Sustainable and impact investment are on the rise around the globe today. Integration of environmental, social, and governance (ESG) factors into investments is an increasingly accepted practice. Large investment managers now typically offer sustainability products and recognize climate change as a risk with which they must contend. Green bonds are a sought-after new asset class in the fixed income markets. The European Union is setting standards for ESG disclosure by corporations and investment firms. Estimates of assets under sustainability investment management now reach as high as $30 trillion.[i]
The remarkable growth in an investment discipline that 50 years ago was an easily dismissed footnote in the world of finance raises important questions about the nature and future of investing. What exactly are sustainable and impact investments? Why is interest in them so strong? Do they represent a fundamental, positive change in investment or are they no more than old wine in a new bottle, a form of greenwashing capitalizing on baseless marketing claims?
Having started in this field in the mid-1970s, I have followed its development with great interest, at various times worrying that it would be no more than a flash in the pan and that those entering the field were not true practitioners, and at other times amazed at its growing sophistication and embrace. Today, I believe the investment community has come to a tipping point at which this new approach may come to fundamentally alter the conduct of mainstream finance. Whether this potential will be realized remains to be seen, but powerful historical forces are pushing the investment community in this direction.
I began in sustainable investment by accident and before it was a field. In the mid-1970s, as an aspiring playwright I moved to New York to test my wings in the theater world. To keep myself in room and board, I took more or less by chance a day job opening the mail at the Council on Economic Priorities (CEP). CEP happened to be one of the only organizations in the United States at that time, and probably in the world, that was rating and ranking publicly traded companies on their social and environmental records: environment in the steel, oil, and pulp and paper industries, employment of women and minorities in retailing and banking. Data on company records was scarce and the number of investment options for “socially responsible” investment, as it was then known, for individuals could be counted on one hand.
Since then, I have watched the movement grow as it spread beyond the United States and Great Britain to Europe and ultimately the rest of the world. Twelve years later, when it finally occurred to me that this line of research would make an interesting career, the South Africa divestment movement was the issue of the day: cities, counties, and states were pulling their investments from companies operating there to protest that country’s racist apartheid laws. When Los Angeles, or the State of Wisconsin, or another public entity voted for divestment, it made front-page headlines. This use of investment to address the ills of society while still seeking competitive returns intrigued me, although the mainstream financial community still dismissed the practice as impractical and irresponsible.
In 1990, I joined with Amy Domini and Peter Kinder to form Kinder, Lydenberg & Domini (KLD), where we began to produce the first systematic social and environmental profiles of the companies in the Standard & Poor’s 500 Index. From this base, we launched the Domini 400 Social Index, the first socially screened benchmark stock index. It now has a 30 year track record and is maintained under the auspices of MSCI as the MSCI KLD 400 Social Index.[ii]
Since 1997, when Domini Impact Investments was spun off from KLD, I have seen environmental sustainability, labor practices at home and abroad, and a host of other social and environment issues become a major focus of the movement. Institutional investors including banks, insurance companies, pension funds, and mutual funds are increasingly interested in this developing discipline.
Having started with low expectations 45 years ago and seen change happen only slowly over the first 35 of those years, I remain amazed at the progress in the past decade. Nevertheless, I recognize that much of the mainstream remains unchanged and it is far from clear how deep the current commitments by many recent adherents run.
Originally known as “socially responsible” or “ethical” investment in the 1970s and 1980s this approach combined two primary groups of investors: those faith-based groups who had historically shunned alcohol, gambling, tobacco, and military weapons as they sought to “do no harm,” and second a new cohort of investors aligned with the activists’ issues of the times: peace in the wake of the Vietnam War, racial justice as exemplified by the civil rights movement, and the environment in response to rampant pollution of land, water, and the air. In the 1990s “sustainability” became a focus with its concern for intractable environmental issues such as climate change and its confronting of the twin challenges of achieving global economic development and avoiding environmental destruction. In the 2000s, the concepts of “best-in-class” and “double-bottom-line” investment found favor as more mainstream institutional investors began to incorporate environmental, social, and governance criteria into their investment to manage portfolio risks and potentially improve returns. Then in the 2010s, as many became impatient with the slow pace of change among large corporations and Wall Street, the language of “impact” investment took hold with its emphasis on direct and often small-scale, on-the-ground interventions that addressed such issues as poverty alleviation, access to healthcare, information technology, and finance, renewable energy and energy efficiency and organic and regenerative agriculture.
