In this fourth article in the series on building a winning impact investment strategy, I discuss impact and ESG integration. I explain why they are different and why you need both. We look at how each are addressed at various stages of the investment lifecycle, and I provide a small example to differentiate these in the design phase.
Impact is not ESG, ESG is not impact
In an earlier article in this series, I explained why impact investments differ from ESG investments. In short, impact investments, look to create positive environmental and social benefits alongside generating a financial return. ESG investments on the other hand, assess Environmental, Social and Governance issues to ensure that they are sufficiently addressed, as to not damage the financial outcome of the investment, and have any other negative, unintended consequences. They are not one in the same, and I argue that both are needed, and both need to be addressed independently.
Managing ESG goes beyond scratching the surface of complex issues that may arise on the periphery of investment itself. In the context of forest investments in the tropics, the ESG manager, considers environmental issues, such as fire risk, or ground water contamination, or social issues, such as encroachment likelihood, or health and safety, and governance risks, such as corruption, and identifies ways to mitigate these risks. ESG management is not necessarily interested in positive impact outcomes, but on reducing risk.
Impact management is an investment approach that goes beyond do no harm, and instead focuses on doing well by doing good. Impact investment looks to create alternative returns (social and/or environmental benefits) alongside traditional financial returns. If we were to use the example above of ground water contamination, – an impact investment might look to improve water quality through its investment activities. Thus it would set up management systems that would deliver positive results on water quality.
I believe that both are important. An impact thesis should be specific. In Part 3 of this series, I describe a Theory of Change (ToC), and different impact pathways that can make up an impact investment strategy. There should be clear connection between what your impact objectives are, and how you will meet them. It may address some ESG issues, but it won’t touch on all of them, because it gets deep on impact opportunity, not risk management. So even within an impact investment, it is necessary to identify all ESG risks, and manage them to prevent both a poor financial result, and a poor impact result.
A good way to understand how to integrate your impact thesis with ESG management is through looking how each of these are addressed in the investment lifecycle.
Impact and ESG in the investment lifecycle
The investment cycle begins with the design of your investment strategy, and follows into deal sourcing and due diligence, decision to invest, investment management, and divestment. To simplify this explanation, I am leaving out all other elements of an investment lifecycle apart from impact and ESG (i.e. financial analysis and return expectations).
Strategy design
In the strategy design phase, you will develop your impact thesis, you will create a ToC, you will develop impact targets that you aim to achieve. You will design screening criteria to assess deals for their ability to deliver on impact objectives. You will establish a management framework, for how you will manage, and report on impact in the ongoing holding period of your investment. You will incorporate investment activities into your budget to ensure you capitalize on impact return drivers.
With ESG, you will develop an ESG policy – the rules for how ESG issues will be identified and managed within your investment, so as not to damage the financial outcome of your investment, nor cause harm in the ESG realm. You will go further to identify the ESG risks associated with your investment strategy, and explain how these will be mitigated.
Deal sourcing and due diligence
From the impact perspective, you will have established investment criteria, that can quickly weed out if an opportunity can deliver the impact you desire or not. This will be both within the characteristics of the opportunity itself, and also within the ability of the project developer to deliver on those objectives (i.e. the developer needs to share your impact philosophy).
ESG will be built into your due diligence checklist, categorically ensuring that all opportunities are compatible with your policy, or on some items, that they can transition to ESG compliance after the investment has been made.
Investment decision
An investment decision will be backed by evidence that the opportunity being considered has both the ability to deliver the intended impact, as well as manage ESG risk, all while being a good fit to deliver the expected return expectations. The recommendation leading up to the investment decision should include data that demonstrates how the investment will deliver on impact and ESG objectives. On the impact side, it might include a preliminary baseline report describing the situation that the impact will improve, and on the ESG side, it might be historic data demonstrating low likelihood of the risk eventuating.
