The Next 10 Years of Impact Investment – Stanford Social Innovation Review

the-next-10-years-of-impact-investment-–-stanford-social-innovation-review

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Just over 10 years ago, JPMorgan and the Rockefeller Foundation, together with the Global Impact Investing Network (GIIN), published a report claiming that impact investment was an emerging asset class that would reach between $400 billion and $1 trillion in assets under management by 2020. At the time, this prediction seemed like a very ambitious forecast to us as authors of the paper and to the people who read it.

Our doubts were misplaced. In 2020, the market reached roughly $715 billion in assets under management, according to GIIN. The International Finance Corporation (IFC) put the estimate even higher: $2.1 trillion. With such remarkable growth over the last 10 years, we wondered how far impact investment might advance from 2020 to 2030.

To answer this question, we need to step back to note a few important trends. For one, we know that the climate crisis, economic inequality, gender disparity, racial injustice, and other crises—prime targets of solutions supported by impact investments—were already posing deep challenges to governments around the world at the start of this decade. We know there is a $2.5 trillion annual gap in the funds needed to deliver the Sustainable Development Goals (SDGs) by 2030. And we all know that the COVID-19 pandemic has devastated and disrupted the lives of people around the world; it has also made it even harder to achieve the SDGs as governments shift resources and take on new levels of debt to survive the threats of the disease, including the exacerbation of inequalities.

Not only will private impact investment capital be key to funding the SDGs, but it will also play an important role in finding solutions to problems conventionally seen as the domain of the public sector as it struggles with new and unprecedented crises. Given those pressures, what opportunities and innovations in impact investing might we see over the next 10 years? To get an idea of where things might be headed, we take a look at where they’ve been in three areas we believe play an outsized role in the goals and practices of impact investing: equity and inclusion, climate, and financial and analytical tools.

1. Diversity, Equity, and Inclusion (DEI)

Historically, there was little the private sector was expected or willing to do about inequality, especially in the free market Milton Friedman capitalism of the past decades. Today, as Friedman’s doctrine abates and businesses increasingly recognize their responsibilities to stakeholders instead of just shareholders, investors have a greater opportunity to improve the equality of access to affordable, high-quality capital, goods, or services for all people. Here are a few ways investors have seized this moment that show a way forward:

Backing diverse entrepreneurs  | Social movements like Black Lives Matter and #MeToo have resounded well beyond the protests on the streets in 2020. They have spurred investors and corporations to act on systemic racial and gender inequalities, particularly when it comes to access to capital and economic opportunities. Both Citigroup and Bank of America made $1 billion pledges to address the racial wealth gap. Softbank launched a $100 million fund for entrepreneurs of color. PayPal is putting $530 million toward supporting Black and underrepresented minority businesses and communities. Twitter announced a $100 million commitment to the Finance Justice Fund, which aims to bring $1 billion in capital from corporate and philanthropic partners to the most underserved individuals and communities in America. These recent commitments are building on a trend developing over recent years. In 2019, private equity, venture capital, and private debt made $4.8 billion in investments focused on benefitting women, up from $1.1 billion in 2017.

Historically, much of the funding targeting women and minority homeowners or business owners in the United States came through community development financial institutions (CDFIs), private entities whose primary mission is to help communities traditionally underserved by the banking and investment system. In turn, CDFIs were for many years largely funded by the regulation-mandated capital made available through the Community Reinvestment Act of 1977. Today, impact investors as diverse as the Kellogg Foundation, JPMorgan Chase, and Prudential Financial are putting money into CDFIs to advance racial equity. Corporations like Google, Netflix, PayPal, and Starbucks are housing deposits with CDFIs, with some calling for this to lead toward equity investment. Philanthropist Mackenzie Scott has provided traditionally scarce unrestricted funding to more than 30 CDFIs, allowing them to expand their balance sheets. Additionally, an increasing number of CDFIs have accessed the capital markets with rated bond issuances.

Another factor driving this trend is the business case. Companies in the top quartile for gender diversity were 25 percent more likely to have above-average profitability than companies in the fourth quartile, according to McKinsey. The boost is even more apparent for firms demonstrating the same top-tier levels of ethnic diversity—they are 36 percent more likely to have above-average profitability than organizations doing the least to variegate their workforces. This distinction in earnings is growing more pronounced over time as stronger firms pull ahead in the marketplace, increasingly solidifying the connection between DEI and a robust business. Investors who ignore this trend risk making less money while also missing an opportunity to get more capital to women, Indigenous groups, and communities of color.

Pioneering technology to reach people outside of cities | Metropolitan centers have for decades attracted the bulk of economic activity. As recently as April 2020, cities generated 80 percent of global GDP, according to the World Bank. With attention focused on urban areas, people living in peri-urban and rural communities have been left behind, consistently lacking reliable access to high-quality, affordable goods, despite a decade of investment.

However, technologies have been emerging that can help solve this problem. At the same time, the COVID-19 pandemic has turned remote work from a perk to a priority, increasing job opportunities for internet-connected people all over the world.

