Why It's Time for Institutional Investors to Embrace SDG

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We Need to Talk: Why It’s Time for Institutional Investors to Embrace SDG-Aligned Investing

January 2021 Authors

Table of Contents Mirtha Kastrapeli, Founder & CEO, Beyond Alpha Luciana Aquino-Hagedorn Scott Mills, CFA

I. Executive Summary 4 About Beyond Alpha

II. Methodology 6 Beyond Alpha is a specialized research and consulting firm that focuses on helping mainstream investors adopt investment models III. Addressing Sustainability 7 that target social and environmental outcomes, in addition to tra- Challenges: Expectations Versus ditional market outperformance. We believe such an approach will Reality better position these investors for long-term success.

IV. Why Investors’ Actions are Falling 9 Beyond Alpha’s research is designed to fuel capital markets innova- Short tion based on independent, action-oriented, and practitioner-led V. Barriers to Embracing the SDG 12 research around topics of sustainable investment and transforma- Agenda tional change.

VI. Changing the Investment Narrative 14 Acknowledgements Around the SDGs We would like to express our deep appreciation to the more than VII. SDG-Aligned Investing: A Better Way 17 40 interviewees who participated in our research. If it were not for Forward their generous time and thoughtful responses, this paper would VIII. Strategies for SDG-Aligned Investing 22 not have been possible. Special thanks to Carolina Ocampo-Maya and Perrine Toledano, from the Columbia Center on Sustainable IX. Towards a Common Goal 24 Investment (CCSI), for their support and valuable contributions.

X. Appendix: Case studies 25 This paper has greatly benefited from the professional insights and expertise of the members of our Advisory Board: XI. Endnotes 28 Rick Alexander, The Shareholders Common Dazzle Bhujwala, CERES Pallavi Borse, Institutional Investor (II) Bill Burckart, The Investment Integration Project (TIIP) Marcela Pinilla, BSR Christina Shim and Eduardo Tugendhat, Palladium Bob Stammers, CFA Institute Marilyn Waite, Hewlett Foundation

We are grateful for all those involved in the review, production, and design of this paper, in particular Dmitriy Ioselevich from 17 Com- munications, Michael Morgan, and Tamsen Webster.

To reference this research, please use this citation:

Kastrapeli, M., Aquino-Hagedorn, L., & Mills, S. (2021, January 21). We Need to Talk: Why It’s Time for Institutional Investors to Embrace SDG-Aligned Investing. https://www.beyondalpharesearch.com

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About the Authors

Mirtha Kastrapeli

Mirtha Kastrapeli is the founder and CEO of Beyond Alpha. She is also a Fellow at Columbia University’s Center for Sustain- able Investment, CCSI. Most recently, Ms. Kastrapeli was Managing Director and Global Head of State Street’s Center for Applied Research, an independent think-tank designed to provide insights about the future of the investment industry. In this capacity, she co-authored multiple papers, including ‘The Big Shift; Finding a New Center of Gravity for the Investment Industry’ in 2019, ‘The Investing Enlightenment: How Principle and Pragmatism Can Create Sustainable Value through ESG’ in 2017, and the award-winning study ‘Discovering Phi: Motivation as the Hidden Variable of Performance’ in 2016. She has presented her research and led workshops at dozens of industry conferences globally and c-suite and fund board meetings.

Ms. Kastrapeli has over fifteen years of experience in the private and public sectors, analyzing capital markets, and shaping public policy. She spent seven years as a Global Macro Strategist at State Street Global Markets in Boston. In the public sector, Ms. Kastrapeli served as an advisor to the Secretary-General of the Ministry of Economics in Nicaragua. She also worked at the Economic and Commercial Office of the US Embassy in Managua, where she received a Meritorious Honor Award from the US Department of State. Ms. Kastrapeli earned a bachelor’s degree with honors in Finance and Economics from Ave Maria College in Nicaragua and a Master’s Degree in Business Administration, MBA, from the Brandeis International Business School.

Luciana Aquino-Hagedorn

Luciana Aquino-Hagedorn is an international lawyer with almost 20 years of experience in finance. Ms. Aquino-Hagedorn is currently an angel investor and Senior Fellow at CCSI, where she focuses her research on the theory and practice of impact and sustainable investments. Before that, she was a partner at Goodwin Procter LLP, where she was co-leader of the Impact and Responsible Investing practice. At Goodwin, she focused her practice on advising asset managers and institutional investors in direct investing, fund formation, joint ventures, incentive compensation, and investments, including sustainable timber and agriculture. Ms. Aquino-Hagedorn is fluent in Spanish and has extensive experience in cross-border investments involving assets in Latin America, Africa, Europe, and Oceania. Prior to rejoining Goodwin in 2015, Ms. Aquino-Hagedorn was Senior Vice President of Natural Resources at Harvard Management Company (HMC), where she was involved in all legal aspects of HMC’s global forestry and agriculture portfolio. Before joining HMC, Ms. Aquino-Hagedorn was an associate in Goodwin’s Boston office, where she counseled clients on fund formation, transactional and regulatory matters. She also previously worked as a foreign associate for Linklaters in New York City and began her legal career at Le Pera & Lessa in Bue- nos Aires. Ms. Aquino-Hagedorn holds a J.D. from Boston University School of Law, an LL.M. from Columbia Law School, and a law degree (abogada) from the Facultad de Derecho y Ciencias Sociales de la Universidad de Buenos Aires.

Scott Mills, CFA Scott Mills is an investment professional with more than fifteen years of industry experience in fundamental equity analysis and business development. Scott is currently the Chief Investment Strategist at Proactive Planning Partners, a Registered Investment Advisor based in New York City. Scott is also Vice President of Sales & Business Development at Charity Foot- prints Inc. (CF), a social enterprise startup and fundraising platform serving nonprofits and the private sector. At CF, based on his core belief that businesses and nonprofit organizations can drive positive change in the world, he facilitates strategic partnerships that align with corporate social responsibility initiatives and philanthropic goals that amplify impact. Scott recently joined Columbia Center on Sustainable Investment, CCSI, focusing his research on Sustainable Investing. Previously, Scott was a Senior Equity Analyst at Voya Investment Management in New York City. In this capacity, he led and managed fundamental stock selection in the Global Healthcare sector across multiple strategies with $45 Billion in total assets. Scott earned his Bachelor of Science in Finance from Rutgers University and is a CFA® charterholder.

