From Measuring Risk to Measuring Impact
To transform our economy and billions of lives on this planet, we must be willing to explore new avenues and evolve our old ways of thinking. Previously, I introduced to you the triple helix of risk–return–impact and how it needs to become the driving force of our economy. Today, I want to explore this pivotal shift from measuring risk to measuring impact, and how this is a key factor in the “Impact Revolution.”
When measuring risk was introduced in the second half of the twentieth century, it had a profound effect on investment portfolios across the world. The new notion of risk-adjusted returns led investors to include higher-risk investment categories in their investment portfolios when the expected return was sufficiently high. This thinking resulted in portfolio diversification, which opened the door to new higher risk and return asset classes, including venture capital, private equity and investment in emerging countries.
Similar to measuring risk, impact can also be measured. In fact, impact can be measured even more dependably than risk, and I believe we will soon see impact measured systematically in impact-weighted financial accounts, which will reflect both the impact companies create and their financial performance. Once such accounts start to take hold, impact thinking will become mainstream, just as risk thinking did, and investment portfolios will change to deliver measurable social and environmental impact alongside financial returns.
The social impact bond is a good example of impact investment innovation. Since a SIB’s return is based on the achievement of social or environmental outcomes, its returns are basically independent of movements in stock markets or interest rates. As a result, SIBs reduce the volatility and improve the returns of a portfolio when the stock market takes a nosedive or interest rates soar.
SIBs and DIBs also clearly demonstrate the inherent logic of risk–return–impact, proving that by optimizing this triple helix we can reach a higher ‘efficient frontier,’ where for the same level of risk, we can achieve higher returns and greater impact. Because of the importance of investment flows within our economies, risk–return–impact investing puts us on the road to impact economies, where impact will come to influence every business and investment decision.
The Watershed: Impact-Weighted Accounts
It is a basic management principle that you can’t manage what you don’t measure. Accurate data and reliable measurement are essential to achieving real change because they create transparency, authenticity and trust. This is why standardized impact measurement is so important--it makes it possible for impact to take its rightful place alongside profit by enabling us to assess a company’s net impact, or in other words, its social and environmental bottom line.
Until now, the work around impact metrics and the valuation of impact has stopped short of providing a system for measuring and comparing the real net impact created by companies, yet useful progress has been made.
Some of these include the Global Impact Investing Network (GIIN), founded in 2009, which provides a catalogue of standardized performance metrics for businesses receiving impact investment capital. The Sustainability Accounting Standards Board (SASB), founded in 2011, focuses on serving the needs of investors – SASB standards measure the impact of businesses across a range of issues relating to sustainability. The Global Reporting Initiative’s (GRI) Sustainability Reporting Standards, first launched in 2000, focus on sustainability, transparency and corporate disclosure, rather than on impact measurement. Other measurement initiatives include those of the World Benchmarking Alliance and the World Economic Forum’s International Business Council, which both seek to assess companies’ performance in contributing towards the UN’s Sustainable Development Goals (SDGs).
But these efforts are still early steps in our journey to establishing a standardized, comprehensive system of impact measurement. If investors and their portfolio companies are to start making decisions that prioritize impact, they will require data that reflects both the profit and the impact a company makes through its products, employment and operations, preferably within the familiar framework of regular financial accounts.
The Impact-Weighted Accounts Initiative (IWAI) incubated at Harvard Business School is leading the way to make sure this can be achieved. Launched in 2019, the IWAI is a research-led joint initiative of the Global Steering Group for Impact Investment (GSG) and the Impact Management Project (IMP). Under the leadership of Professor George Serafeim, the initiative is building a framework for financial accounts that integrate the impact a company creates along with its profits. This ground-breaking initiative brings together academics, practitioners, companies and investors and seeks to build on all impact measurement work that has been accomplished to date.
To learn more about the Impact Revolution, order a copy of my new book, IMPACT, here
To achieve impact-weighted accounts, the IWAI has created a system to apply monetary values to the social and environmental impacts created by businesses. This monetization of impact pushes portfolio theory to the next level, allowing investors to optimize risk–return–impact in the same way that risk and return have been optimized for decades.
But how will monetization of impact be achieved? Impact coefficients will be applied to the various lines of a company’s profit and loss statement – sales, employment costs, cost of goods sold – to arrive at an impact-weighted profit line, which reflects the impact a company has on the environment, the people it employs directly and within its supply chain, and on its consumers. They will similarly apply this weighting to the assets that appear on a company’s balance sheet.
By monetizing the impact that companies have on people and the environment, the IWAI enables rigorous comparison between companies. This comparison will influence consumers, investors and employees, and ultimately affect a company’s value. The result will be a transformational change in capital flows as our money starts to move throughout our whole system in search of impact.
In what ways can you reevaluate your investments to make the most impact? It is time to demand more from the companies we do business with and seek those who aim to do good for society. Find out more—read IMPACT and become a part of the Impact Revolution.