Investment management
Regardless of how your impact investment is held – whether through a debt or equity instrument, you should have the ability to ensure that impact is managed, measured, reported, and in some cases verified. As in a traditional investment, you will have a solid understanding of the financial situation of a business before you invest and be able to assess its progress toward meeting financial goals throughout the holding period. Likewise with an impact investment, you will need to establish a baseline for your impact thesis, so you can understand the impact progress being made.
ESG also needs to be managed throughout the holding period. Baseline information may be needed as part of a risk mitigation strategy, but it is more to understand that your actions are doing no harm, rather than creating positive impact. As ESG covers so many facets, it tends to address many issues at a high level, rather than get into detail on few, as in impact management.
Divestment
When looking to exit an investment, it will be important to an impact investor that the next phase of the investment’s development maintains the same impact ethos. In a way, this is the final way of delivering impact to the shareholders or other capital providers exiting the investment. It assures them that the impact they have created will continue.
Good ESG management and documentation throughout your holding will facilitate a smooth exit. You will be able to demonstrate that through ESG management, you were able to reduce risk to your investment and secure value.
An example of Impact and ESG integration in the design phase
Let’s look at an example of how Impact and ESG could be integrated into a hypothetical strategy. In sticking with the water example above, let’s assume that the investors want to have a positive impact on improving water quality with their commercial forest investment strategy. In the strategy phase, they would structure a ToC around water quality. It might employ tactics, such as forbidding operations during wet weather, or re-establishing riparian areas with natural, stabilizing vegetation. They would develop targets, such as increase water flow in natural drainages, and have no increase in contaminants in the ground water by certain percentages. It would lay out the structure for how this would be managed, which could include following an international standard on protecting riparian integrity, training on how to avoid water contamination, etc. It would describe how often key metrics would be assessed, how often they would be reported, and describe how the exit strategy will continue to deliver positive water quality impact.
On the ESG side of things, an ESG policy would describe how key elements will be addressed. It will likely align to several industry-relevant norms, such as IFC’s Environmental and Social Performance Standards, conformance to sustainable forest management certification standards, ILO labor Standards, include a code of conduct that addresses corruption and bribery (among other things), address how encroachment and gender will be addressed, and on and on, considering much more than just water. ESG will be considered in the risk assessment. Categorically, it will address various ESG risks: climate, biodiversity loss, erosion, encroachment, health and safety, and identify mitigation tactics for these. As with the impact management, in the design phase, investors will communicate how ESG will be managed throughout the holding period. For example, there will be management overseeing ESG issues, identified ESG risks will be assessed and reported on at a certain frequency, and ad hoc events will be addressed as they arise. The exit strategy likely does not incorporate ESG explicitly. However, solid ESG management at the outset of designing your investment strategy, and on to exit, will build a more solid case for exit.
Three takeaways for Impact and ESG integration in your strategy
I hope I have demonstrated the importance of Impact and ESG integration into your forest impact investment strategy in the tropics. A clearly defined impact management process will keep you focused on delivering the impact results you desire, while a robust ESG policy and management framework addresses a multitude of issues that likely go beyond the scope of your impact thesis, to protect you from negative financial and impact outcomes.
To sum up, here are the individual strengths of an impact thesis and ESG management framework, and why it is most beneficial to integrate them together:
1. Your impact thesis, and all the foundational blocks that build it enable you to generate additional, measurable, and positive impact on aspects of your investment that are important to you. Specificity helps keep you on focus and target your efforts to the results you aim for.
2. Your ESG management framework should be categorically exhaustive, considering all relevant environmental, social and governance issues to your strategy. However, to allow this to be practical, specificity can be foregone in many instances. This will allow you to keep an eye on everything so to speak, rather than solely being focused on your impact strategy.
3. Integrating Impact and ESG, allows you to deliver focused and meaningful impact, while at the same time manage risk across a broad spectrum of issues.
Do you need support with Impact and ESG integration?
If you need support in Impact and ESG integration in your forest impact investment strategy in the tropics so that you can:
i.) communicate the value to your investors and other stakeholders,
ii.) assist management in sourcing and screening suitable deals,
iii.) establish a robust, yet practical integrated management framework, please reach out.
