Day 147 in MIT Sloan Fellows Class 2023, Financial Market Dynamics and Human Behavior 7 - "Impact investing"

Impact investing 101

Impact investing, particularly in the Environmental, Social, and Governance (ESG) field, refers to the practice of investing in companies and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return. It's an investment approach that goes beyond traditional financial considerations by factoring in the broader impacts of business activities.

The fundamental question - fiduciary duty

The concept of fiduciary duty generally involves an obligation to act in the best financial interests of clients or beneficiaries. Historically, this has been interpreted to mean that fiduciaries should seek the highest risk-adjusted returns, irrespective of other considerations.

In the context of impact investing, the question arises whether considering Environmental, Social, and Governance (ESG) factors, or making investment decisions based on these considerations, may violate that fiduciary duty. This is particularly pertinent if such considerations could potentially lead to lower financial returns.

Many argue that ESG factors do have a direct impact on financial performance and risk, and thus should be a part of fiduciary duty. They point to evidence that companies with strong ESG practices often have better long-term financial performance and lower risk profiles. Furthermore, issues like climate change, social inequality, and corporate governance are increasingly seen as financially material over the long term.

Typical problems ( Greenwashing and Divergence )

Greenwashing: This term is a blend of "green" (referring to environmentally friendly practices) and "whitewashing" (the practice of covering up or glossing over wrongdoing). Greenwashing is when a company or organization gives a false impression of its environmental responsibility. For example, a company might spend more time and money on marketing themselves as environmentally friendly, through advertising or packaging, than they do actually implementing practices that reduce their environmental harm. It's like someone talking a lot about how much they recycle, but they're still wasting a lot of energy and resources in other parts of their life.

Divergence: In the context of ESG (Environmental, Social, and Governance) scores, divergence refers to the lack of consistency or agreement between different ESG rating systems. Different organizations or rating agencies might use different criteria or place different emphasis on certain factors when they calculate ESG scores. This can lead to a company receiving a high ESG score from one agency but a low score from another, even though both scores are supposed to measure the same thing. It's like different teachers grading an essay: one teacher might focus more on grammar, while another focuses on creativity, leading to different grades for the same essay.

I think those problems come from some fundamental issues around ESG.

Difficult to measure consistently and universally
Difficult to forecast the impact and what would happen next
We have no data and formula so far(except for non-academic ones)
Uncertainty about other risks such as pandemic. Then ESG strategy itself gets affected.

Basic framework

Prof Andrew Lo said there is a potential criteria to filter out assets to invest in.

Here is examples.

ESG→？
Industry consortia→？
Divesting "sin" stocks such as tabacco→×
Venture philanthrophy→？
Meme stocks(e.g. Gamestop)→？

Also, there are some factors to consider the investment strategy in this field.

Regulatory changes
Investor sentiment
Market dynamics
New metrics
Energy transition funds
Carbon offsets market

Existing metrics and problems

Carbon Footprint: This is the total greenhouse gas (GHG) emissions caused directly and indirectly by an individual, organization, event, or product. It's usually measured in equivalent tons of carbon dioxide (CO2).
- Pros: It's a straightforward and easily understood measure that can be used to compare the environmental impact of different companies, products, or activities.
- Cons: It only measures one aspect of environmental impact, and it can be challenging to accurately measure indirect emissions. It also doesn't take into account other important environmental factors like water usage, waste production, and biodiversity impact.
Life-Cycle Assessment (LCA): This is a methodology for assessing environmental impacts associated with all the stages of the life-cycle of a commercial product, process, or service. It includes raw material extraction, materials processing, manufacture, distribution, use, repair and maintenance, and disposal or recycling.
- Pros: It provides a comprehensive view of environmental impact throughout a product's life-cycle. It can help to identify opportunities to improve environmental performance.
- Cons: It's a complex and time-consuming process that requires a lot of data. It can also be difficult to compare LCAs between different products or companies due to differences in methodology and assumptions.
Science-Based Targets (SBTs): Companies set SBTs to reduce their emissions in line with the level of decarbonization required to keep global temperature increase below 2 degrees Celsius, the central aim of the Paris Agreement.
- Pros: SBTs align corporate goals with global efforts to mitigate climate change. They provide a clear pathway for companies to reduce their emissions over time.
- Cons: Setting and achieving SBTs can be challenging for companies, particularly those in carbon-intensive industries. There's also currently no standardized approach to setting SBTs.
Carbon Offsetting: Companies or individuals invest in environmental projects to balance out their own carbon footprints.
- Pros: Offsetting allows companies to claim carbon neutrality and provides funding for environmental projects.
- Cons: It's often seen as a "quick fix" that doesn't encourage companies to reduce their own emissions. There's also a risk of investing in ineffective projects or those that would have happened anyway.