Investors need better ways to measure and integrate ESG outcomes

Investment returns have long been somewhat disconnected with the social returns of ESG-related and impact investments, leading to confusion around different targets and how to integrate them into an investment framework, according to a leading expert in sustainable and green finance.

Speaking at Conexus Financial’s Fiduciary Investors Symposium, Associate Professor of Finance Weina Zhang, Academic Director of MSc in Sustainable and Green Finance Programme and the Deputy Director of Sustainable and Green Finance Institute (SGFIN) at the National University of Singapore, ran through a case study demonstrating how investors can better allocate their capital by explicitly incorporating impact preference and returns into portfolio theory.

Zhang chose the WaterCredit Investment Fund 3 (WCIF3) as a “testing ground” for her team’s theories, after a high-net-worth colleague received an invitation to invest in the fund launched by WaterEquity whose founders are Gary White and Matt Damon. WCIF3 aims to provide clean water solutions to four developing countries including India, Indonesia, Cambodia and the Philippines.

The blended finance initiative involves equity sourcing and debt sourcing. Investors give money to WaterEquity as a fund manager, and then the manager disperses this to micro-finance institutions and water credit enterprises, who will lend to provide clean water solutions. The initiative has also received loans from entities including the Bank of America and the IKEA Foundation, she said.

Her team looked at three types of investors interested in putting money into these kinds of funds: foundations, financial institutions and high-net-worth individuals. The team assigned financial institutions as having the lowest risk aversion, and high net worth individuals having the highest, with foundations in the middle. 

The team also used a parameter called “impact preference,” which looks at how much the investor cares about the social and environmental returns of the investment. The team assumed foundations are the most interested in the impact, caring 70% about the impact and 30% about the traditional financial returns. Financial institutions would be in the middle, and high net worth individuals would care the least about impact. 

“Don’t blame us for the exact numbers, and if you disagree it’s okay, because the numbers are basically for us to understand how the math works out,” Zhang said.

In assessing the expected outcomes of the investment, there were some challenges because WCIF 3 fund only described what it was going to do with the money–distribute it to 25 MFIs–without providing the names. Investors would need to know about the expected social or environmental outcomes of the project and the associated risk before they make the decision to invest, such as how many people it aims to be given access to clean water, Zhang said.

The team resolved this problem by accessing a microfinance institution database to calculate social outcomes and the associated social risk based on how much money was lent to the poorest among the population, and how many were female borrowers.

“Because in the microfinance literature, reaching to the poor and woman empowerment are two important social outcome indicators,” Zhang said.

A few months later, WCIF3 did in fact publicly report these two numbers together with other social and environmental outcome, but this was “realized outcome,” Zhang said, “because investors actually need these numbers ex-ante when they are making the rational investment decision.”

Incorporating social risk into the parameters involves more sophisticated mathematics, she said, but is crucial as risk aversion applies both to the financial returns and the expected social returns of the project, Zhang said.

This would lead ultimately to the highest allocation coming from financial institutions because they are more comfortable with risk, “and there’s a lot of social risk with this kind of micro-finance institutions investments where many difficult things can happen on the ground during the actual implementation,” Zhang said.

The team then calculated the utility, or level of satisfaction, from the different types of investors, finding financial institutions had a level of satisfaction 57% higher than if the capital was allocated to comparable financial investments alone. 

“So this is how you can convince your traditional investors to move into a new paradigm because you can show them that they actually would be happier about this type of investment and you have a very quantitative model to parameterise all these things,” Zhang said.