Understanding the impact of your investments: Measuring environmental and social performance

Most investors who measure environmental and social performance do so in order to understand and mitigate risk. Some use the information to identify environmentally and socially (E&S) themed investment opportunities. A small number of these, including those investing indirectly via funds, are becoming interested in understanding the impact of these investments.

But there are barriers. Measuring impact requires systems to collect and aggregate data across a number of funds. This can be both complicated and costly. However, with the development of standard indicators, there are methods and tools emerging that simplify this process for investors.

From risk mitigation to impact

Many responsible investors seek information on environmental, social and corporate governance (ESG) performance from the funds and companies in which they invest. From an investment perspective, analysis of ESG issues is required to:

• assess fully the risks and opportunities associated with particular investments;
• help investors make better investment decisions;
• generate more accurate valuations of businesses.

Understanding ESG issues can help mitigate the risk of potential negative outcomes that can affect a business. For example, fair pay and good working conditions may reduce the risk of high staff turnover and strikes; good water management can help avoid local water contamination and the possibility of associated fines.

Greater investor focus on ESG issues can also lead to a higher quality dialogue between companies and their investors on creating long-term value. It can motivate companies to improve their governance and management, and encourage investors to proactively seek out opportunities presented by these issues. For example, fair pay and good working conditions can result in higher employee productivity and retention; good water management can result in cost savings in times of water scarcity. These actions should help direct capital towards better governed and better managed companies, and towards companies that are better positioned to contribute to the goals of a sustainable society.

“Investors are actively looking to the environmental and social impact that may be felt locally, regionally or even globally”.

Some investors are actively looking beyond the positive impact for the company itself to the environmental and social impact that may be felt locally, regionally or even globally. Continuing the labour conditions example, beyond understanding the risks of strikes or high workforce turnover, and the opportunities for increased employee productivity and retention, such investors may focus on changes in the standard of living for the workforce. Typically, such investors are investing in environmental and social (E&S) themed areas where the investee companies provide a product or service that is expected to result in environmental or social benefits.

Why investors look at impact

Investors who make E&S themed investments will want to measure the social and environmental impact of their investments, for a number of good reasons:

• to communicate the social or environmental performance of investments to external stakeholders – for example, investment managers may need to respond to reporting requirements from clients with specific preferences regarding the use of their capital and asset owners may want to respond to interest and demand from their beneficiaries and external stakeholders.
• to ensure their funds are not supporting poor practices that could lead to reputational risk – for example, over-indebtedness among end users of microcredit;
• to improve the environmental or social impact of their investments – measuring impact enables investors to set targets for the companies or funds in which they invest, providing a basis for engagement to improve performance over time;
• to create positive social or environmental impact as an integral part of their mission – such investors may want to evaluate the social and environmental impact of their investments to assess and improve their performance against these objectives.

Outputs, outcoms and impact

Investors interested in understanding the environmental and social impact of their investments will require additional information from the companies or funds in which they invest. The impact chain is commonly used to frame the different stages of measuring environmental and social performance, for which data could be collected.

• Inputs are the resources, both human and capital, that are invested in the company’s activities.
• Activities relate to the core product or service of the company, or to the company’s policies and procedures, such as staff training or water management. Activities lead to outputs, outcomes and impact.
• Outputs are the directly measurable results arising from a company’s activities. These could include greenhouse gas emissions, water consumption, number of employees or workplace training programmes.
• Outcomes are the ultimate changes in a system, intended and unintended, that result from these outputs. For example, the contamination of a river, workforce retention or an improvement in the standard of living of employees.
• Impact is the proportion of the total observed outcome that can be attributed to a company’s activity, above and beyond what would have happened anyway. For example, to show an improvement in employees’ standard of living would require evidence that this is due to employment with the company and not a result of other factors.

Measuring impact requires counterfactual analysis and is therefore rarely feasible for investors. It is more common to track outputs and outcomes, using indicators that imply rather than prove impact. This is a justifiable way of simplifying the process and making it manageable, particularly where there is evidence that such indicators relate to the desired impact.

Moving towards standardisation

Clear financial reporting guidelines exist for investors to assess and compare the financial performance of companies and funds. Equivalent standards for the robust measuring of social and environmental performance are still in development.

Developing systems in-house allows investors to select the indicators relevant to them. It also allows them to compare performance across investments. However, establishing bespoke systems can lead to duplication of reporting and additional costs in the investment chain.

Alternatively, investors may choose to accept the indicators proposed by the company or fund in question, as a cheaper and easier option. However, social and environmental performance covers a huge range of issues, across different industries and regions, so the indicators are neither comparable nor interchangeable.

So how can investors compare the environmental or social performance of different investments? How can they aggregate this data for management and reporting purposes?

By providing a standardised approach to measuring environmental and social performance, some publicly available systems have begun to help investors answer these questions.