In India, for example, Loadshare strings together small, local logistics providers to create a delivery chain that reaches remote areas. The company has around 6,000 workers and suppliers in its network, and over the past four years has expanded across 18 Indian states and established 500 branches. iMerit, founded in 2012, annotates and organizes data for global companies. It has almost 3,000 employees, with 80 percent from under-served regions in India, Bhutan, Europe, and the United States. Over half of the employees are women, who in some nations often have limited access to jobs outside the home due to cultural factors.

Workex (a CDC Group investee) provides workforce management for enterprises that are shifting toward using remote employees, a trend accelerated by COVID-19. A large portion of the platform’s 10 million workers has blue-collar backgrounds. Firms like Workex and others began offering tools for working with remote employees in Africa and South Asia several years ago, and there is plenty of room for the industry to grow. This holds particularly true as the “Uber-ization” of last-mile delivery puts more customers within reach. However, as regulation struggles to catch up with the technology, some of these gig platforms come with a significant risk of exploiting the labor and data of those who use them. Impact investors need to identify those that holistically protect and support their workers, such as Steady.

Aggregating demand for smaller buyers | The affordability and geographic reach of many basic products and services have long been prominent issues for impact investors, but the COVID-19 crisis shone a light on a related challenge: volume.

Some low- and middle-income African nations, for example, struggled to buy COVID-19 supplies because high-volume purchases—which G7 nations could more easily execute—became a pre-condition for successful procurement. At the same time, selling supplies also became more difficult for some countries; in India, the world’s biggest supplier of generic drugs, the government restricted exports of medicines. As a result, global supply chains, typically a source of cost efficiency, became points of vulnerability, raising awareness of the importance of local production.

Help with aggregating demand came from the Africa Medical Supplies Platform, UNICEF, impact investors such as MedAccess (owned by CDC Group), and the Bill and Melinda Gates Foundation, which recently published an analysis showing that 10 of the world’s richest nations would benefit by at least $153 billion over the next year from ensuring equitable distribution of the COVID vaccine. The World Health Organization (WHO) warns that advanced economies face output losses of up to $2.4 trillion—3.5 percent of their annual gross domestic product (GDP) before the pandemic—because of disruptions to global trade and supply chains. Despite the interconnectedness of the global economy, vaccine nationalism has so far prevailed: The Covax facility set up to ensure equitable distribution of vaccines has struggled to mobilize support from rich nations and faces a $27 billion funding shortfall (at the time of writing).

This is the type of funding gap that impact investment could fill through the use of innovative instruments like guarantees, advanced market commitments, and global access commitments. For example, the Gates Foundation-backed Adjuvant Fund, which finances the development of treatments for neglected diseases and child and maternal health challenges, is using global access commitments to guarantee benefits are made available to vulnerable populations. While there is an opportunity for impact investors to play a role in supporting equality of access through this kind of partnership, success will depend on public and philanthropic capital working together with private capital.

2. Climate

Much impact investment over the last decade was focused on minimizing the increase in global temperatures, or climate change “mitigation.” In 2017 and 2018, mitigation projects made up 93 percent of total climate finance. Renewable energy opportunities have often been the focus of such funding—the same two years, they made up 58 percent of climate finance. Today, investors can find a growing set of options to support communities struggling with climate change and to achieve global “net-zero” carbon emissions. The investments can be categorized in two ways: those focused on adapting and increasing resilience to climate change, and those targeting carbon sequestration.

Adaptation and resilience | More businesses are offering products and services to enable smart cities and circular economies that tackle climate issues through adaptation and resilience. For instance, the wastewater management firm Roserve in India provides technology and financing solutions for sustainable water use in industries ranging from tannery to paper to steel. The company is expanding from India into Africa, where providers of wastewater treatment and recycling are practically non-existent.

While Roserve is generating revenue from goods and services focused on climate change resilience, other companies are also adapting operations to reduce their potential exposure to costly climate change risks, creating other benefits in the process. Zephyr Power, a renewable energy firm, is developing a 50MW wind power plant on Pakistan’s coast, which is threatened by rising sea levels. To counter the risks of flooding, Zephyr invested in a program to protect and rehabilitate the local mangrove trees that provide a natural barrier against the ocean. The investment will attract more fish and other creatures that rely on the trees—boosting the livelihoods of fishermen in the process—and reduce the cost of maintaining the area’s infrastructure by making the soil more stable.

There’s a clear gap between the need for investment in response to climate change and the financing on hand. Estimates from the United Nations put the need at $300 billion per year, yet only $30 billion is available. We expect this investable universe to grow significantly over the next ten years as calls for climate action intensify.