Beyond Alpha | 3 We Need to Talk Why It’s Time for Institutional Investors to Embrace SDG-Aligned Investing

I. Executive Summary

The multiple crises of 2020 contributed to a growing Furthermore, the SDGs provide a framework to analyze the awareness of the scope and scale of the sustainability externalities that companies should internalize to be more challenges that we face, from the climate emergency and resilient vis a vis the expectation of future crises, more the loss of biodiversity to systemic racism and income stringent regulations, growing societal pressures, and the inequality. Alongside this growing awareness, there has move towards stakeholder capitalism. From an investor’s been a parallel increase in sustainable investing as part of perspective, the UN PRI notes that the SDGs can help in- rising interest from institutional and individual asset own- vestors understand “the sustainability trends relevant to ers to use their capital to help address the world’s most investment activity and their fiduciary duties,” thereby pressing challenges. resulting in better risk management and opportunities at the micro and macro level. However, despite record inflows into sustainable investments, these investment vehicles appear unable to sup- These reasons explain why the SDGs are increasingly be- port the kind of progress that is needed. The past year has coming adopted in the corporate and financial world as revealed the deep vulnerabilities of our economic, social, a way for businesses and investors to show how they are and environmental systems and how interrelated and in- attempting to address different sustainability challenges. terconnected these systems are today. But to turn the increased interest in sustainability from a trend to a transformation will require investors taking a A better path forward is needed to take all systemic risks more holistic approach that aligns all investment activities into account, thereby turning expectations for progress with the SDGs. into tangible results. Towards SDG-Aligned Investing The UN Sustainable Development Goals (SDGs) can offer such a path. Introduced in 2015 and agreed to by all the Existing sustainable investment approaches by asset own- 193 members of the UN General Assembly, the SDGs pro- ers and asset managers have largely fallen short in deliver- vide a robust and comprehensive framework for strength- ing on expectations for progress. For example, ESG integra- ening our shared social and environmental systems by tion is one of the most prevalent sustainable investment 2030. Although the SDGs were primarily designed with strategies. Still, it is used mostly as a risk management governments in mind, they also provide a shared blueprint tool, and it is not intended to achieve positive impacts or for people and planet outcomes that all investors can rally reduce negative externalities. Impact investing, with its fo- behind, thereby offering a common set of environmental cus on positive social and environmental outcomes, con- and social performance goals for companies to follow. tributes to the achievement of the SDGs, but its reach and scope thus far remain limited. Neither of these strategies Protecting our shared social and environmental systems, - ESG integration nor impact investing - as defined today, is fundamental for institutional investors that have expo- are enough to meet our shared social and environmental sure to global financial markets, as described by the Uni- goals as outlined by the SDGs. versal Owners theory. This idea has been gaining a lot of attention of late, particularly given the increasing influence We propose the widespread adoption of a niche but of long-term institutional investors in the capital markets, emerging approach we call: SDG-Aligned Investing. SDG- with assets under management estimated at USD 70 tril- Aligned Investing considers the risk and return character- lion globally. istics of an investment, including ESG aspects, as well as

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positive and negative externalities. This holistic approach Project (IMP), The Investment Integration Project (TIIP), to investing solves for many of the shortcomings of current the Global Impact Investing Network (GIIN), the Interna- approaches to sustainable investing. tional Finance Corporation (IFC), and United Nations De- velopment Programme (UNDP). While each organization Conviction, Clarity, and Consensus: The 3C’s of SDG- is working on the larger goal of catalyzing more private Aligned Investing capital to achieve better social and environmental outcomes, we believe an SDG-centric approach to invest- To be successful, SDG-Aligned Investing requires Con- ment management is the best way to make progress in a viction, Clarity, and Consensus from investors (the ‘3Cs’). systematic way. These qualities are the basis for building a comprehensive investment approach that truly supports the SDGs. SDG-Aligned Investing Tools

After building the foundation for SDG-Aligned investing with the 3Cs, investors should mobilize specific investment strategies to achieve the SDGs. The tools noted in this matrix are the ones that we found in our research to be the most effective in contributing to the SDGs. Ide- Clarity ally, an institutional investor embracing SDG-Aligned Investing would use each box in this matrix as part of a

Conviction holistic approach. Investors' Action Consensus Change company Allocate capital practices

Conviction that the SDGs are interconnected and indivisi- Minimum safeguards or guardrails ble and that their achievement will strengthen the shared Divestment / social and environmental systems and create long term Exclusionary value and resilient markets for generations to come. Do not harm Screening Impact Investment Clarity includes both clarity of definition and clarity Active engagement (debt and equity, of impact. public and private) Investors' Approach Investors' Public Private Solutions Clarity of definition is having a clear and honest under- Partnerships standing of what current sustainable investment strategies do and do not do concerning the SDGs’ achievement. Conclusion Clarity of impact is understanding that all investments Adoption of SDG-Aligned investing won’t happen over- have an impact. Therefore, it is necessary to analyze both night. Still, there are important steps that institutional the positive and negative effects of portfolios’ underlying investors can take to better account for the total impact- holdings towards the achievement of the SDGs. -both positive and negative-of their portfolios. We intend to explore specific, actionable steps and implementation Consensus among investors on what’s expected from roadmaps as part of subsequent research. In the mean- companies regarding SDG alignment. This type of agree- time, we welcome any feedback on the contents of this ment is paramount to amplify the impact that investors report that may help inform our future work. can have on companies’ actions and, consequently, our shared systems.

