Sustainability and Development Impact - Putting responsible value creation at the center of investments

ESG Investing: Practices, Progress and Challenges

Investment incorporating sound environmental, social and governance (ESG) criteria, also known as impact or sustainable investment, has grown rapidly over the past decade - by some counts to over US$17.5 trillion globally.[1] While some of the interest springs from the desire of investors to have a positive impact on the world, much of it is based on the conviction that ESG factors affect the long-term performance of investments and thus profits.

The worldwide focus on the specific and pressing ESG factor of health and safety during COVID ?further accelerated the trend. From January through November 2020, investors in mutual funds and Exchange Traded Funds alone invested US$288 billion globally in sustainable assets, a 96% increase over the whole of 2019.[2] The pandemic may have served as the tipping point for ESG and should have a long-term impact on the financial ecosystem. It has also put a spotlight on ESG issues beyond health, such as income inequality, diversity and inclusion, social injustice, employee welfare, and climate change.

Although defining and measuring ESG criteria is complex, studies suggest that ESG investing can improve risk management and lead to returns that are equal to those from traditional financial investments.[3] In addition, growing awareness about climate change, responsible business conduct, and diversity is increasingly influencing consumer choices and thus putting pressure on investors and asset managers to integrate ESG criteria into their investment decisions. There is a discernable shift away from short term thinking, to sustainability, incorporating broader external factors to maximise returns and profits over the long-term, while reducing controversies that erode consumer and stakeholder trust. The trend is being supported not just by Multilateral Development Banks, but also by major investment banks and asset managers, institutional investors, and central banks. The number of ESG rating agencies, ESG indexes, and ESG focused mutual funds is booming.

Notwithstanding this progress there are some challenges that delay development and implementation of ESG standards. For ESG to work and become more than white- or green- washing we need to overcome them.

First off, we must ensure that reporting on ESG issues is relevant, consistent, transparent, and objective. Secondly, we need to improve the alignment of ESG with investors’ sustainable finance objectives. And, thrid, as in all investment matters, we need public and regulatory engagement nationally and globally. To be effective and credible ESG practices must be consistent and comparable at the global level, which involves coordination between policymakers, investors, and other stakeholders.

Moreover, ESG criteria should not just be written into contracts, they must be implemented. Investors need to put in place an ESG Management System and embed an ESG culture throughout their organizations. Policymakers, for their part, should assure that social and environmental principles are not only written into law and ratified but applied. This is not always the case in all jurisdictions, so DFIs and donors should help governments build the necessary capacity.?

Investigating implementation is also difficult, especially in developing countries. It requires regular performance reviews of projects based on data supplied by the company or a government entity. This may not always be reliable or objective, so it should be augmented through the services of local specialists or specialized agencies. In practice, doing thorough initial due diligence on the investee company or relevant government entity is one of the best ways of assuring the reliability the data they supply.

Assuring sustainability of and through infrastructure

The UN’s Sustainable Development Goals (SDGs) are good targets for impact investment, including for infrastructure. Beyond the Sustainability Development Goal 9, “Industry, Innovation and Infrastructure”, infrastructure has a substantial impact on about two thirds of the other SDGs, from energy and clean water to sustainable cities, climate action and more. In fact, it can be argued that none the overall targets of the SDGs of eliminating poverty and inequality and preserving the environment can be achieved without adequate infrastructure.

Following ESG standards is particularly important for infrastructure projects since most involve diverse ESG risks that can affect their viability. These include risk factors such as greenhouse gas emissions and energy consumption, soil and groundwater pollution, labor and working conditions, occupational and community health and safety, and involuntary economic or physical displacement of communities. It is crucial to integrate ESG into the whole investment cycle, from deal origination, pre-investment screening and due diligence, to investment decision and disbursement, to post-investment monitoring and final exit.

Another requirement is driving an ESG culture across the organization, with ESG-centered paradigms engrained into the organizational DNA through the alignment of ESG objectives with the investment strategy. Investment officers are also tasked to identify and support ESG-related value adding initiatives that enhance portfolio companies’ performance. This is done at the pre-investment stage, followed by on-going monitoring post-investment. To ensure development impact and sustainability there must be a proactive dialogue and information sharing with all stakeholders to understand what is working, or where additional attention may be required to improve ESG performance.

To make all this work you need capacity building through training of senior management, Board members, and investment teams, as well as assisting project sponsors and portfolio companies, where applicable, to implement ESG action plans and address areas of non-conformance with applicable requirements. And finally, one of the most important and difficult functions is monitoring and reporting on ESG performance by identifying key performance indicators for tracking progress and deciding on the method and frequency of data collection and the people responsible for it. This requires appropriate disclosure on ESG performance from project sponsors and portfolio companies.

