Impact investment bodies are calling for greater emphasis on investor contribution rather than ‘additionality’ to clarify impact funds classification
- Labelling rules due to implemented in 2024
- Concerns that impact funds targeting equities could be disadvantaged
- Calls to prioritise theory of change over counterfactual modelling
The UK’s Financial Conduct Authority (FCA) is facing pressure from parts of the industry to revise its proposed sustainability and impact labelling system for funds, due to concerns that parts of the scheme may be hard to implement meaningfully or lead to unhelpful classification of potentially high impact strategies.
In October 2022, the FCA, the country’s financial services watchdog, published a consultation paper on its plans for the labelling system, due to be implemented in 2024. The system aims to reduce the scope for greenwashing in the impact investment industry, the danger of which has prompted parallel efforts to tighten industry oversight in the EU, US and elsewhere.
Much of the FCA paper has won plaudits from fund managers and other industry professionals, following the end of the consultation period in late January. But concerns are being voiced that the scheme as currently proposed could lead to some high impact strategies being bundled together with less ambitious ESG strategies in its classification. Some believe that risks causing confusion for investors and could lead to a reduction in the size of the UK’s impact investment market, estimated by the Impact Investing Institute (III) to be worth £58bn in 2020.
The FCA proposes to introduce three labels – “sustainable focus”, “sustainable improvers” and “sustainable impact” – to distinguish between types of sustainable products. Only funds with specific types of impact objectives and investor contribution would be eligible for the “sustainable impact” classification.
The FCA proposals emphasise the concept of additionality in its classification – requiring funds to show that the positive social or environmental outcomes from their strategies would not have happened if their investments had not been made. But proving additionality is often easier said than done.
Some say public equities investors are likely to find it harder to prove additionality directly caused by their investments than would be the case for private impact funds where the investor is often providing early-stage finance. Others argue that impact can be applied across all asset classes.
Theory of change vs additionality
Sean Gilbert, chief investment officer at GIIN, told Impact Investor that requiring funds to develop specific methodology to build “counterfactual” models for measuring additionality was a complex and not necessarily helpful way to assess impact across asset classes.
He gives a hypothetical example from the healthcare sector of two investment products: one with an objective of finding a cure for a thus-far untreatable disease afflicting people in developing countries, and one aimed at investing to double global production of aspirin.
“Trying to make models of what would or would not have happened as a counterfactual is difficult to do in a definitive way and the investments are quite different in what problems they aim to solve,” Gilbert said.
Rather than relying on counterfactual modelling, industry bodies are calling for more emphasis to be placed on how funds’ shape their capital allocations to achieve impact – their “theory of change” – and on ensuring that progress towards that impact at investee companies is measured accurately, comprehensively and transparently.
Investors need to think about these questions while also working to increase transparency around strategy, objectives, and theory of change, according to Gilbert.
“The FCA is making significant progress in trying to establish shared definitions for products in the market and have included some very important industry innovations such as recognizing the growth of impact investing and the role of theories of change. There are certain aspects of the consultation that will require additional input from the impact investing industry, but we are pleased with the direction the sustainable disclosure requirements are headed,” he said.
The Impact Investing Institute, a UK industry body, has also welcomed the move to bring in rules to improve trust in funds’ sustainable investment strategies, but also asked for changes.
“We are concerned that some ‘best in class’ impact investing products, that have a strong theory of change and robust metrics and disclosures, would struggle to be eligible for the [sustainable impact] label as currently designed. This would also lead to confusion within other FCA labels, as impact products could be forced into the Sustainable Focus or Sustainable Improvers labels,” the III said in a written response to the consultation document.
The III and others are calling for the requirement for additionality to be replaced by a description of investor “contribution”, which, it said, would be more easily and widely understood and applied.
The institute said the FCA’s consultation paper referenced the belief that financial additionality – the provision of new capital – was “a necessary element of impact investing”. It said that implied both that the provision of new capital was necessarily impactful and that other forms of investor contribution, such as stewardship, were not impactful.
“We are concerned that this results in an arbitrary prioritisation of the provision of new capital over other forms of investor contribution, in turn essentially restricting eligible investments to private assets (or primary issuances),” the III said in its response to the paper.
The FCA will now need to assess how best to accommodate the industry’s various concerns before it publishes its rules later in 2023 ahead of implementation.