These recommendations build on important work done by others in this space, including the Impact Management

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II. Methodology

Our research sought to understand why, after five years This 12-month practitioner-led, independent research since the UN’s SDGs were announced, institutional inves- gathered input from: tors are not actively participating in achieving this shared, global agenda. 1. Over 40 interviews, conducted over Zoom between March 2020 and July 2020 with market par- Specifically, our study looked to answer the question: ticipants across Asset Owners, Asset Managers, and Academia. Interviews were approximately 60 What can investors do to contribute to the achievement of minutes in length. The interviewee’s breakdown the SDGs and, by doing so, support the shared social and is as follows: Asset Owners: 9 interviews (6 North environmental systems that will fuel long-term investment America, 1 EMEA, 1 Latin America, 1 Asia-Pac); opportunities? Asset Managers: 14 interviews (5 Global, 4 North America, 3 EMEA, 2 Latin America). 2. Literature review of over 70 secondary research papers, sourced from the authors, participants, news outlets, and internet searches. 3. Insights from an advisory board of leading industry organizations and academics.

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III. Addressing Sustainability Challenges: Expectations Versus Reality

Sustainable investment had a breakout year in 2020. Con- practiced, is not creating better social and environmental trary to what many expected, the economic contraction outcomes? resulting from the COVID-19 pandemic and the market volatility that followed did not induce investors to flee The well-known political science theory of Revolution of from sustainable investment funds. On the contrary, flows Rising Expectation,7 first introduced by the American so- into Environmental, Social, and Governance (ESG) strat- ciologist Jamie Davies in 1962, provides a warning. Rising egies have soared,1 and ESG funds have outperformed expectations that are not consequently satisfied precede the market.2 a revolution.

Wider acceptance of sustainable investment3 comes with Sustainable investment, both as an opportunity to reduce higher levels of scrutiny. Even though achieving better risk and improve performance in a portfolio as well as a risk-adjusted returns remains the primary motivation for way to help address society’s most pressing social and institutional investors4 when pursuing ESG strategies, environmental challenges, has created new expectations there are also expectations that these types of strategies among end-investors and beneficiaries. These new expec- create better people and planet outcomes. tations are not being met as social and environmental conditions continue to deteriorate.8 This, along with increased A 2020 survey of institutional asset owners by the Morgan access to information and transparency, puts pressure Stanley Institute for Sustainable Investing5 found that as- on sustainability-oriented institutional asset owners and set owners’ perspectives are changing, as “almost half now managers to deliver on their implicit promise of producing believe that generating social and environmental returns better people and planet outcomes. is as important as generating financial returns.” The 2020 Trust Report by CFA Institute noted similar trends, with the We believe that institutional investors’ commitment to majority of institutional asset owners and retail investors aligning their practices with an internationally agreed saying they are interested in ESG investing because they upon agenda for sustainable and inclusive growth, such as want to positively impact society and the environment, the Sustainable Development Goals (SDGs), can help them with or without better financial returns.6 meet these new expectations.

However, despite growing flows into sustainable invest- Through an SDG-Aligned investment approach, institu- ments, there is no evidence that shows that these invest- tional investors can ensure that their sustainable investments are helping halt the deterioration of our shared so- ment strategies are indeed contributing to “set the world cial and environmental systems. Recent studies from both on a path of peace, prosperity, and opportunity for all on scientists and financial institutions show that social and a healthy planet.”9 environmental conditions are getting worse, not better, in many parts of the world. This fact raises an important question — what happens when investors realize that sustainable investment, as currently

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ply don’t have an additional 62 years to wait to ensure a The UN Sustainable Development Goals (SDGs) sustainable future.

The United Nations (UN) launched the Sustainable This lack of progress should be very concerning for all insti- Development Goals (SDGs) in 2015 as a plan for the tutional investors, particularly those that have expressed world to achieve a more sustainable, equitable so- a commitment to sustainability. The fact that investors’ ciety by 2030. The UN estimated that to meet these actions are not translating into clear positive people and ambitious objectives, it will require investments planet outcomes and reducing negative impacts and ex- of about USD 3.5 trillion a year, both from public ternalities, undermines the credibility of the investment and private capital. It’s been five years since this community’s sustainability efforts. What is more, by not fo- announcement, and estimates show an annual cusing on supporting our shared social and environmental funding gap of about USD 2.5 trillion, in large part systems, investors weaken their ability to guarantee last- due to the disappointing participation of private ing returns for their clients and beneficiaries.14 sector investors. What can investors do to contribute to the achievement of the SDGs and, by doing so, support the shared so- Research Motivation: A Missed Opportunity cial and environmental systems that will fuel long-term investment opportunities? Sustainable investment has been attracting increased attention from institutional and individual investors for To answer this question, Beyond Alpha interviewed more more than two decades. This enthusiasm is reflected in than 40 investment managers, asset owners, and thought the more than 3,000 signatories to the UN Principles for leaders globally over a 12-month period. This original Responsible Investment (PRI) from 60 countries and rep- research was complemented by extensive secondary re- resenting USD 103.4 trillion in assets under management search, including a review of recent articles and studies on as of 2020.10 the subject of sustainable investing.

This growing interest is also reflected in the number of ini- We concluded that institutional investors’ inability to tiatives aimed at spurring the investment management in- meaningfully contribute to the SDGs has to do with the dustry to take on sustainability. In December 2020, a group fact that current sustainable investment practices are ei- of 30 asset managers with USD 9 trillion in combined as- ther not designed to produce better people and planet sets under management introduced the Net Zero Asset outcomes, as is the case of ESG integration strategies, or Managers initiative to “galvanize the asset management are limited in their reach and scope, as in the case of most industry to commit to a goal of net-zero emissions” by impact investing strategies. 2050 or sooner. This announcement follows a similar effort by the Net Zero Asset Owner Alliance, a group of institu- As a solution, institutional investors interested in pro- tional asset owners with more than USD 5 trillion in assets ducing better people and planet outcomes, in addition launched in September 2019 with a shared commitment to achieving positive market returns, should embrace an to aligning their portfolios with a 1.5C° scenario. SDG-Aligned Investing approach. This approach needs to be centered not only on investing to deliver positive im- However, although current sustainable investment efforts pacts, such as impact investing, but also on ensuring that may have created a positive impact on investors’ portfo- all investment decisions do their best not to undermine lios with higher risk-adjusted returns,11 they have fallen the health of our shared social and environmental sys- short in achieving positive people and planet outcomes,12 tems. Moreover, we believe all institutional investors, giv- as articulated by the SDGs. en their size and influence, have a unique opportunity and responsibility to drive this change and provide lasting in- In addition to this contradiction, the COVID-19 pandemic vestment opportunities to their clients and beneficiaries. has made the achievement of the SDGs even more chal- lenging. Some estimates show that the SDGs are now on track to be achieved not in 2030, the original target date, but in 2092, 62 years behind schedule.13 We sim-