Measuring impact

Impact Investing?is defined as investing into companies and organizations with the?intent?of?contributing?to?measurable?positive social or environmental impact alongside financial returns. According to the Global Impact Investor Network, investors’ approaches to impact measurement will vary based on their objectives and capacities, and the choice of what to measure usually reflects their goals. In general, best practices for impact investing measurement include establishing and stating ESG objectives to relevant stakeholders, setting performance metrics related to these objectives using standardized metrics, monitoring, and managing the performance of investees against these targets, and reporting on ESG performance to relevant stakeholders.[4]

IFC, the world’s sustainable investing pacesetter with its Performance Standards, posits that to judge whether they are contributing “additionality” to an investment DFIs should estimate the difference between how the country and sector are with the DFI investment compared to how they would have been absent the investment. For example, how does a DFI address a client’s financing needs in terms of longer-term or local financing? How does it bring non-financial risk mitigation—such as introducing the client to other financial institutions and investors or providing political and country risk coverage to the host country? Or how does the DFI bring global, technical, and industry knowledge to a local client when it moves into new markets and sectors? And finally, how does a DFI bring “financial additionality” through longer financing terms, resource mobilization, or market risk comfort?[5]

Why Africa?

Investors have good reasons to choose Africa for impact investing. With broad development needs and unsaturated markets there are countless opportunities to make a difference while making a good return. Many of the SDGs have been met in more advanced economies, so having a significant development impact there is more difficult. Meanwhile, Africa is starting with a low-base, so visible progress, measurement, and impact can be far greater. It is also increasingly in the eye of concerning consumers in developed markets who encourage the work of DFIs to support sustainable investments in Africa, including non-commercial ones.

A turning point could be reached if Africa’s growing domestic capital can be tapped more consistently. Local companies and investors know local circumstances and are more beholden to making a positive difference than outsiders. McKinsey estimated that in 218 there were over 400 African companies with revenues of over US$1 billion.[6] And this is only the tip of the African potential investment iceberg. Prior to COVID, assets under management by African institutional investors were expected to rise to $1.8 trillion by the end of 2020 from $670 billion in 2012.[i] PWC further estimated that pension fund assets in 12 African markets were to rise to about $1.1 trillion by the end of 2020 from $293 billion in 2008.[7] African sovereign wealth funds are also growing, and 20 countries now have them. These home-grown institutional investors, whose holdings are expanding into stocks and bonds, real estate, infrastructure, and private equity, are helping deepen local capital markets. This is crucial for infrastructure investment at a time when international capital is becoming more cautious and foreign exchange risks are growing.

Impact investing increasingly offers institutional investors the opportunity to earn a risk-adjusted, market-rate return on their investment while having a positive social or environmental impact.?Institutional investors can put capital to work?directly?in funds, organizations, companies, or projects that generate a financial return alongside a?measurable?social or environmental impact. While not exclusive to impact investing, the direct and measurable effects achieved through impact investments often distinguish this approach from other categories of Responsible Investment (RI) (e.g., ESG Integration and ESG-screened funds), which tend to be more indirect and, therefore, more difficult to measure. In the?2019 GIIN Annual Impact Investor Survey, most impact investors surveyed by the GIIN expect non-concessionary, market-rate returns on a risk-adjusted basis and 87% of impact investors targeting market-rate returns reported that their expectations were either met or exceeded. [8]

However, since institutional investors are relatively new to impact investing, and even more so to African infrastructure, they seek the help of MDBs and DFIs. They prefer co-investments with the MDBs because they feel that MDBs have a better understanding of the underlying risks at the country level and that MDBs can help mitigate potential political risks.

In the GIIN Survey:

- Investors appreciate the technical expertise that MDBs have in project origination and the rigorous due diligence that they conduct. Investors would therefore be interested in seeing investment products that build on the MDBs’ technical expertise and country-level knowledge.

- Investors confirm that MDB capital should be used as risk capital and to provide credit enhancement—by creating subordinated capital tranches, guarantees, and other applicable instruments to encourage additionality.38

- Blended concessional finance for private sector projects is one of the significant tools that MDBs can use to increase to finance for important private sector activities and mobilize private capital. Investors confirm that they are interested in learning more about the blended finance instruments that the MDBs are developing.

Of particular interest to institutional investors is taking over projects that MDBs have financed during the greenfield phase, implying that the MDB would sell down the project debt to institutional investors during the brownfield phase. In this way, the MDB assumes the risk during project design and preparation, which are perceived to be the riskiest stages of the project but would then exit the project through securitization. This will allow the MDB to monetize its infrastructure investment earlier than is currently the case and free up capital for new projects. At the same time, it will allow institutional investors to participate in less-risky projects that are already operational

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[1] OECD ESG Investing: Practices, Progress and Challenges, 2020

[2] OECD ESG Investing: Practices, Progress and Challenges, 2020

[3] OECD ESG Investing: Practices, Progress and Challenges, 2020

[4] GIIN, https://thegiin.org/impact-investing/need-to-know/

[5] IFC Working Paper 562, 2020, Measuring the Development Impact of the IFC and Development Finance

[6] McKinsey Quarterly, Africa’s overlooked business revolution, November 15, 2018

[7] AfDB, African Economic Outlook, 2018

[8] GIIN, Annual Impact Investor Survey, 2019

[i] AfDB, Working Paper 325, Unleashing the Potential of institutional investors in Africa, 2019