These varied approaches persist today, each with its own particular focus. Despite their differences, however, several common themes exists and constitute, to my way of thinking, a basic definition of the discipline writ large and highlight its fundamental differences from Wall Street.
To begin with, these investors want change: change from today’s laser focus on the maximization of returns in the shortest possible time to an understanding that all investments have, along with financial returns, impact on the fundamental social, financial, and environmental systems essential for investors’ long-term success. Similarly, they wish to reframe corporate managers’ single-minded drive toward the maximization of shareholder value to encompass as well other key stakeholders in the corporation—employees, suppliers, customers, and the environment—essential to value in the long run.
Second, while seeking to generate financial returns, these investors intentionally also seek to “do no harm” and when possible ameliorate the major social and environmental challenges of our time. This emphasis on the simultaneous creation of financial returns and of social and environmental value is often referred to as “aligning value with values.” These values are not, and should not be, those of idiosyncratic personal preference, but rather representative of challenges that threaten economic and social stability and hence the long-term prospects for investments. They include, for example, climate change, access to fresh water, pandemics, and biodiversity in the environmental sphere, and poverty alleviation, labor rights, income inequality, and gender and racial diversity in societal realms. This approach embraces, among other tactics, investments that increase access to communications and information technology, to financial services, and to medicine and healthcare for those most in need around the world, as well as environmental protections in a zero-waste-generating circular economy.
In addition, they believe that their role as investors includes the setting of and advocating for social and environmental standards and norms of conduct for the financial and corporate worlds. In the wake of the immensely influential Sullivan Principles for corporations’ employment practices in apartheid South Africa in the 1970s and 1980s, sustainable and impact investors have taken part in the creation of a multitude of codes of conduct for suppliers’ fair labor standards in the apparel, footwear, rug, electronics, cocoa, banana, and other industries. In addition, these investors engage with individual corporations on issues such as climate-risk mitigation, human rights and indigenous peoples, and diversity on boards of directors and among senior executives.
The path forward
The challenges of the 21st century are becoming more acute—climate change looms larger with each passing decade; COVID-19 reminds us that pandemics can easily wreak damage throughout economies in this globalized world; income inequality exacerbates social and political instability. The complexity of challenges such as these and the uncertain impacts of their ultimate risks have forced investors to think deeply about what changes are most fundamentally needed to contend with these conundrums that they face.
Two themes that hold out the promise of fundamental change increasingly resonate: the creation of new market mechanisms geared to sustainable and impact investment; and the development of investment policies and practices that can influence the dynamics of those systems that themselves are producing harmful outcomes—and help them produce desirable outcomes from the outset.
Two market innovations that sustainable and impact investors have made use of are microfinance and “green bonds.”
Microfinance and its sister, micro-insurance, typically provide small-scale, on-the-ground loans, private equity investments, or insurance products that address substantial social and environmental needs. Since the 1990s, a multitude of microfinance lending organizations has sprung up around the world, many of which help women with the funding of small, independent businesses that can help assure their self-sufficiency. In the United States community development banks, credit unions, and loan funds are similarly devoted to serving low-income communities in need. Some serve urban neighborhoods, others operate banks and credit unions in the small towns of rural regions. A network for impact venture capital funds also invests in start-ups or small-scale, for-profit ventures addressing a wide range of social and environmental challenges from youth unemployment and community healthcare to alternative energy sources and regenerative agriculture. And large insurance companies now offer micro-insurance products to low-income persons in developing countries for life insurance, property insurance for home-based businesses, and maternity benefits.