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IV. Why Investors’ Actions are Falling Short

Advancements in the sustainable investment space, ei- One of the key reasons why ESG integration is not produc- ther through ESG integration, the most commonly used ing meaningful people and planet outcomes is because sustainable strategy among US money managers,15 or im- ESG integration was designed mainly as a risk manage- pact investment, a sustainable investing strategy growing ment tool, not to measure or manage social or environ- steadily,16 are encouraging steps for bringing increased mental impact. ESG integration is not intended to actively awareness to some dimensions of the SDGs. Although promote positive social and environmental outcomes. there are many strategies used within the sustainable in- Therefore, any positive effect or reduction of negative ex- vestment space, we have chosen to focus on ESG integra- ternalities these strategies may have are mere side effects. tion because of its broad level of adoption, and impact Because of this, it is not surprising that ESG integration investing because of its focus and growth. However, our lacks impact or outcome tracking, as “very few investors research reveals that these two sustainable investment analyze how their activities cause companies to change.”20 strategies, as they are defined and implemented today, are not enough to achieve the SDGs, as we explain below. Impact investment is not a magic bullet

ESG integration is far from a panacea Impact investments, defined by the International Finance Corporation (IFC) as “investments made in companies or ESG integration - an investment strategy in which investors organizations with the intent to contribute measurable systematically consider Environmental, Social, and Gover- positive social or environmental impact, alongside a finan- nance issues in their investment process17,18 - is becoming cial return,”21 are also not sufficient to achieve the SDGs by increasingly accepted by mainstream investors, given the 2030. Investments that are made without the intention to mounting evidence that these strategies can help improve generate a positive social and environmental impact fall risk-adjusted returns of a portfolio.19 This is happening out of the impact investment universe, as currently de- even in markets that have been traditionally behind the fined. SDG-Aligned Investing intends to capture all invest- curve in this space, such as the United States. ments, whether they are “impact” or not.

However, while there is plenty of evidence that sustainable SDG-Aligned Investing helps advance impact investing. investment strategies can help improve risk-adjusted re- While the impact investing industry continues to grow and turns of a portfolio, there is no conclusive data that shows mature,22 what is still missing from the market is a shared these strategies are changing companies’ behaviors con- consensus around what impact needs to be achieved and cerning their environmental and social performance. This a mechanism for measuring the role of each investor in was flagged in the recent paper, “Can Sustainable Invest- achieving that impact. The SDGs provide this consensus, ing Save the World? Reviewing the Mechanisms of Investor and SDG-Aligned Investing provides a roadmap for how Impact,” by Kölbel, Heeb, Paetzold, and Busch. This study investors can play their part. Notably, the Global Impact concludes that there is no empirical evidence showing Investment Network (GIIN) highlights that coalescence that current ESG investment strategies drive more sustain- around the SDGs, in particular, has contributed to the stan- able corporate practices. The authors define investors’ im- dardization of impact measurement and management.23 pact as “investors’ ability to change companies’ activities around social and environmental parameters.” A sustainable investment strategy that can work for all investments is needed because, despite growth in the impact investing market, most of the estimated $269 trillion

Beyond Alpha | 9 We Need to Talk Why It’s Time for Institutional Investors to Embrace SDG-Aligned Investing in investable capital is not currently invested in “impact “Because of the stage of development 24 investments.” One of the reasons why impact investing of impact investing, the ticket size for has not been widely adopted is the perception that, due to its intentionality and resulting customization geared [impact private markets] deals tend to be towards impact, it could imply sacrificing returns, limit- small, which is an additional obstacle...to ing the adoption by many mainstream investors that may meaningfully contribute in this way to the 25 have a mandate to maximize returns. achievement of the SDGs.” There are also significant differences in how impact in- - Head of ESG and Stewardship, Large Asset Owner, Asia-Pac. vesting can be practiced in the public markets versus the private markets. In the public markets, where most capital Impact investment can provide solutions to address the is invested, impact investing appears to be at earlier stag- systemic risks identified by some of the SDGs. We hope es of development. While investors in public markets can that, as this industry develops, it will be able to attract contribute to measurable impact through engagement more capital, including institutional capital. However, im- and shareholder action, the issue is that “we do not have pact investing, as currently understood and practiced, is a basis to identify how much investment in these assets not enough to meet the SDGs. To achieve the SDGs, we is motivated by the intent to contribute to measurable need a solution that can work for as many investors and impact.”26 In the case of private markets, where impact in- investments as possible. vestors have been more active, and there is more clarity in scope and measurement, deals tend to be small and com- paratively more expensive when compared to traditional private investments. According to a World Economic Fo- rum report,27 “the costs of due diligence may be higher for [smaller size] impact investments and the deal economics may look fundamentally different... [partly because] sourc- ing the right deals in the pipeline can be costly.” Once impact investing becomes more established and efficient, mainstream investors may adopt it more widely and its contribution to the achievement of the SDGs may become more meaningful.

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“ESG integration is a step in the right direction, but it can also be a dead- end. The issue is that it is currently used as a risk tool, not as a driver of change or to accomplish impact goals.”

- Head of Thought Leadership, Multinational Bank

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V. Barriers to Embracing the SDGs

Given the limitations of the sustainable investment prac- 2. “SDGs are not tied to materiality” tices highlighted in this report, institutional investors that have expressed their commitment to sustainability need There is a recognition that the SDGs are not always tied a new investment approach that, by design, ensures that to financial materiality. This prevents portfolio managers any investment contributes to and does not undermine and analysts from considering the SDGs as part of their de- the achievement of the SDGs. cision-making process. Even though the SDGs identify system-level issues, such as water scarcity, income inequality, Our research identified three main challenges that pre- and biodiversity, that affect the risk and return character- vent institutional investors from aligning their investment istics of a long-term portfolio, we found that institution- activities with the SDGs: First, many institutional inves- al investors struggle to articulate the business case for tors are not convinced that achieving the SDGs is their re- these issues. sponsibility. Second, some investors require evidence of financial materiality before incorporating the SDGs into “The systems ‘element of the SDGs is often their investment decision-making process. Lastly, measuring the impact on the SDGs requires a combination of ignored or missing.” quantitative data, qualitative information, and multi-dis- ciplinary skills that most investment professionals simply - Executive Director, Sustainable Investment Non- don’t have. Governmental Organization.