Carbon sequestration | Institutional investors are increasingly transitioning their portfolios to net-zero greenhouse gas emissions by 2050. As the mission of groups like the Net-Zero Asset Owner Alliance becomes more widely adopted, opportunities for carbon sequestration will become increasingly attractive. The forestry sector stands out in this regard. It can reduce rather than just avoid increasing carbon outputs for a portfolio, though it must complement, not replace, the reduction of emissions. It also supports the livelihoods of 1.3 billion people around the globe. Investors are responding to its appeal: According to the Principles for Responsible Investment (PRI), the total amount of global institutional investment in forestry has increased to $100 billion from $10 to $15 billion in the early 2000s.

An example can be found in Kenya, where Komaza is tackling the challenge of deforestation through what it calls “micro-forestry.” In this approach, the company helps tens of thousands of smallholder farmers grow trees on their previously unproductive land to sell as timber in commercial markets, generating long-term income along with environmental benefits. The oceans can also capture carbon at scale, with coastal ecosystems able to sequester up to 20 times what forests can.

The upcoming 26th UN Climate Change Conference of the Parties (COP26), focused on improving the global market for carbon credit, will help monetize the environmental impact of carbon sequestration. We expect it to be one of many steps taken in the years ahead to build the right revenue models and genuine community engagement that will shape forests, coasts, and oceans into a new setting for impact businesses.

3. Tools

Improved standards of impact measurement and management have helped elevate the role of impact investing over the last decade, demonstrated by more and more mainstream asset managers incorporating the practice into their products. The increased attention has also brought a healthy dose of skepticism about “impact washing,” or attributing impact to investments when it isn’t warranted. To grow impact investing over the next 10 years, we need more publicly listed investment vehicles and more improvements in measurement and standards to assuage investors’ fears about the integrity of the field.

Innovating capital markets instruments | When impact investment emerged, private debt and private equity dominated how it was funded. In 2011, for example, less than 1 percent of the number of impact investments reported—and less than 1 percent of the amount of capital invested—went into publicly listed instruments, according to a survey by JPMorgan and GIIN. By 2020, the same survey showed publicly traded debt comprising 24 percent of the impact capital invested, and public equity making up another 10 percent.

We foresee the continued expansion of liquid investments like bonds or publicly listed equities designed for impact over the next decade. For one, their simplicity and speed are needed by investors seeking the dynamic allocation of their capital. Furthermore, there are numerous institutional investors managing billions of dollars of capital who need individual investments that match their scale. With average impact investment check sizes of $3 million reported even in 2020, these investors are limited from participating.

There are some promising innovations in capital markets instruments to serve the liquidity needs of institutional investors. Recent announcements from Germany and Britain about new issuances have helped set the green bond market to grow to $1 trillion. New bonds linked to social outcomes—such as the Ford Foundation’s $1 billion offering—are starting to leverage the growing investor demand for impact in listed securities. Collateralized loan obligations, securitizations of development finance risk, and special purpose acquisition vehicles (SPACs) can be structured to finance the SDGs and are better suited to the scale of institutional investors.

Increasingly, these products are also linking outcomes to the financial design of the instruments. We expect to see more structures with impact incentives, such as loans or bonds that adjust terms in response to how much they contribute to the achievement of sustainability goals. The simplicity and accountability of these structures’ design, with the ability to meet impact objectives and return expectations, will attract investors in the years to come.

Transparency and accountability | The combination of improved standards and increased scrutiny is leading to a new era of accountability for investors laying claim to the impact label. Frameworks and tools such as IRIS+, the SDGs, and the Impact Management Project (IMP) have helped build a global consensus on how to classify, characterize, and measure impact. However, impact measurement remains fragmented, and efforts are underway to align leading sustainability and integrated reporting organizations, alongside ongoing initiatives to harmonize global sustainability reporting standards. The steps build on those taken by the Task Force on Climate-related Financial Disclosures (TCFD) to establish global climate-related reporting standards.

As companies and asset managers start to align with best practices and performance standards, independent verification is also set to become increasingly commonplace. Already, the Operating Principles for Impact Management (OPIM), launched in 2019 and adopted by more than 100 investor signatories, explicitly requires such verification. The PRI is increasingly encouraging external assurance of signatories’ reported data, and the emerging SDG Impact Standards also include a framework for third-party assurance. Tideline launched BlueMark in 2020 to verify investors’ impact practices and performance, and the four major US accounting firms have also introduced sustainability and impact assurance services.

As standards, transparency, and external assurance spread and strengthen, we also anticipate increased efficiency in impact management. Together, this should produce more evidence about the kinds of investments that are most effective at addressing global inclusion and sustainability challenges.

Familiar Risks, Essential Rewards

These trends reveal the huge opportunities for impact investing over the next decade, but finding success within the field will remain challenging. Generating financial returns alongside progress on social and environmental issues has always been difficult, and impact investors will face even more accountability with the increasing rigor and scope of verification tools. The risk is worth the reward. The potential for progress on inclusion and sustainability over the next decade is immense. Hopefully, just as the ambitious forecasts we made in 2010 proved out, we will look back in another 10 years and find that impact investing has made significant advances again.

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