11 min read 3 May 23
Fund managers need to be aware of unintended negative consequences of their investments, even when the fund is designed and managed exclusively to target positive impact. As impact investors, we need to take measures that proactively reduce the risk of negative impacts being generated from these investments, and, where peripheral negative impacts may occur, work hard with portfolio companies and other stakeholders to actively address these issues.
Do positive impact investors have to accept unintended negative sustainability outcomes – also described as 'trade-offs' or negative externalities – from their investments? Or can they effectively mitigate these negative outcomes via intentionally managing them in the impact investment process?
This article sets out how, for M&G’s public equity impact funds, we incorporate the critical concepts of 'net impact' or 'impact balance' in our impact investment approach, and how we manage our impact portfolios to help avoid, minimise and mitigate potential negative impacts.
Every business has an effect – or impact – on the world. In simple terms, companies can either contribute to societal goals or detract from them. In turn, investors can choose to invest in companies whose overall impact is either positive or negative. Investing for positive impact is not an exact science; and yet a robust process, rigorous analysis and a focus on evidence can help to ensure the overall portfolio is focused on positives and avoids negatives.
Our approach in M&G's equity impact team targets companies seeking to make a significant and intentional positive impact on critical social and/or environmental challenges, ranging from climate change and pollution to poor health and social exclusion. While a company’s operations, actions in the community or treatment of its workforce can all play a societally beneficial role, the main impact most companies can achieve is via the role of their core business in tackling the world's major challenges. An example would be a company whose core business is the generation of clean energy, rather than one simply reducing its own carbon footprint; or a company providing access to communications that can drive economic empowerment for vulnerable groups, rather than a company simply improving the diversity of its board.
So, our approach naturally focuses on 'solution-providers'. To identify such companies, our approach starts with a particular challenge, be it global warming, excessive waste or lack of access to healthcare, and then seeks out companies whose core business is directly tackling the issue. Materiality (or 'significance') is an important concept for us (as well as in the field of impact investing more broadly), so we look to find companies where the significant majority of the business, usually indicated by its revenues, is focused on the solution in question.
This part of our approach – identifying genuinely positive impact solution-providers – requires a lot of work, but is logical enough. However, we also want to ensure that the companies we invest in are not having – nor likely to have – a significant negative impact on other social or environmental factors. This deepens our analysis and ensures the net or overall impact is clearer and stronger.
It would be difficult to justify the case for a company that is creating a solution to address climate change but causing significant harm to natural ecosystems, or a company that manufactures life-saving treatments but uses forced labour in its supply chain to produce them. We think of this conceptually as 'net impact' or 'impact balance', whereby the impact of companies we invest in needs to be significantly positive overall, with any minimal negatives being outweighed by the positive impact generated.
We do need to recognise that it is effectively impossible to identify a company that has zero negative impact. However, companies with a clear and authentic purpose to tackle global sustainability challenges tend to naturally minimise their negative impacts, or are otherwise open to working with their stakeholders to reduce them. We think of these as 'net positive impact' businesses.
The 'netting off' of impact should not be thought of as a mathematical equation, nor should it be an excuse to permit significant negative impacts just because of the primary positive impact. But it is a useful concept to focus on with businesses where the overall impact is overwhelmingly positive, while also intentionally identifying and working on areas for development and improvement.
We employ a number of steps to identify, avoid or manage any actual or potential negative impacts in our impact investment approach. These are built into our ‘III’ (Triple I) approach, which focuses on Investment, Intention and Impact.
The first step is to apply rigorous screening, which enables us to rule out companies exposed to activities highly likely to cause significant harm, i.e. those operating in inherently unsustainable sectors such as tobacco, alcohol or fossil fuel extraction, or companies breaching norms and standards of sustainable and ethical business. This extensive exclusion list, covering both values and norms-based screens, plays a critical first-line role in avoiding negative impacts. It may restrict our investable universe, but it minimises our exposure to negative impacts and aligns our investments with the high expectations of our clients.
ESG analysis is a central aspect of our investment approach and is designed to identify and mitigate our exposure to sustainability risks. By systematically analysing potential investments, we build our understanding of challenges the company may be exposed to and how it is managing those risks. As well as analysing the company's own operations, we also consider its supply chain, as this is where egregious activities can sometimes be hidden. Companies that fail to meet our standards for ESG risk management will not make it through this stage of the process.
Tesla would be an example of a transformational solution to a systemic problem (unsustainable transport), but which failed our analysis on a number of ESG issues, including corporate governance and supply chain sustainability. While the Environmental and Social aspects of ESG are most naturally linked to our impact objectives, our focus on Governance also plays a crucial role in helping us to understand the business's purpose, whether its management are incentivised to deliver that purpose, how the board balances the interests of shareholders with other stakeholders, and whether the company has the right controls in place to effectively guide the company’s mission.
In the same way that we analyse our investments for the positive impacts they generate, we apply a similar lens to any negative impacts. For our positive impact assessment, we look at the revenues being generated from positive impact activities. In the same vein, we assess how material any negative impacts are to the company's business model. If the negatives are of significance, this would rule out the company as a potential investment. This may best be illustrated by way of several examples:
Within our Impact analysis (the third ‘I’ of our III), as well as assessing any actual negative impacts, we also focus on potential negatives or impact risks. We use the framework designed by the Impact Management Project (IMP) which covers nine different types of impact risk that may undermine the delivery of the impact. These range from ‘evidence risk’ (lack of sufficient data to understand the impact occurring) to ‘execution risk’ (the risk that the activities are not delivered as planned) to ‘unintended impact risk’ (the risk that a significant negative impact is experienced).
As active impact investors, we use engagement to encourage improvements to the ‘net impact’ and provide additionality. By engaging with investee companies, we can encourage greater positive impact, request more comprehensive data disclosure, or take steps to manage or reduce potential negative impacts. For example:
We believe that a positive impact balance is an important aspect of any impact investment strategy. It doesn’t make sense to play ‘whack-a-mole’ by aiming to tackle one societal problem while simply exacerbating another one. This is why we analyse the actual and potential negative impacts of companies, while also considering the impact risks. We do this before investing in companies, but also on an ongoing basis for companies held in our impact funds.
However, it remains important to recognise that the answer is never simple, and it is impossible to avoid all negative impacts. For example, the emissions generated in the production of climate solution products clearly release greenhouse gas emissions into the atmosphere. But the question for us is: how significant are these emissions, what is the company doing to reduce or mitigate them, and are they more than counterbalanced by the emissions-saving potential of the product itself?
By carrying out this analysis, we can direct capital towards investments which aim to make measurable, intentional, and truly positive impacts on the world’s most pressing challenges.
The value of the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.