1. “It’s not our job” 3. “Measuring impact is hard”

One of the obstacles that prevent institutional investors This brings us to the third and most complex obstacle: ac- from considering the SDGs is that there is a widespread curately measuring environmental and social outcomes is perception that the achievement of these goals falls large- difficult and requires a new set of data and skills. ly under the responsibility of governments rather than investors. Most asset owners and some asset managers we In public markets, rating agencies and index providers are interviewed did not see themselves as having a clear role developing new SDG data products to help investors un- to play in the achievement of the SDGs. Others noted that derstand companies’ contributions to the SDGs. There are the SDGs, as a framework, was not designed for investors. two key limitations to the current efforts, however. First, there is limited data because companies do not typically report on SDG performance, at least not yet. Consequent- “SDGs were not explicitly designed for ly, data providers have to rely on broad company sustain- investors…we are now trying to retrofit them ability reporting and third-party sources. MSCI noted that in our process.” “fragmented data on how companies are aligned with a respective SDG further exacerbates the challenges facing - Head of ESG and Compliance, Large US Endowment investors.”28 Organizations like the UN Global Compact and the International Business Council29 are working on addressing the lack of relevant SDG metrics for companies.

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The second limitation is that data offerings are mostly fo- In the private markets, where impact investment strat- cused on SDG revenue and activity alignment or mapping egies are more prevalent than in public markets, impact (i.e., how a companies’ products and services support or measurement is much more advanced on the back of the contribute to achieving one or more SDGs, but not all of leadership of organizations such as IFC,31 the IMP,32 and them). This enables the practice of SDG cherry-picking the GIIN.33 However, impact measurement still presents (also sometimes referred to as SDG-washing) instead of a challenges. The tools developed for the management and commitment to understanding how investments impact measurement of positive outcomes and negative external- the achievement of all the SDGs, both positively and neg- ities are still being improved and are not widely adopted. atively (i.e., externalities). For example, a water services investment can be deemed as contributing to the SDGs Lastly, during our interviews, we found that some inves- due to the activity involved and its contribution to SDG tors struggle with limited bandwidth. Many institutional 6 (clean water and sanitation). Still, the investment proj- investors remain focused on building and developing their ect’s environmental policies, employment policies, pricing ESG integration strategies to create value and protect their strategies, maintenance standards, and other operational portfolios from ESG risks. This is already a monumental dimensions may, in fact, undermine other SDGs. task for many investors, particularly those smaller asset owners with limited resources. Some data providers are starting to look at this. For example, S&P’s Trucost has developed data on SDG risk expo- So how can investors overcome these barriers? And sure defined as “the risk that a company may be directly how can we begin to change the narrative to align in- or indirectly causing a negative impact on the SDGs…or vestment decisions with the SDGs and, by doing so, cre- the risk that a company may be dependent on practices ate positive people and planet outcomes and reduce and activities that conflict with the SDGs.”30 However, this negative externalities? analysis remains limited to “their direct application to the private sector,” in line with the company’s supply chain or reputational risk, and not on its impact on the social and environmental systems. More research needs to be done in this space.

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VI. Changing the Investment Narrative Around the SDGs

There are three key rationales that institutional asset own- Furthermore, the explosion of passive investing42 creates ers and asset managers can use to build a new narrative the opportunity for the Universal Owner Theory to take where the SDGs are central to their sustainable investment greater hold given the nature of the returns of this type approaches: The SDGs serve as a) a system-level frame- of strategy, which are largely dependent on the mar- work, b) a proxy for resilience, and c) a blueprint for people ket as a whole. Supporters of this theory, such as The and planet outcomes. Shareholders Common Initiative (TSC),43 point out that these “modern investing techniques lead investors to di- a. The SDGs as a Systems Framework versify their holdings across companies, asset classes, and geographies. And as a consequence, these inves- The SDGs serve as a robust and comprehensive frame- tors... are affected by the performance of equity as a class work to strengthen the shared environmental and social much more than by the relative performance of individual systems that global investors’ portfolios rely on. Protecting companies.”44 This theory also suggests that long-term in- these systems is fundamental for institutional investors, as dividual investors that participate in index-based invest- described by leading sustainable investment organiza- ing are also considered “small-scale voluntary Universal tions such as The Investment Integration Project (TIIP)34. Owners,”45 particularly younger investors with a relatively longer-term investment time horizon. Similarly, the Universal Owners theory, as most recently discussed in the paper Universal Ownership in the Some influential asset owners, such as the Government Anthropocene by Ellen Quigly, notes that “large diversified Pension Fund of Norway (GPFG) and the Japanese institutional investors with long-term investment hori- Government Pension Fund (GPIF), are already embracing zons”35 have an interest “in the health of the economy and this concept of universal ownership.46 society as a whole due to the nature of their portfolios; the Universal Owner owns a more or less representative slice of the economy.”36

This concept has gained a lot of attention as of late, particularly given the increasing influence of long-term institutional investors in the capital markets, with assets under management estimated at USD 70 trillion globally.37 To a large extent, this growth has happened as the global retirement system moves from defined benefit plans38 (fully funded by the employer) to defined contribution plans39 (funded by both the employer and the employee and managed by an institutional investor, such as an asset manager).40 To give some context, according to a CFA Institute report, using OECD data,41 “as a group, institutional money managers control more than 40% of public equity market capitalization worldwide as of year-end 2017.” According to the report, in the US, this number was 72%, up from 6% in 1950.

