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THE STATE OF SOCIALLY RESPONSIBLE INVESTING

by Adam Connaker and Saadia Madsbjerg

In 2007, the European Investment Bank issued its first green bond, a EUR 600-million equity index-linked security, whose proceeds were used to fund renewable energy and energy-efficiency projects. A year later, the World Bank followed suit, and by 2017, over $155 billion worth of public and corporate green bonds had been issued, paving the way for the Seychelles government to issue the first ever “blue bond” last year—a $15-million bond to fund marine protection and sustainable fisheries.

The success of these instruments reflects the fact that investors are increasingly conscious of the social and environmental consequences of the decisions that governments and companies make. They can be quick to punish companies for child labor practices, human rights abuses, negative environmental impact, poor governance, and a lack of gender equality. Pair this with an increase in regulatory drivers post-2008 crisis and a deepening understanding of the impacts of climate change and associated risk to performance and we begin to see more clearly the need for investment models that will better address investors’ concerns.

The result has been an increasing demand for integrating environmental, social, and governance (ESG) criteria into investment decisions. In the beginning of 2018, $11.6 trillion of all professionally managed assets—$1 of every $4 invested in the United States—were under ESG investment strategies, a sharp increase from 2010, when the amount was close to just $3 trillion overall.1

Inevitably, the financial services sector has responded with a host of innovative financial instruments, some like those mentioned above, others quite different. The through-line that ties together these new investing models and strategies is quite simple: While they have generated competitive returns, it so happens that they all positively benefit society as well. Essentially what investors want is the performance promise of financial engineering combined with the assurance of a better tomorrow.

Many of the innovations have been driven by a collaboration between public, private, and philanthropic institutions. At the Rockefeller Foundation, we recognize the value of engaging private capital markets for societal good and have stepped in to fund the research and development of new instruments that can bring capital to cause. We have increasingly seen, firsthand, how readily these instruments meet not just investor needs but also values, and how interrelated the two can be.

Let’s look at some particularly interesting examples.

Risk-Sharing Impact Bonds

Fixed income is one of the largest asset classes as determined by asset owner allocation and market size. Compared to the other asset classes, it has the lowest expected returns, hence also the lowest cost of capital. At $4 trillion, the U.S. municipal bond market is one of the largest fixed income markets globally.

Climate change is becoming increasingly important for the U.S. municipal finance sector. On the one hand, U.S. cities need to raise more capital to implement environmental projects—many of them based on innovative climate solutions—to protect their economies and communities from the effects of climate changes (for example, green infrastructure to manage flooding and waste-to-energy microgrids to prevent power outages during hurricanes). On the other hand, if they do not show meaningful results, they won’t only risk economic losses from disasters but also risk seeing an increase in their overall cost of borrowing. Rating companies such as Moody’s are increasingly assessing climate risk as a negative factor when assessing credit ratings.

Environmental impact bonds—in many ways an extension of the green bonds market—offer a solution to this problem, because they can draw in investors interested in taking on the environmental risk in exchange for potential monetary reward. These securities are municipal bonds that transfer a portion of the risk involved with implementing climate adaptation or mitigation projects from the public agency to the bondholder. A good example is a $25 million bond issued by the Municipal Water Board in Washington, D.C., in 2016.

The water board used the bond to fund the construction of green infrastructure to manage storm water runoff and improve water quality. The return to investors is linked to the performance of the funded infrastructure, which allows D.C. Water to hedge a portion of the risk associated with both constructing green infrastructure and, once it’s in place, how well it works. Another such bond is currently under development by the city of Atlanta, for approximately $13 million worth of green infrastructure projects in flood-prone neighborhoods on the city’s west side.

In the case of the D.C. Water bond, investors receive a standard 3.43% semiannual coupon payment throughout the term of the tax-exempt bond. Toward the end of a five-year term—at the mandatory tender date—the reduction in stormwater runoff resulting from the green infrastructure is used to calculate and assign an additional payment. If the results are strong (defined in three tiers; tier 1 being best performance), the investors receive an additional payment ($3.3 million), bringing their interest rate effectively to 5.8%. If the results are as expected, there is no additional payment. And if the infrastructure underperforms, the investors owe a payment to D.C. Water ($3.3 million), bringing the interest rate to 0.8%.

Financially Passive, Socially Active Funds

One of the most interesting of the new generation of ESG–driven financial innovations can be seen in the exchange-traded fund (ETF) sector, where we are starting to see the passive investment movement linked to activism on key social and environmental issues through ESG–themed ETFs. The first ESG ETF, iShares MSCI USA ESG Select ETF, was launched in 2005, and the model has caught on so quickly that today there are at least $11 billion in assets under management across 120 ESG funds globally; stateside, the growth of assets in ESG funds is up over 200% from the past decade. BlackRock recently predicted that the investment in ESG funds will rise to more than $400 billion over the next 10 years.2

A good example is the NAACP Minority Empowerment ETF, or NACP. Issued by Impact Shares, a nonprofit fund manager, the specific criteria for the index, which includes companies such as Microsoft, Pepsi, and Verizon, are identified and compiled by the NAACP. The criteria assess the levels of social activism, equal opportunity, and diversity of workplaces within each company. These criteria are measured and tracked by the fund’s ESG research provider Sustainalytics. The index is then constructed from the top 200 scoring companies by Morningstar, which uses a weighting methodology that maximizes exposure to companies with high scores on the NAACP criteria, while maintaining risks and returns similar to the Morningstar U.S. Large-Mid Cap Index.