Green bonds are essentially a new asset class for fixed-income investors, issued by governments, corporations, or other entities and devoted to specific environmental purposes. Principles and criteria for independent certification have been established to assure that the funds raised go to projects with substantial environmental impact. These bonds fund projects such as renewable energy, energy efficiency, clean transportation, sustainable agriculture and forests, and water management. The concept of bonds targeted specifically to environmental and other social purposes is finding increasing traction.
As the interrelated nature of the global social, financial, and environmental systems has become all too clear along with the ability of the repercussions from the collapse of one to reverberate throughout the economy, institutional investors are increasingly developing policies and practices that go beyond simple management of ESG issues within a portfolio to a system-level approach to the management of long-term social and environmental risks and rewards.
Japan’s Global Pension Investment Fund (GPIF), with its $1.6 trillion in assets and corresponding market influence, has insisted on the management of risks and opportunities for two issues it believes are essential to the value of its portfolios over its 100-year investment timeframe: climate change and diversity. In 2019, GPIF updated its Stewardship Principles, which it requires its external managers to follow, to apply to all asset classes; to obligate its managers to engage on these issues not only portfolio companies but with other stakeholders as well, including index providers; and to vote on proxy resolutions according these Principles. At the heart of these Principles is GPIF’s belief in the need for long-term sustainability in the capital markets, which in turn depend on “long-termism” by investors.[iii]
Now a global coalition of over 450 investors with $40 trillion collectively under management, Climate Action 100+ is an example of a different systematic approach to addressing climate change. Having identified the 100 “systemically important” corporate emitters of greenhouse gases, who account for approximately two-thirds of industrial emissions, this coalition has embarked on a five-year program of engagement by regional teams of investors. Engagements focus on the creation of adequate climate-risk governance structures; the setting, monitoring, and meeting emission- reductions targets; and the disclosure of business climate-risk management plans.[iv]
These are just two of an increasing number of efforts by institutional investors to manage risks and create positive outcomes in those social and environmental systems posing the most serious challenges of our times.
Since my earliest days with Domini, the firm has been committed to the twin goals of promoting ecological sustainability and universal human dignity. We do so by applying social and environmental standards, supporting community economic development, and engaging with companies and others to change practice in these areas. We believe that if we are to confront and manage our greatest challenges—addressing systemic risks such as those posed by climate change and maximize our possible rewards such as those offered by gender and racial diversity—we need to promote fundamental change that will help protect and enhance our investment opportunities over a long time-horizon, across industries, and across asset classes.
We set social and environmental standards in our investment process. By applying social and environmental standards, we believe we can identify strong long-term investments, as well as sources of opportunity and risk often overlooked by conventional financial analysis, while simultaneously creating a sustainable economic system.
These standards have led to our exclusion of certain industries: for example, those substantially involved in manufacture of nuclear weapons, tobacco products, firearms, and operation of for-profit prisons, as well as those in the fossil-fuel production industries. We also have developed a framework within which to evaluate potential investments according to their stakeholder relations—that is, their performance relating to ecosystems, local and global communities, customers, employees, investors, and suppliers. These standards are spelled out in our Impact Investment Standards published on our website and serve as a guide our research and analysis.[v]
We support community economic development primarily through our fixed-income investments. We believe this asset class is particularly well-suited to help address a wide range of economic disparities. To help build a more sustainable and equitable society, our fixed-income investments focus on three key goals: increasing access to capital for those historically underserved by the mainstream financial community; creating public goods for those most in need; and filling capital gaps left by current financial practices.
We have paid particular attention to support for affordable and low-income housing. In addition, our fixed-income investments support health care, education, jobs, transportation, energy, water, financial services, and other critical resources. We have placed funds with community development financial institutions that channel money to projects in low-income neighborhoods and regions of need. We also hold green bonds issued by municipalities, real estate investment trusts, renewable energy providers, and non-profit environmental organizations, among others.