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b. The SDGs as a Proxy for Resilience c. A Blueprint for People and Planet Outcomes

Alignment with the SDGs is also helpful when analyz- Lastly, as noted earlier, an increasing number of asset own- ing companies’ resilience. For decades, as a default ers, both institutional and individual, appear to be count- best practice designed to maximize returns, many coming on sustainable investment strategies to create better panies transferred the costs of negative externalities people and planet outcomes. According to the 2020 Trust to society. This narrative of shareholder primacy has Study by CFA Institute,50 53% of institutional investors (in- since flipped in favor of a more stakeholder-centric ap- cluding public and private pension funds, endowments proach. Many companies are now starting to consider and foundations, insurance companies, and sovereign the SDGs as part of their overall decision-making, with wealth funds) and 71% of retail investors say they invest a growing recognition that continuing the practice of in ESG strategies expecting better social and environmen- externalizing costs would expose them to policy and tal outcomes, with or without better risk-adjusted returns. reputational risks. Even more interesting was the fact that one-third of the 921 institutional investors surveyed globally said that “in- A recent analysis by Schroders highlights that the USD 4.1 vest[ing] in companies that have a positive impact on so- trillion in earnings of listed companies would fall by 55% ciety or the environment” was their main reason behind to USD 1.9 trillion if all of the social and environmental im- investing in ESG strategies, not achieving better risk-ad- pacts identified by this analysis would materialize as finan- justed returns. cial costs, while as much as one-third of companies would become loss-making.47 Most recently, George Serafeim Despite this, sustainable investment strategies are falling and State Street Associates48 found that companies that short in generating the type of positive impact expected had internalized the social cost of a strong labor policy from this type of strategies. This creates a gap of unmet during the pandemic (e.g., offering paid sick leave, flexible expectations that jeopardizes the industry’s credibility in work arrangements, and either putting a moratorium on their sustainable investment efforts. The reputational risk layoffs or increasing hiring) saw stronger investor inflows that this shortcoming creates puts pressure on the indus- and better market performance during the beginning of try to find a new approach that can effectively meet cli- the COVID crisis in the US in the spring of 2020. ents’ demands. The SDGs provide a shared blueprint for people and planet outcomes that all investors can ral- The power of the SDGs is that they provide a framework ly behind and provide a common set of environmental for analyzing the externalities that companies should in- and social performance aspirational goals for companies ternalize to be more resilient vis a vis future crises, more to follow. stringent regulations, growing societal pressures, and the move towards stakeholder capitalism. From an investor’s So, where do we go from here? How can investors truly perspective, the UN PRI notes that the SDGs can help in- embrace the SDGs as a central component of their invest- vestors understand “the sustainability trends relevant to ment processes? investment activity and their fiduciary duties,” resulting in better risk management and opportunities at the micro and macro level.49

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“There is a lack of imagination… SDGs are interconnected and indivisible…not many investors or corporates understand this.”

- Head of Responsible Investment & ESG, EMEA Asset Manager

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VII. SDG-Aligned Investing: A Better Way Forward

The journey to SDG-Aligned Investing beings with accept- ing that all investments always have an impact on society and the environment.

If investors want to take on an active role in creating positive people and planet outcomes and strengthening our Clarity shared environmental and social systems, then investors need to move beyond focusing exclusively on portfolio Conviction financial performance and find ways to incorporate the positive and negative impacts, or externalities, into their decision-making processes. The SDGs provide a frame- Consensus work for investors to do just that. Conviction SDG-Aligned Investing: Definition Forward-looking investors and fiduciaries are starting to We define SDG-Aligned Investing as a system-lev- recognize the interconnectedness of our social and environmental systems and the importance of these shared el investment approach that takes into consider- 51 ation both the risk and return characteristics of systems for long-term financial performance. These in- an investment, including environmental, social, vestors also recognize that what was not material years and governance (ESG) aspects, as well as the posi- ago can become material in the future, and vice versa. In tive and negative impact of that investment in the other words, as investors have new information on events, achievement of the SDGs. This approach consid- facts, consumer preferences, legal and policy shifts, and ers not only investing in solutions, but also mak- discoveries that impact a portfolio, they have to reassess what is material and what is not. Materiality is a dynamic ing sure that investments do not undermine the 52 achievement of the SDGs. concept. In SDG-Aligned Investing, there is an additional sense of urgency, particularly around issues of climate change and Conviction, Clarity, and Consensus: The Basis for SDG- inequality, especially given the current environment. The Aligned Investing COVID-19 pandemic added further pressure to act because it has demonstrated the devastating consequences of ig- SDG-Aligned Investing requires a new level of Conviction, noring systemic issues at an economic and human level. Clarity, and Consensus from investors. Without one of Thus, waiting for evidence of financial materiality over a these aspects, investors will not be successful in support- long period, as in traditional investment analysis, doesn’t ing the SDGs in a meaningful way. allow for the swift response required to address the systemic issues identified by the SDGs. At the end of the day, investors need to have the conviction that SDG investing creates long-term value.

