet challenges in sectors such as sustainable agriculture, renewable energy, biological conservation, and affordable basic services such as housing, healthcare, and education.
How Does Impact Investing Work?
Impact investing involves investors gauging a particular company’s commitment to corporate social responsibility (CSR).
Contrary to Friedman’s well-known proclamation that the only social responsibility of a business is to increase its profits, the corporate social responsibility business model requires companies to be aware of the social impacts of their activity and work to promote positive social consequences.
Corporate social responsibility derives from the concept of corporate citizenship, the idea that businesses, like everyday citizens, have an obligation to give back to their communities.
Therefore, the idea of impact investing is to invest in companies that show a high level of commitment to corporate social responsibility. The exact form of corporate social responsibility differs depending on the company and industry.
For example, say investors have the option to invest in one of two agricultural technology companies, company A and B. Company A does not practice sustainable techniques and does not utilize green technologies, while Company B not only uses both of these things but also reinvests a share of their profits into their local community. The prospective impact investor should vie to invest in Company B, in virtue of the net positive social impact Company B produces via their economic activity.
Hence, corporate social responsibility and impact investing are meant to create a self-regulating economic model. Investors actively encourage the growth of companies that provide social benefits while simultaneously discouraging the activity of companies that cause harms by fewer investments. The positive feedback loop of positive social benefits and profit generation incentivizes companies to enact socially responsible practices.
CSR Standards
So what kinds of features and practices should the aspiring impact investor consider before investing? Which company practices are a good indicator of a high level of corporate social responsibility and sustainable growth?
- Community involvement and development: Issues such as education/culture, employment creation, technology development, income creation, health, social investment.
- Consumer issues: fair contractual practices, consumer protection, sustainable consumption, consumer service, consumer privacy, education, and awareness
- Human rights: Due diligence, risk situations, avoidance of complicity, resolving grievances, discrimination, civil rights, economic rights, workers rights
- Labour practices: Employment/employee relationships, work conditions, social dialogue, health and safety, human development
- Environmental effects: Pollution prevention, sustainable resource use, climate change mitigation, environmental preservation/restoration,
- Fair operating practices: Anti-corruption, responsible political involvement, fair competition, promotion of social responsibility, respect for property right
- Organizational governance: Transparency, accountability
The idea is that these seven core factors and related issues are the constitutive dimensions of corporate social responsibility and companies should be judged by how well they adhere to these ideals.
The crux of the theory is to implement policies that balance these core dimensions while maintaining profitability.
So, Why Impact Investing?
10 years ago, impact investing was a virtually unknown practice. Today it is estimated that over 1,340 impact investor organizations manage over £385 billion worldwide.
So what exactly has driven the hype surrounding impact investing?
Individual social responsibility
Investors play a unique social role in that they are the prime drivers of economic development and innovation. As members of society, individuals have an obligation to promote good in their communities and work towards more just and equitable arrangements.
Impact investing is one way to make a big difference in the world by allocating capital to produce social benefits for all. Impact investing gives one an opportunity to broaden their horizons and expand their bottom line to include more than profit.
Contrary to what some may believe, all human beings are interdependent on each other. In light of this fact, we have a moral responsibility to collaboratively act to create measurable change for our planet and future generations. Impact investing allow investors to be agents of social change while simultaneously achieving their individual goals as economic actors.
Good financial returns
Contrary to what one may assume, impact investing is not inherently riskier than regular investing. Like regular investments, impact investments have diverse financial return expectations. The majority of respondents surveyed in the Global Impact Investing Network (GIIN) 2023 Annual Impact Investor Survey indicated their portfolio performance overwhelmingly met or exceeded their expectations in both social impacts and returns on investments. In other words, you are just as likely to see a return on your investments as you are with other investment strategies.
Many argue that restricting investment choices based on social or political factors increases risk; an idea based on the “portfolio theory” that holds diversifying your portfolio decreases risk. In actuality, the truth of the portfolio theory is not so clear cut.
If you have a diverse portfolio but they are all bad investments, you are unlikely to make any money. The key is to do the right research is to see if companies have what Warren Buffett calls a “sustainable competitive advantage;” unique characteristic of companies that give them a long term advantage over their competitors. To be clear, this is a fuzzy concept that is difficult to translate into hard metrics, which is why impact investing has a characteristic reliance on intuition rather than hard statistics.
Impact investing makes valuation more consistent
Impact investing seeks to realign the disconnect between financial markets and the “real economy’ by focusing on the origin of value.
In contemporary markets, many gains are achieved through a practice of exploiting small differences between the two markets.
High-frequency trading is a manifestation of this behavior and artificially inflates the value of shares in those markets. While this practice does net a large profit for a small number of investors, it decouples the value of the financial market from the “real value” of the non-financial parts of the economy.
For example, it is commonly argued that current fossil fuel industry drastically underestimates the value of the natural environment and in doing so contribute to environmental damage by neglecting this value. Impact investors would seek to invest in companies that stimulate the development of renewable energy and protect the environment, therefore accurately reflecting the value of the natural environment in their investments.
This is a tricky task as “value” is inherently subjective, but impact investing is meant to prop up the value of currently undervalued things so that the value of financial markets accurately reflects the value of the real variables in the economy.
Increases market competition
In a free market system, there is the notion that competition is beneficial — it’s a fundamental principle for how markets grow and innovate.
Impact investing is a good way to even the playing field in financial markets and give smaller companies a fighting chance against large companies.
Think of it this way: impact investors invest in companies that promote social benefits or produce products that have positive environmental impacts (think things like solar panels and other green technologies).
As the market for these kinds of investments grows, other companies will have a financial incentive to modify their practices to reflect heightened levels of social responsibility. Through investments that stimulate societal benefits, impact investing can make markets more competitive and promote growth and innovation.
Read More: 5 Passive Income Ideas That Work In 2024
Future of Impact Investing
Impact investing is a relatively new trend and it will take some time before we can see the full breadth of its effects on the global economy. However, initial observations look good.
Consumers and customers show a high level of desire for companies that exhibit socially responsible practices.
According to a recent survey from Nielsen, 43% of consumer indicate they would be willing to spend more on products and services provided they contribute to worthwhile causes. So the client demand necessary for successful impact investing is there.
In a broader sense, impact investing fits into the philosophy of “conscious capitalism”, the idea that business should serve all relevant stakeholders, including the environment. Conscious capitalism seeks to assimilate common interest in the management and structure of business activities.
The conscious capitalism credo is based on 4 basic guiding principles.
- Higher purpose: Businesses should also be focused on long-term goals other than the pursuit of profit.
- Stakeholder Orientation: Conscious businesses seeks to redistribute gains to all relevant stakeholders which include employees, customers, suppliers, investors, and more. This is different than the idea that companies should only be beholden to shareholders. Stakeholder orientation is focused on the entire “business ecosystem” that allows for corporate activity.
- Conscious leadership: Emphasis on a “we” mentality rather than a “me” mentality.
- Conscious culture: A conscious business is one where the values of conscious capitalism permeate every level of organization and are readily advanced by management and executives.
Conscious capitalism is not opposed to the gain of profits, only that people recognize the value of the economy over its capacity to return on investments. Conscious capitalism and impact investing seek to balance moral principles with corporate values to create a powerful economy that can handle the growing problems facing the globe.
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