Essentially the ETF allows investors to allocate their capital passively, while the NAACP takes on the role of the activist organization that directly engages with the companies on how to adopt and maintain strong practices to the benefit of investors. The management fee is 76 basis points, of which 15–25 points are used to cover expenses. The remainder goes to the NAACP in return for its engagement with the companies indexed, representing $5 to $6 a year for every $1,000 invested in the fund.

Impact Securitization

Pooling various types of contractual debt—such as mortgages or loans—and selling the related cash flows to third-party investors as securities has long been recognized as a useful way to create liquid secondary markets. Yes, the reckless use of securitization contributed to a meltdown of the financial markets. But used responsibly, securitization helps (and has helped for decades) hardworking people get affordable mortgages at rates only modestly higher than those charged to the U.S. government.

With the right incentives and financial structure in place, securitization can also be a highly effective means for gathering large amounts of (cheaper) capital in a relatively short period of time for environmental and social investments. If we can learn from the mistakes of the crisis and address their weaknesses, these tools can have a transformative role in many socially important initiatives.

The U.S. student loan start-up Sixup represents a step in this direction. Sixup is an education finance platform that gives high-achieving low-income students, including first-generation and minorities—collectively termed “Future-Prime”—a pathway to attending four-year colleges and universities. They have built a new model for assessing creditworthiness of “thin-file” students who gain admission to high-value four-year colleges but cannot afford to attend as they are shut out of the financing market due to lack of FICO scores or their parents’ low-income status.

Along with loans, Sixup provides students with tutoring, job matching, and other counseling. Sixup currently counts Goldman Sachs as its largest lender. Once it has reached $100 million in total lending assets, it will test the market with securitization—a critical milestone toward scale. Over time, as their lending assets grow, Sixup plans to tap into the broader fixed-income markets, as well as more traditional securitizations. If successful, it has the potential to mobilize more than $1 billion toward the Future-Prime market providing thousands with a stronger pathway to economic mobility.

A similarly promising securitization project is under way at MIT’s Laboratory for Financial Engineering, which is developing a new investment model for orphan disease drug development with an eye to investing in multiple drug trials simultaneously. Rare and orphan diseases—like pediatric cancers or cystic fibrosis—are diseases that affect a very small part of the population (less than 200,000 patients in the United States). Research into new therapies for these diseases struggle to raise funding as the patient sizes are small, the cost of clinical trials is high, and the probability of success for any one R&D project is low.

But if you aggregate many research projects into one portfolio, at critical scale, the fund becomes more predictable and yields a more attractive risk-adjusted return on the investment, as well as a higher likelihood of success in finding cures for these diseases. This, in turn, enables the fund to raise money by issuing research-backed obligations (RBO) bonds guaranteed by the portfolio of possible drugs and their associated intellectual property. As the MIT team explains, What one has to do to attract the vast majority of capital in the world to the early-stage space like this is to say, look, it’s true, we’re going to take mostly losses, but the couple of wins are going to pay us out for those losses.”

The RBOs will be structured as bonds, targeting fixed-income investors, who collectively represent a much larger pool of capital and who have traditionally not been able to invest in early stage drug development. The fund is collaborating with the Harrington Project—a $340-million initiative to support the discovery and development of new therapeutic breakthroughs with a special focus on rare and orphan diseases. Successful implementation of RBOs could result in an unprecedented amount of capital available for translational biomedical medicine to treat rare and orphan diseases. It is estimated that 50% of those affected by rare diseases are children, and of those, 30% will not live to see their fifth birthday.3

In one sense, nothing about what drives us to invest has changed. We invest because we are planning for the future and hoping for a better, wealthier tomorrow. What has changed, perhaps, is our sense of what constitutes wealth. The ever-innovative financial service industries have responded to these changes—as they have always done—by creating new modes and tools of investment. And with these innovations, perhaps, we can all work more effectively to make the world a healthier, safer place for our children.

TAKEAWAYS

Investors are increasingly concerned about the environmental, social, and governance (ESG) consequences of investment decisions. In response, organizations are partnering with financial service companies to develop innovative ways to fund positive ESG projects and companies. Such options include:

  • Impact bonds: An extension of the green bonds market, impact bonds draw in investors interested in taking on the environmental risk in exchange for potential monetary reward. These securities are municipal bonds that transfer a portion of the risk involved with implementing climate adaptation or mitigation projects from the public agency to the bondholder.
  • Socially active index funds: ESG–themed exchange traded funds (ETFs) link passive investment to activism. They allow investors to allocate capital passively, while an activist organization directly engages with companies on how to adopt and maintain socially responsible practices to the benefit of investors.
  • Impact securitization: This option gathers large amounts of cheaper capital in a relatively short period of time for environmental and social investments. When the projects associated with this capital are aggregated into a portfolio, the fund becomes more predictable and yields a more risk-adjusted return on the investment.

NOTES

  1. 1. The US SIF Foundation, “2018 Report on US Sustainable, Responsible, and Impact Investing Trends,” 2018, https://www.ussif.org/files/2018%20_Trends_OnePager_Overview(2).pdf; Social Investment Forum Foundation, “Report on Socially Responsible Investing Trends in the United States,” 2010, https://www.ussif.org/files/Publications/10_Trends_Exec_Summary.pdf.

  2. 2. David Ricketts, “BlackRock Predicts Sustainable ETF Assets Will Top $400bn,” Financial News, October 23, 2018, https://www.fnlondon.com/articles/blackrock-predicts-sustainable-etf-assets-will-top-400bn-20181023.

  3. 3. Global Genes, “RARE Facts,” 2019, https://globalgenes.org/rare-facts/.

Adapted from content posted on hbr.org, January 17, 2019 (product #H04QYP).

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