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“You don’t need a materiality map for the SDGs – you need a strong hypothesis for long Call to action: term value creation to consider the SDGs.” For Asset Owners: - Global CIO of Large Asset Manager • Revise investment mandates to incorporate the As a start, investors can embrace a broader definition of concept of ‘double materiality’ aligned with SDG materiality, such as ‘double materiality,’ where you con- outcomes. Carefully review and discuss invest- sider the information about how a company’s activities ment policies and strategies to ensure they align impact financial performance, as well as how it affects a with the interests of a broader set of stakeholders. broader set of stakeholders. The European Commission in the Non-Financial Reporting Directive (NFRD)53 introduced • Incorporate an SDG-Aligned investment screen the concept of double materiality, requiring large listed in your manager selection due-diligence process companies to report on their performance and “impact of and incentive structures. [their] activity, relating to, as a minimum, environmental, social and employee matters, respect for human rights, For Asset Managers: anti-corruption and bribery matters.” The EU received ini- tial support on this approach from various investment or- • Engage with clients in a discussion of the value ganizations, including The Global Investment Sustainable proposition of considering the SDGs in their in- Development Alliance (GISD)54 and the Sustainability vestment mandate. Accounting Standards Board (SASB), which focuses exclu- • Abstain from trying to shape regulations against sively on issues of financial materiality for investors.55 the public interest (by supporting directly or indirectly lobbying efforts), screen the companies doing so, and cooperate with other Asset Managers SASB has explained: to vote against company management engaged in this practice. “The double materiality perspective appropriate- ly acknowledges that non-financial information is For both Asset Managers and Asset Owners: important to multiple constituencies. It effectively captures the important interactions between • Consider SDG- advancing investments in emerg- businesses, the markets they serve, and the world ing and frontier markets to fill the financing in which they operate, and it enables meaningful gaps necessary to achieve the SDGs in these re- accountability to a broad range of stakeholders. gions. Collaborate with Development Finance ... [T]he double materiality concept [also] usefully Institutions (DFIs) to expand investment in these recognizes the dynamic nature of materiality in the underserved markets and sponsor financial inno- context of sustainable business practices—that is, vations in this area. the idea that an issue that is material solely from • Create a culture where investment analysts deep- a social or environmental impact perspective can ly understand and internalize the value proposi- also become financially material over time.”56 tion of the SDGs. Consider expanding your talent pool to include professionals with knowledge and experience in the diverse areas of development or Double materiality implies the “treat[ment] of all stake- seek partnerships and research to inform invest- holders with equal respect”57 as well as constant balancing ment decisions. between profit and purpose ensuring “sustainable wealth • Consider indexing paychecks and bonuses to the 58 creation.” realization of Key Performance Indicators (KPIs) linked to the SDG targets at the portfolio level. Publicly disclose this incentive system.

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“SDGs aren’t material unless a market force makes them so.” - Head of ESG Product Strategy, Global Data Provider

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Clarity In September 2020, a group of five international framework and standard-setting institutions, including CDP, the The need for clarity is twofold: clarity on the definition of Climate Disclosure Standards Board (CDSB), the Global SDG-Aligned Investing and clarity on environmental and Reporting Initiative (GRI), the International Integrated social performance or impact. Reporting Council (IIRC), and the Sustainability Accounting Standards Board (SASB), released a “Statement of Intent”60 a. Clarity of definition: to work together towards building a corporate reporting system, based not only on materiality relevant for “enter- Institutional investors who want to take an active role in prise value creation,” but also “on matters that reflect the supporting the SDGs need to have a clear understanding organization’s significant impacts on the economy, envi- of what sustainable investment strategies do, and do not ronment, and people.” This effort could be an important do, concerning the achievement of these goals. step towards having the clarity of impact needed to build an SDG-Aligned investment approach. As mentioned earlier, an SDG-Aligned investment approach seeks to have a positive impact and reduce or avoid negative externalities through the strategic investment and management of assets. This approach is dis- Call to action: tinct from current sustainable investment strategies such as ESG integration and impact investing. For Asset Owners

While ESG integration provides information on how • Work with your asset manager to design an SDG- Environmental, Social, and Governance issues impact the Aligned investment strategy, emphasizing clarity risk and returns characteristics of a portfolio, SDG-Aligned of definition and clarity of impact. Investing looks at how portfolios impact people and planet issues. For Asset Managers:

On the other hand, we consider impact investments a sub- • Develop investment strategies and products that set of SDG-Aligned investments, as long as the impact of comprehensively considers companies’ impact the investment on all the SDGs, either positive or negative, based on high SDG alignment. is internalized throughout the life of the investment. For both Asset Managers and Asset Owners: b. Clarity of impact: • Undertake an SDG ‘impact assessment’ of your SDG-Aligned investing needs to incorporate impact anal- portfolio across asset classes. Leverage industry ysis of the underlying holdings of portfolios and their ef- efforts to measure and classify impact or exter- fects, both positive and negative, on the SDGs. This analy- nalities, such as the Impact Management Project’s sis needs to be comprehensive. As noted by the UN Global (IMP) ABC framework.61 Compact,59 analysis should extend beyond companies’ direct operations to also cover their activities across the • Communicate clearly what type of sustainable in- “business ecosystems of suppliers, customers, and peers.” vestment approach you are using in your portfolio and the motivation behind your decision to do so. If you are talking about SDG-Aligned investment, make sure it incorporates analysis of the positive outcomes and negative externalities of your investments.

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Consensus

The achievement of the SDGs will require strong con- Call to action: sensus and coordination between the investment community, corporate sector, and governments and more For Asset Owners: decisive collective action based on shared standards for SDG-alignment, reporting frameworks, and comparable • Create a culture of collaboration with asset man- metrics. agers, beneficiaries, peers, government, and civil society organizations to mainstream the use of Research shows62 that one of the reasons that ESG inte- the SDGs, and the accompanying targets, as the gration does not translate to better companies’ people optimal framework to measure environmental and planet outcomes is that there is a lack of agreement and social performance. on which issues matter, what the reporting standards for companies should be concerning each of those issues, For Asset Managers: and how performance with each factor should be measured. The proliferation and divergence of ESG ratings • Use the SDGs, and their accompanying targets, for have contributed to this challenge.63 The SDG goals and investment decision-making, active engagement targets, even with imperfections, do provide the opportu- strategies, and portfolio construction across asset nity to create a common language for investors to signal to classes. The SDGs are not a menu of options but a companies what is expected from them regarding ESG and framework to consider systemic issues holistically. system-level performance. • Foster strong relationships with companies’ management teams to create long-term value through alignment with the SDGs.

For both Asset Managers and Asset Owners:

• Support efforts for mandatory company measurement and disclosure of SDG outcomes.

• When possible, encourage companies to re-incorporate as Delaware Public Benefit Corporations and/or pursue certification as a B-Corp. If not applicable in a specific market or jurisdiction, then hold companies accountable to similar standards or corporate behavior.

