With ESG firmly embedded into the financial system as underlined by increasing regulation as well as the gravity and scale of social and environmental issues exacerbated by a pandemic, how are investors addressing and evolving what is traditionally a financial-first approach in order to put real world impact at the heart of investments?
There is a spectrum of approaches available to sustainable investors, ranging from exclusions and ESG integration through to impact investing. Investors along this spectrum might also have different motivations and objectives, from alignment with their values and better risk management to driving real-world positive change. In responsible and sustainable investing, one size does not fit all.
The ESG challenges themselves can be viewed from two different viewpoints: one focuses on how external ESG issues are affecting a company’s business and financial value (an ‘outside-in’ perspective); the other focuses on the effect the company is having on society and the environment (an ‘inside-out’ perspective). A holistic approach which combines both these perspectives is known as “double materiality”, since it focuses both on what is financially material to the company and on what is material to people and the planet.
To illustrate with an example, single materiality might consider the financial risk to the company’s value of disruptions in its water supply; but a double materiality viewpoint would also consider the impact on local communities and the environment of the company’s water extraction methods. This latter aspect may not (yet) be a driver of the company’s value, but it is certainly meaningful from a sustainability perspective.
“The principles and processes of impact investing need to be embraced by mainstream finance.”
ESG integration has played a huge role in aligning portfolios with client values and better managing long-term portfolio risks, there are concerns that it hasn’t had the desired effect on real-world outcomes such as slowing climate change, reducing inequality and halting degradation of the natural environment. Impact investing – which looks to increase positive impacts and reduce negative impacts – aims to change that.
“Many investors are focusing more on societal outcomes, thinking about what additional role their capital can play and the contribution they can make to the Sustainable Development Goals (SDGs),” says Ben Constable-Maxwell, Head of Impact Investing at M&G Investments. “If we’re going to address society’s priority challenges, the principles and processes of impact investing need to be embraced by mainstream finance. And a focus on double materiality has a role to play in this transition.”
Swapping footprints for handprints
Climate change is a vast area of risk that stops at no borders – and requires a multitude of actions and solutions. Here, traditional ‘outside in’ ESG approaches would look at climate change largely through the lens of how regulation or customer preferences might affect the prospects of a high-carbon company – and investors would encourage the company to manage its risks by reducing its negative emissions footprint; an inside-out approach flips this and recognises how a company’s own activities might be contributing to climate change or causing environmental damage. Investors using both lenses will naturally have a more holistic view of the risks and opportunities, and might have a preference for businesses actively creating a positive impact, or a ‘handprint’, through their core business activities. So, for climate focused-investors, what type of business would this lead you towards?
“You might be a business that is embracing the circular economy to reduce waste and cut the use of virgin materials,” says Constable-Maxwell. “You could be a clean tech company developing the use of low carbon and non-polluting green hydrogen, or a power utility orienting towards renewable wind and solar generation away from fossil-based power generation. In other words, you’re really embracing a solutions approach, on top of reducing the negative operational footprint that you might have.”
Addressing our linear economic model
How is M&G applying double materiality to drive transformational change to one of the biggest challenges we face – excess emissions and waste from our current linear economic model?
There are various options across both public and private markets to support a more circular economy where companies are mitigating excessive waste into the environment. Major consumer and retail businesses are committing to reduce their use of plastic packaging – i.e. their footprint – driven by pressure from citizens and regulators.
But certain companies are going further and employing innovation to intentionally tackle and solve the issue. In public markets, M&G’s Equity Impact team invests in sustainable packaging producer, DS Smith, and global circular logistics business, Brambles, as well as Darling Ingredients, which transforms waste products into feed and fuel. All of these are designing waste out of the system. On the private assets side, investors also have the opportunity to invest in earlier-stage solutions.
“M&G’s Catalyst team has invested in a circularity pioneer called UBQ Materials, which takes items from the household waste stream that would normally end up in landfill and were previously hard or impossible to recycle – everything from mixed plastics through to organic materials can go into this process,” explains Constable-Maxwell.
“UBQ has developed a unique and highly efficient process that can transform all of that waste into a high-quality recyclable thermoplastic that has uses in industries as varied as retail, transportation and construction,” he adds.
What would happen to that high-quality plastic material once it’s run its course?
“The argument is it’s completely recyclable,” says Constable-Maxwell. “The process turns waste into a valuable feedstock – a new, high-quality material that can be used in electric vehicles or durable construction materials. It’s the antithesis of single use.
“We need plastic for all sorts of things – it’s a lightweight, durable and versatile material but the problem is that manufacturing it tends to be highly carbon intensive, it uses oil feedstock and we haven’t got the infrastructure to recycle it at the end of its product life so it tends to get landfilled or incinerated. However, the UBQ product captures carbon and waste at the front end, has a very long life and is then recyclable at the back end of its use. It is designed explicitly to solve a problem, or in fact a range of problems.”
Investors increasingly recognise their responsibility as actors in society to help tackle sustainability gaps, and where appropriate, provide solutions to them.
Embracing the concept of double materiality can take sustainable investing to a critical new level which is intentionally designed to tackle real world challenges as well as managing portfolio risks.
As regulators increasingly focus on societal outcomes and investors recognise the potential negative impacts of their investments, double materiality has the scope to become a prominent prong of sustainable investment.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
