11/04/2013 12:31 BST | Updated 11/06/2013 06:12 BST

The Rise of Impact Investment

Awareness of the need for new ways of investing is growing, and there are some tentative signs that it is having some impact on investor behaviour.

More investors are coming forward with 'socially responsible' funds, but their impact is equivocal. Could a new form of investment make a difference? Heather Connon reports.

There can rarely have been a better time for proponents of sustainable investment to make their case. This year started with the scandal of horsemeat being passed off as beef, exposing fraud and a lack of rigour in the (often tortuously complex) food supply chain; in the last two years, environmental catastrophes - including hurricanes Irene and Sandy, the prolonged US drought, and flooding in Australia and the Americas - have added to evidence of global warming; and the financial crash has exposed flaws in the banking system so substantial that they threaten the existence of the global economic system.

Awareness of the need for new ways of investing is growing, and there are some tentative signs that it is having some impact on investor behaviour. EIRIS, the environmental consultancy, calculates that British investors had almost £11 billion invested in ethical funds in 2012, a 10-fold increase since June 1996, and a survey by the UK Sustainable Investment and Finance Association in 2011 found "early signs of a step change in the number of ... corporate pension funds that are responding to the case for responsible ownership and investment". Across the world, investment institutions now have $13.6 trillion of assets incorporating environmental, social and governance concerns into their strategies, according to the latest report from the Global Sustainable Investment Alliance, accounting for more than a fifth of total assets under management. Investment managers responsible for $6.5 trillion of foreign capital investment have signed up to the United Nations-backed Principles for Responsible Investment, launched in 2006.

Many initiatives fall under the umbrella term 'socially responsible investment' (SRI), used to describe everything from strategies based around negative screening ('no guns, no gambling') to those which positively select sectors, such as renewable energy generation. Nick Robins, a veteran of the SRI movement and head of the climate change centre at HSBC, thinks momentum on this particular approach is gathering: "The financial crisis has shown that financial markets can exhibit huge systemic risk. That puts the question of SRI into a bigger arena", Robins told Green Futures. He believes SRI has moved beyond being a niche area of investment, and is now "about asking what sustainability means for the resilience of the whole financial system".

For Simon Howard, Head of Sustainable Financial Markets at Forum for the Future, this is indeed the question we need to ask. "SRI is a welcome step in the right direction, acknowledging the need for smarter investment, but it isn't enough", he warns. "Forum for the Future wants to see investors taking into account more than just short-term monetary returns, through new models in which financial gain is considered along with the investment's contribution to environmental and social sustainability."

Even those who do profess to consider SRI issues in their investment strategies often pay little more than lip service to it. The FTSE4Good ethical index, for example, which institutions can use to screen their investment, has only limited exclusions, and allows oil and mining companies. Jamie Hartzell, Managing Director of the recently launched ethical investment exchange Ethex, points to research showing that, in 2011, the biggest holdings in many retail ethical funds included companies like gas producer BG Group, and HSBC, which has been fined for breaches of money-laundering regulations in the Americas.

Howard would like to see mainstream capital markets embrace the principles of SRI, but within their core operations. "There is a business case, but the stock market rewards need to be more widely recognised. Leading companies, such as M&S with Plan A, are working to demonstrate the benefits of sustainability to investors."

But this is easier said than done. Seb Beloe, Head of Sustainability Research at WHEB Asset Management, points out that the average holding time for shares is now just seven months; in the 1970s, it was five to six years. "If you are holding a share for five or six months, you don't look at [SRI] stuff, and why should you? It is not relevant to that kind of time horizon." While there is a growing recognition that controlling the costs of energy, waste management and water provision makes sound business sense, there is not yet a clear and widely recognised stock market reward for those companies which manifest optimal behaviour on such things.

There's increased pressure for cultural change at financial institutions

That said, shareholder engagement does seem to be increasing. The 'Shareholder Spring', as increasing activism at company annual meetings has been dubbed, has seen executives ousted, pay packages blocked, and increased pressure for cultural change at some financial institutions. There has also been an increase in specific campaigns, such as that in the US to persuade university pension funds to pull out of investment in fossil fuels, or campaigns by groups of investors against labour market exploitation or extracting oil from shale (fracking). It may be easier to engage pension funds in this kind of activism; after all, their role is to manage people's finances for the long term - as many as 50 years ahead, when many of the environmental consequences (of, for instance, fracking) may have crystallised.