We engage with corporations to improve social and environmental practices. We use a combination of direct dialogue, filing shareholder proposals, proxy voting, and speaking out on public policy issues. Our engagements have focused on diversity and climate change, but also include human rights, weapons and firearms, access to medicine, the opioid crisis, and employee relations and labor issues, as well as forests.
We view the responsible exercise of our proxy voting obligations as part of this engagement process. For example, Domini will oppose the election of some or all directors where women make up less than 40% or at least three members of the board (whichever is greater). We recently contacted all 42 Japanese companies in our portfolios to explain our rationale in supporting so few Japanese directors and to encourage corporate practices that help elevate women in management.
Taking a systems-oriented approach – focusing on forests
In recent years, we have intentionally undertaken a systems-oriented approach when social and environmental challenges involve potentially complex systemic risks and rewards such as climate change, income inequality, and pandemics. We believe that strengthening the resilience and integrity of these critical systems can create lasting value for investors, as well as society, and that failure to do so may well cause irreparable harm.
As part of this system-level approach, we are currently 18 months into a multi-year project with the goal of contributing to the slowing deforestation and promoting of the preservation and enhancement of forests’ value-creating potential. Forests contribute to countless environmental, social, and economic services including clean air, a stable climate, food, and biodiversity. Around the world, indigenous peoples and local communities depend on forests for their livelihoods. Loss of forests threatens our clean water supplies, agricultural output, and ability to make progress on climate change. At present, investors tend to undervalue these extrinsic and intrinsic services.
As part of this project, we have created a forest beliefs statement to make explicit our understanding of the relevance of forests to our core investment practices and risk mitigation, to guide our actions, and to help measure our success. To align our investment practices with our forest beliefs, we have analyzed our portfolio exposure to deforestation and use of forest services. We then evaluated our library of proprietary key performance indicators (KPIs) across all industries and adopted new indicators to ensure that they captured decision-relevant risks and opportunities.
Believing that our social and environmental standards can be influential in sending signals to the market and setting a bar for best practice, we have shared our ideas and beliefs about forests and our practices with industry partners and peers. Our engagement work on forests has centered on dialogue with independent experts, NGOs, investors, asset owners, and companies in our portfolios, to better understand the challenges they face, how we can support them in overcoming those challenges, and how to encourage forest stewardship. We engaged by writing to those companies in our portfolios that we identified as both directly depending on and impacting forests, communicating with them to identify and disseminate practices and establish mindsets that are contributing to positive change. Public policy is also an important lever for change; consequently, we made the investor case for disclosure related to forest-risk commodities through a number of efforts.
Having taken these initial steps, we now focus on leverage points that we believe can help heighten awareness of forests’ value. These include: encouraging the world’s largest asset managers and owners to include forest-related risks and rewards in their climate-change policies; documenting the current status of, and advocating the adoption of, best practices in forest-related lending by financial services companies; identifying and documenting corporations implementing forest-positive value-creation initiatives; and support for public policy initiatives devoted to the preservation of forests as a source of sustainable value.
As this initiative has progressed, we have relied in part on the work of The Investment Integration Project, an organization promoting “system-level” investment techniques with which I have been involved over the years.
Whether the increasing acceptance and sophistication of sustainable and impact investment will take the investment community as a whole passed a tipping point to fundamental positive change is unclear. Current hints of such a transformation include the increasingly broad adoption of the language of sustainability and impact, along with a growing market for products with these labels, and the growing recognition that intentionally bringing about changes in underlying dynamics of social and environmental systems themselves can play an important role in creating long-term value for all investors.
The ever-increasing complexity and interconnectedness of social and environmental systems, driven in large part by the need to provide for a world approaching nine billion persons, will make it difficult for investors to ignore long-term systemic challenges. It does not seem unreasonable to anticipate that as the world rapidly changes around us in the 21st century finance and investments must undertake a radical transformation as well.