July 5, 2017

Q&A with the Authors of Environmental Impact Investing in Real Assets—What Environmental Measures Do Fund Managers Consider?

Nicholas Institute for Environmental Policy Solutions

Investors have begun seeking opportunities for generating financial returns and quantifiable environmental gains. But what are investors getting out of their so-called environmental impact investing? To find out, five Duke University-affiliated researchers, including the Nicholas Institute for Environmental Policy Solutions’ Martin Doyle, interviewed investment fund managers of environmental real assets—assets that rely on ecological systems like forestlands and farmlands to generate cash flows. Their report sheds light on how fund managers think about measurement and reporting of environmental returns.

Q: One of your study findings is that there’s little consistency in how the environmental returns of funds are measured and reported. What kind of metrics are fund managers using?

The types of metrics generally fall into three categories: environmental metrics required by regulators like the EPA, voluntary certifications using specific metrics and parameters, and voluntary metrics used to demonstrate mission-oriented, performance, or marketing goals. These latter metrics tend to be qualitative, and their main value appears to be just their existence. Ideally, they would not be merely descriptive statistics, but instead be comparable across funds, allowing investors to use environmental returns to directly compare investment options.    

Q: With such diversity in how funds are measuring their environmental performance, how do we know that environmental impact investing is a worthwhile activity?

At the moment we can’t answer that question. Because of lack of measurements and metrics—and wide variability in measurements and metrics that do exist—it’s difficult to say that environmental impact investing is generating meaningful environmental outcomes.

What we learned is that most of the environmental metrics that fund managers are using are designed for the purpose of reporting rather than for evaluating fund environmental performance. That is, fund managers and investors appear to be more interested in reporting of environmental returns than in actual performance. What we have are binary measures and evaluation approaches—funds are rated as environmentally sustainable or not environmentally sustainable. They aren’t rated on their rising or falling performance, so investors can’t distinguish among funds in terms of environmental returns. If a fund is identifying itself as an environmental impact fund, investors can exercise some level of upfront due diligence but otherwise will have to take the word of the fund. Investors certainly don’t have the information to directly compare two different, if similar, funds.

Q: Yet you note that impact funds are not necessarily identified as such. Why?

This was one of the more interesting and subtle findings of our work. Investment funds are free to self-identify as impact investment funds. Funds that intentionally create environmental returns and measure and report those returns may choose to identify themselves as conventional funds because impact investment funds are often associated with reduced financial returns—that is reduced financial returns are the perceived cost of providing environmental returns. So impact funds may attract fewer investors than non-impact investment funds. For other funds, identification as an impact fund may provide a marketing edge. We think there may be investors sitting on the sideline waiting to see whether environmental impact funds can generate near-market returns. 

Now consider the investors. Institutional investors like university endowments or pension funds, are typically the largest sources of investment capital. These investors require returns to be consistent and long term. But now these types of investors are getting a lot of pressure, including environmental pressure, to invest in socially responsible ways.  For instance, we’re seeing more university endowments divesting from fossil fuel-based holdings. Impact investing gives institutional investors the ability not just to avoid negative investments, but also to target positive investments. So their interest in environmental impact investing is growing, although it remains very limited compared to traditional investing by institutions. 

Another type of investor is high-net-worth individuals, or family foundations and offices. These investors have always been thought to be a likely source of impact funds because they have the most leeway to put their money into targeted funds, especially funds that might match their mission.   

Q: Does your research point to a different conclusion?

Our survey shows that investors—particularly high-net-worth individuals—are not sources of capital for environmental impact funds. Rather, they are seeking risk-adjusted, market-rate returns regardless of environmental performance.

That brings us back to the matter of metrics. One reason that investors—whether individual or institutional—have metrics inadequate to distinguish among funds’ environmental returns is because they have been generally uninterested in that information. That reality reflects their disinterest in or unwillingness to compromise financial returns for environmental returns.

Q: That explains how investors influence the environmental measures provided by funds. But you also say that funds are turning to third-party investment advisors to interpret environmental impact.

Many investors and fund managers look to investment advisory services to translate investment goals into a recommended investment strategy. Advisory services commonly act as kind of conduit for which opportunities get the attention of interested capital. As a result, they have a lot of influence on which specific funds, or types of funds, attract capital from investors. The problem is that many of these services don’t have the environmental expertise to determine the highest environmentally performing funds. And again, without any metrics or measures of environmental performance, investors have no ability, with or without advisors, to find environmentally meaningful investments.   

Q: In the environmental impact investing landscape you portray, funds compete on the basis of environmental accounting and reporting rather than environmental performance, and self-identification as an impact fund does not correspond to environmental accounting effort. And yet you say that despite their general disinterest in sophisticated and ongoing environmental returns information—disinterest that has in part led to lack of rigorous and comparable metrics—impact investors are now turning to poorly equipped advisory services for that information. What does that mean for the future of environmental impact investing?

The bottom line is that the environmental real assets investment sector, which we describe in detail in the report, is growing for a variety of reasons. And as it grows, environmental measurement and reporting must advance. Standardization both in metrics and reporting format would be beneficial. Because the products of standardization efforts are not gaining widespread adoption, funds must directly engage the environmental science and management community in those efforts. In turn, that community must look for opportunities to bridge the gap between its expertise and the expertise of investors, fund managers, and advisors.