Rethinking Policy Shaping Impact Investing
To wield the full potential of capital is impact investing. To confront the challenges facing society is impact investing. Impact investing serves the future, and it is the future of investing.
Impact investors fund companies in order to directly generate both a positive impact and a financial return. By providing capital to impactful companies, investors hope to address the world’s leading issues. The foundations of these companies rest on a mission to serve the common good. Some investment verticals are improving access to education, preserving the environment, harnessing technology, fostering social justice, and supporting healthcare. No matter the industry they feel called into, the hearts of all impactful companies prioritize making a difference.
Investors select the companies they feel align with their values and priorities, yet their financial contributions are not donations to charity. In fact, the hallmark of impact investing relies on the premise that investors will receive a financial return on their capital, albeit a smaller return than if they aggressively invested without considering the social good. Impact investing blends the strengths of philanthropic donations with market investments by channeling capital into impact. From a fund manager to a religious institution to a bank, impact investors come from unique experiences, yet all experience the unique objective of making a difference.
Separating impact investors from traditional investors or philanthropists are three core attributes: the investor intends the impact, contributes to the impact, and measures the impact. The ultimate criterion is arguably the industry’s most pressing issue. Impact investors and companies face the burden of measuring the social good from their investments. “Good” is a qualitative term, so impact investors must come up with a myriad of ways in order to try to quantify the impact. Widely used metrics for impact investing are ESG metrics, which stand for environmental, social, and governance metrics. These three benchmarks measure climate change, pollution, or carbon emissions reduction; diversity inclusion, community relations, or cybersecurity; and political contributions, executive compensation, or boards of directors compositions. ESG metrics are a common starting point to measure impact.
With the capacity to repair our society and heal our environment, impact investing as a field has surged over the past couple of years. Impact investing funds exploded to $715 billion at the end of 2020, from $500 billion just a year earlier. A diversity of stakeholders views impact investing as the future of investing, giving rise to an interest from policymakers. This past May, President Biden signed an executive order detailing how his regulatory agenda will focus on ESG. This past June, the House of Representatives passed a bill intended to standardize and mandate ESG disclosures.
Known as the ESG Disclosure Simplification Act, H.R. 1187 would require the Securities and Exchange Commission to both mandate and develop metrics for ESG disclosures from publicly traded companies. More specifically, the SEC would use its congressional authority to instruct companies to report their political expenditures, pay ratios, climate risks, tax havens, workforce demographics, workplace harassment, cybersecurity, board diversity, and forced labor to investors. The policymakers hope to encourage impact investments by requiring companies to disclose their metrics. Thus, impact investors could more easily determine which potential investments align most closely with their priorities.
Even though many companies already voluntarily report on elements of these ESG metrics, many investors find that these disclosures are insufficient. Congressman Meeks (D-NY) points out that H.R. 1187 “is a means to fill the gaps left unresolved by market forces,” claiming companies will not bolster their disclosures without government intervention. Ultimately, these disclosures are crucial for the public to understand how a company treats itself, its neighbors, and its environment. One of the critical features of the ESG Disclosure Simplification Act is climate risk transparency. Once a company must report on its environmental impact, it could feel the pressure to adopt cleaner practices by current or potential investors.
However, this assumes that companies do not freely disclose their environmental impacts. 90% of companies in the S&P 500 published their corporate sustainability reports in 2020. Most companies willingly self-report their findings because they understand that the information is material to investors. The materiality standard has been the guide for determining what should be included in disclosures for decades. Dating back to the 1976 Supreme Court case TSC Industries, Inc. v. Northway, Inc., companies are required to disclose information that is material, or relevant, to an investor. Therefore, publicly traded companies must report on their ESG metrics. They already include these in their disclosures, meaning it is duplicative for the SEC to require companies to report on what they already do.
The SEC Chair agrees with the materiality standard, for he stated, “If confirmed, materiality will guide my decisions as SEC Chair related to disclosure requirements under the federal securities laws.” H.R. 1187 would usurp the SEC’s focus on materiality for disclosures, replacing the accepted guideline with unnecessary regulations. If every company reported on every metric defined in H.R. 1187, the Supreme Court warns that investors will be buried in “an avalanche of trivial information, a result that is hardly conducive to informed decision making.” Although counter-intuitive, impact investors will actually be harmed by having significantly more information to parse through. They will be overwhelmed by unnecessary disclosures, for the investors will find it more challenging to isolate the metrics that are relevant to them and the company.
The ESG Disclosure Simplification Act is a questionable bill. Even the lead author, Congressman Meeks (D-NY) acknowledges that it is merely a messaging bill. Putting the concerns with materiality aside, this legislation attempts to resolve problems that it creates. H.R. 1187 would instruct the SEC to obligate companies to report on their ESG metrics—without first standardizing what the metrics mean. Especially since the legislature fails to define ESG metrics, it is doubtful that the SEC will be able to come up with a definition that can apply uniformly across all industries. Absent a clear definition of ESG, “investors are becoming frustrated with the hodge-podge of standards and ratings designed to guide their allocation decisions.”
"Investors are becoming frustrated with the hodge-podge of standards and ratings designed to guide their allocation decisions"
Rethinking this flawed policy aiming to shape impact investing, the ideal solution would be for the industry to formulate its own standardized metric. The credibility of an impact investment relies on investors being able to assess their impact. However, although there are over 30 ESG data providers, no uniform practice of measuring impact exists. Because even the industry has failed to define these measurements, investors are told to take the ratings with a grain of salt. In fact, an investment company believes that impact investors would be better off sifting through the raw data themselves and applying the information to their own priorities, for the relevance of metrics differs from industry to industry. Ultimately, both the government and the market fail to define the measurements.
Although well-intentioned, the government should not hand down flawed top-down restrictions on companies in the effort of promoting impact investing. The ESG Disclosure Simplification Act would overburden companies with costly expenses to comply with the disclosures, and it would overwhelm investors with scrutinizing immaterial information. Many companies would rather have bottom-up innovation drive the future of impact investing. Companies will have the agency to disclose only the material data, providing investors with relevant information to invest in companies that will truly change the world over.
To sponsor impactful entrepreneurial ventures is impact investing. To heal the environment and society is impact investing. Impact investing serves the future, and it is the future of investing.
Have a comment? Write to Nathan Wong at email@example.com