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Finance

Three factors to watch as impact finance gains traction

Published 29 October 2021 in Finance • 5 min read

As more investors turn to the concept of impact finance, three key trends will shape the immediate future of this rapidly growing field: changed attitudes towards business and investment in the wake of COVID-19, the call for standardized ways to measure impact in accounting, and the appetite among investors for below-market returns to drive innovation. 

 

Ahead of COP26, the UN climate change conference which launches in Glasgow on 31 October, the inaugural Impact Finance Forum took place in Bern, Switzerland, enabling discussion between some 350 visionaries and specialists on how to finance solutions that address global challenges. Although climate change took center stage, the conference generated a range of meaningful reflections across the full spectrum of the 17 United Nations Sustainable Development Goals (SDGs). Walking away, we were struck by three key issues that we believe will drive impact finance innovations in the coming years, and that policymakers and business leaders must consider as they seek to foster greater impact across the global economy. 

 

1. Emergence from COVID-19 with an eye on accelerating social innovation 

As we continue to grapple with COVID-19 nearly a year and a half since initial lockdowns, the default expectation has been that firms will hunker down and focus on bottom-line fundamentals. However, in times of crisis, firms also find opportunity. Already on paths of business transformation, we have seen numerous examples of firms identifying innovative ways to minimize COVID-19’s impact on public health and to limit disruptions to economic life and supply chains. 

From the investment side, demand for ESG products has boomed in recent years and shows no signs of slowing down. Investors are increasingly moving beyond the simple risk-return paradigm to ask how they can deploy capital that reflects their values and beliefs to create positive impact and serve as a lever for sustainable change. Many asset owners are already considering the shift from a dual focus on risk-return to a triangle that balances risk, return and impact. Regulators have also started to act. In the European Union, the Sustainable Finance Disclosure Regulation (SFDR) – effective from March 2021 – sets ESG disclosure rules for asset managers and other investors. 

Triodos Bank is one example of how financial services firms are pursuing a more ethical approach to investment, in line with the EU’s new regulations, by ensuring all of its investment funds are compliant with article 9 of SFDR, or focused on achieving a sustainability goal. 

Reflection point: The emergence of the risk-return-impact paradigm, and any related regulation, will force firms to ensure there is alignment between their core business activities and their impact on society. Using a materiality matrix, which prioritizes sustainability issues relative to their importance to the company and its stakeholders, can help frame dialogue on the social and environmental risks of firms and help to manage stakeholder engagements and expectations. 

 

2. A call for standards and integration into accounting practices 

A second key trend to watch involves the potentially disruptive adoption of universal accounting and reporting practices to measure impact. In his keynote address at the forum, Sir Ronald Cohen emphasized that policy leaders in Europe and the US urgently needed to provide guidance on the issue of how companies reported their impact on society and the environment. This approach is needed not least to help investors and other stakeholders make better informed decisions about their engagements with the private sector. Cohen provided Harvard University’s impact-weighted accounts as one pathway forward. However, the adoption of impact-weighted accounts is likely to face strong opposition from established lobbies. An analysis of how a $100 carbon tax would stress Exxon’s 2020 financials illustrates the far-reaching effects of taxing carbon. Ultimately, we will need to identify and finance sustainable energy production. To this end, the “carbon cost curve” can help to illustrate where investments already make financial sense as well as those that will likely require a blended finance approach with subsidies from the public and philanthropic sectors.  

Reflection point: Accounting rules help to create a price mechanism for organizational impact. For investors, with more than $20 trillion invested globally by funds claiming to factor in ESG, any move to standardize metrics (e.g., impact-weighted accounts) would improve investment diligence, reduce transaction costs, enable benchmarking, and boost financial advisor accountability. For companies, impact-weighted accounting standards would create opportunities to incentivize impact by offering greater visibility to executives, encouraging investment in the most impactful firms, and enabling fiscal incentives to be linked to performance. However, any such large change in the rules of the game could prove difficult to rollout smoothly, although measures such as the EU taxonomy classification system will help to improve clarity.  

 

3. Private capital for impact and the role of additionality 

The conference’s discussions emphasized how below-market rate investors and foundations can help to speed the rate of innovation. Investing in the entrepreneurial ecosystems of developing economies is likely to have a tremendous effect on reducing poverty and empowering the world’s poorest. However, identifying and financing early-stage startups in developing countries requires a special skillset. Most startups focusing on solving a social or environmental problem are characterized by high degrees of perceived risk. Sometimes this may occur because investors are separated by large geographic distances. At other times, sales traction or market potential may not be immediately clear. Here, a key aspect of how asset owners and investors can play a significant role is through the concept of additionality. For impact investors, additionality is participation in an investment that increases the quantity or quality of a social or environmental outcome beyond what would otherwise have occurred. Because impact investments often take place in imperfect markets with poor infrastructure, philanthropic funders may be able to absorb the additional perceived risk of investments or perform extra and costly due diligence that ordinary investors are not willing to undertake.  

Reflection point: The complexity of regulation and its application, particularly in federal systems such as Switzerland and Germany, is a challenge for the new field of impact finance. To encourage more impact investors to support social innovation, regulators should consider updating and simplifying any rules that might, for example, hinder investors and foundations from investing for “below-market” returns. Beyond regulation, more philanthropic investors could be inspired to engage further in the sector as creators of additionality: helping to develop social enterprise start-ups to the point where they are ready for more mainstream investors. 

 

Authors

Vanina Farber - IMD Professor

Vanina Farber

elea Professor of Social Innovation, IMD

Vanina is an economist and political scientist specializing in social innovation, sustainability, impact investment and sustainable finance with also almost twenty years of teaching, researching and consultancy experience, working with academic institutions, multinational corporations and international organizations. She is the holder of the elea Chair for Social Innovation.

Patrick Reichert

Research Fellow at the elea Chair for Social Innovation

Patrick conducts research at the intersection of entrepreneurship, finance and social impact, with a particular focus on the mechanisms and logics that investors use to seed investment in social organizations. He is a research fellow at the elea Chair for Social Innovation.

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