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Getting Paid for Good Behavior

Investors must understand the full impact of their decisions. Several tools exist to help them

We published a white paper today, which explores the increasing importance of externalities in investment decision-making. Amid the upheavals of 2020, a growing number of investors are convinced they must understand the full impact – financial, environmental, and social – of their decisions. While externalities are inherently hard to measure, more progress on this question has been made than many mainstream investors realize.

These are the main ideas, and the PDF is available for download at the button below.

1) Externalities – or the social and environmental impact of business activity – have never been more important.

Evidence mounts that paying attention to impact is associated with superior performance – a finding that holds across asset classes and geographies.

Growing evidence of climate change, along with shifting narratives and social norms, are influencing behavior among consumers, policymakers and regulators.

2) The importance of environmental, social, and governance (ESG) issues is driving asset owners and managers to demand more disclosure, standardization and transparency.

To uphold their fiduciary duty over 75-year horizons, asset owners and their partners must continue to push for ways to “internalize” externalities through greater disclosure and standardization of non-financial data.

While the measurement of ESG factors is still not streamlined, more progress on capturing “non- financial” performance has been made than many market participants realize. Cheaper and broader access to technology such as geospatial data, artificial intelligence and blockchain will drive transparency too.

3) Investors face a calculus about when to switch camps and incorporate ESG-related preferences, measurement and management into their activities.

As the process of ESG integration remains incomplete, it presents opportunities to freeride – or take bold action.

Investment firms today fall into two broad camps: those that address ESG issues with lip service (“minimum viable effort”), and those that address them with genuine intent (“maximum reasonable effort”).

4) The case for switching now to a full embrace of impact-informed investing, despite the inconsistent data, is strong.

Change will continue to be non-linear. In 2018 zero countries had adopted zero-carbon targets. Today, dozens have, including major economies such as the U.K., France, and China.

Asset flows into high-ESG-quality assets will remain strong. In 2018, sustainable investing assets in developed markets surpassed $30 trillion, increasing by a third with respect to two years before.

5) Switching to a more complete accounting of the impact of investment activities has far-reaching implications for asset manager strategy and operations. Development finance institutions (DFIs) offer many resources to enable this transition.

Reorienting towards impact will affect hiring, training, and compensation; organizational structure; information-sharing systems, shared values and cultural norms; brand evolution and all other activities of investment managers. Firms that take a “high sustainability” approach will develop different processes across the board, and over time will differ markedly from those that don’t.

The biggest single untapped resource for mainstream private equity investors is the development finance community. Organizations like the IFC and the World Bank were launched to address market failures. Their “non-financial” impact is essentially why they exist. Yet the research, data and frameworks they have developed have not been widely explored or adopted by mainstream investors.

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