However, as Beloe points out, the vast majority of investors are still more focused on short-term financial performance, rather than the wider long-term needs of pension holders. Moreover, fund managers consider it their legal (fiduciary) responsibility to asset owners to maximise short-term gains - though Freshfields, a leading London law firm, and The UNEP Finance Initiative have jointly challenged this narrow interpretation, saying that it can incorporate social and environmental considerations.

Now, the financial crisis, and disillusionment with the financial system, is increasing interest in positive investing - as opposed to negative screening. Will Dawson, Principal Sustainability Advisor at Forum for the Future, defines sustainable investment as "the allocation of capital into activities which are needed to create a sustainable economy". Such activities range from companies whose products and services have a positive impact (in, say, water conservation) to local initiatives, such as community-owned renewable energy projects. Dawson is seeing more interest from mainstream fund managers in these kinds of projects.

James Vaccaro, Head of Market and Corporate Development at Triodos Bank, one of the leading funders of renewable, microfinance and other impact investments, says there is increasing interest in this area from institutions, too. For example, the Dutch pension fund service company PGGM and Ampere Equity Fund have a stake in the UK's largest wind farm, Walney, off the Cumbrian coast. Of course, it's difficult to judge whether their motivation is environmental or financial, or both.

The parallels between the energy, food and finance systems are striking. Ask yourself where your food and power really come from, and then try and name three companies your pension is invested in. Most of us can't answer. This wouldn't be a problem if we had full trust in those managing the systems for us and the rules that guide them, but crises of late show that would be naive.

Among the Forum's initiatives is an investigation with Barclays into the potential of 'impact investment', in which investors are motivated primarily by the positive impact that the companies they invest in create, rather than by financial returns. "This concept of 'impact investment' is catching on fast", says Dawson. Pension funds and banks are now starting to tentatively enter this sector, embracing the opportunity to lower their overall risks by investing in new areas of the world and sectors of the economy.

"The prospect of this 'big money' entering impact investment is exciting", says Dawson, pointing to the Esmee Fairbairn Foundation as one of the pioneers: "They see that investing a relatively small amount of their capital into innovative new schemes can shift the market in the future, simply by proving alternative concepts." The returns on such investment may be smaller, potentially reducing the capacity of their grant programme, but the effect of their programme in the round, including the social benefits of the impact investing, is arguably increased.

A 10% reduction in re-offending would result in a 7.5% annualised return

This new trend in impact-focused investment takes a number of forms. Esmee Fairbairn invested in the world's first Social Impact Bond: a new concept which pays returns to investors based on the impact they have, rather than the income they generate. One example is Prison Bonds, piloted in the UK and the US, which reward investors depending on the reduction in re-offending rates by released convicts. For example, in Peterborough, £5 million was raised from 17 social investors to fund work with 3,000 male, short-sentence prisoners following their release. If the Social Impact Bond delivers a drop in re-offending beyond 7.5%, investors will receive an increasing return capped at a maximum of 13% per year over an eight-year period. The return is paid by the authorities out of the savings they make by not having to deal with the current, high re-offending rate. For example, a 10% reduction in re-offending would result in a 7.5% annualised return.

Energy generation projects are a key growth area for sustainable investment, not only by large funds but also by local communities. In Germany, 25% of renewable energy projects and 40% of wind ones, are community owned. Abundance Generation is one of the companies striving to increase local ownership of renewables in the UK by asking individuals to subscribe to projects with a minimum investment of just £5. Abundance now has 2,000 members, and 500 investors who have already backed two projects: a solar project in the South Downs, which raised £500,000 with a capacity of 266kW, and a 0.5MW wind project in the Forest of Dean, which raised £1.4 million. Details of the third will be revealed shortly.

Louise Wilson, Managing Director of Abundance, believes projects of this kind should also appeal to those who want a financial, not just a social, return, given the growing disillusion with banks and fund managers. She points out that these institutions are charging high fees, yet failing to provide returns.

The good news is that investment models with an eye to positive change are emerging, and pioneers are coming forward to prove them. But scale remains a challenge. Will 'big' investors be able to embrace them, without repeating the mistakes of the past?

The growing number of financial and governance scandals in recent years have underlined the fact that irresponsible behaviour cannot be divorced from financial returns. Investors have a golden opportunity to demonstrate that they can not only offer attractive financial returns but social and environmental benefits.

Heather Connon is a freelance journalist specialising in finance and investment.