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VIII. Strategies for SDG-Aligned Investing

Conviction, Clarity, and Consensus provide the foundation Current Tools for SDG-Aligned Investing for institutional investors to build an SDG-Aligned investment approach. Investors' Action Change companies’ Allocate capital To provide investors with a head start, we have identified practices specific investment strategies best suited for contributing to the SDGs. Real-world examples of how these strategies Minimum safeguards or guardrails could work in practice are available in the Case Studies section starting on page 25. Divestment / Exclusionary Do not harm Screening As noted in the paper, “Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact,” by Impact Investment Active engagement Kölbel, Heeb, Paetzold, and Busch64, when investors make (debt and equity, public and private) portfolio decisions, they have an opportunity to 1) influ- Approach Investors' Public Private Solutions ence companies’ behaviors in public markets, mainly by Partnerships signaling and engagement, and 2) provide the capital to finance solutions. Minimum safeguards: We note that investors who want to adopt an SDG-Aligned investment approach need to consider not only the solu- A ‘do not harm’ approach is addressed by having mini- tions that a particular investment may provide but also mum safeguards, or ‘deal-breakers,’ around social and the other positive or negative impacts (i.e., externalities) environmental parameters. Minimum safeguards were in- an investment may have on the SDGs. troduced by the European Commission Green Taxonomy under article 3 and article 18, and refers to a corporate There are many different ways that investors can practice practice that is in “alignment with the OECD Guidelines for SDG-Aligned Investing. In the matrix titled: Current Tools Multinational Enterprises and the UN Guiding Principles for SDG-Aligned Investing, we look at the two different on Business and Human Rights, including the principles approaches that we identified as necessary to contribute and rights set out in the eight fundamental conventions to the SDGs (y-axis) and the two main channels where an identified in the Declaration of the International Labour investor can impact environmental or social outcomes Organisation on Fundamental Principles and Rights at 65 (x-axis). The tools noted in this matrix are the ones that Work and the International Bill of Human Rights.” we found in our research to be the most effective in contributing to the SDGs. An SDG-Aligned Investing strategy To make sure that investments are not significantly under- would utilize a combination of approaches and actions. mining the SDGs, institutional investors have the power to, Ideally, an institutional investor embracing SDG-Aligned collectively and proactively, adopt minimum standards for Investing would use each box in the matrix as part of a ho- their investments, as measured by SDG-aligned KPIs and listic approach. ideally tailored to different business practices. A way for investors to implement minimum safeguards is through “guardrails.” Guardrails are being proposed by

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The Shareholders Common initiative (TSC) to encourage Exclusionary screening: investors to request companies to meet “baseline sustainability standards...and reject practices that exploit social Exclusionary screening is defined as “avoiding securities of or environmental costs for company gain.” These guard- companies or countries on the basis of traditional moral rails are meant to be pre-competitive (assessed before values... and standards and norms.”70 Like divestment, this measuring companies’ financial performance), collective type of strategy can be a useful tool for reducing or elim- (to ensure standardization among investors), and systemic inating the exposure to companies responsible for signifi- (as it relates to system-level issues).66 cant negative externalities.

Engagement: Impact Investment:

Engagement is defined as “shareholder activities that are This is an effective tool to focus on environmental and intended to change companies’ ESG practices... these in- social solutions, as long as externalities are internalized clude the right to vote on shareholder proposals during throughout the life of the investment. Institutional inves- annual general meetings, discussions during informal tors should expand their participation in impact investing, meetings with management, and criticizing corporate leveraging the work of the impact investment community. practices in news outlets, as well as threats of selling the There are different innovations in the impact investment companies’ assets.”67 space, including blended finance,71 catalytic capital,72 and others to help de-risk investments and encourage broader Research suggests68 that one of the most effective ways participation of mainstream investors. for investors to influence corporate practice in the public markets is through engagement, particularly when the Public-Private Partnerships: investor or group of investors “holds a large share of the targeted company.” The size and reputation of that inves- The IFC defines Public-Private Partnerships, or PPP, as “a tor or group of investors is also a factor. Given institutional tool that helps governments leverage the expertise and investors’ increasing size in the markets, as noted earlier, efficiency of the private sector, raise capital, and spur de- they are in a unique position to influence the corporate be- velopment. They also help allocate risk across the public havior of public companies in a significant way.69 and private sectors to where it can best be managed and ensure that resources are widely distributed in addressing If engagement is not successful in changing companies’ the most urgent development needs.”73 practices, particularly around the minimum safeguards mentioned above, divestment should be an option. Public-Private Partnerships can be particularly helpful for investment in emerging and frontier markets with a high risk profile.

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IX. Towards a Common Goal

Although the SDGs are not perfect and were not designed Embracing A New Role for investors, they represent an important framework for understanding how our social and environmental systems We recognize that the journey for SDG-Aligned Investing are interrelated and interconnected. will not be easy. Still, we believe that this change from ESG to impact to SDG alignment is already happening “Investors cannot do it alone.” and will only accelerate in the years ahead. From climate change to income inequality to social injustice, the prob- - Head of ESG and Compliance, Large US Endowment lems faced by this generation are too significant and too consequential for investors to remain on the sidelines. It We believe that the SDGs provide the opportunity to cre- is no longer enough for an institution to hide their head in ate a common set of goals, shared across different stake- the sand by saying that “as long as I beat a market bench- holders, from investors and corporations to civil society mark, my work is done.” Instead, institutional investors’ and governments, at a global level. The SDGs can become influence in the markets comes with great responsibility. the framework for investors to collectively address shared, Calls for increased accountability of investors’ impact on complex, system-level challenges, such as climate change people and the planet will only increase. and inequality. They can provide the much-needed map for investors to focus on outcomes, reduce externalities, To accomplish this, investors need strong conviction, a and take on an active role in engaging companies to ad- greater sense of clarity, and widespread consensus, as well dress pressing social and environmental issues. as an expanded toolbox to influence companies’ activities.

The COVID crisis has shown the importance and intercon- If institutional investors assume their critical role in sup- nectedness of systemic risks. COVID spread rapidly among porting the globally agreed sustainability agenda embod- the poor, chronically ill, or those working in poor condi- ied in the SDGs, they will meet the rising expectations of tions, resulting in a serious global economic crisis. This cri- the moment and genuinely provide resilient investment sis shows that poverty (SDG 1), health (SDG 3), and decent opportunities for their clients and beneficiaries for gener- working conditions (SDG 8), just to name a few SDGs im- ations to come. pacted by COVID-19, are systemic issues that affect every- one globally and cannot be ignored by asset owners and fiduciaries with a long-term mandate.

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X. Appendix: Case Studies

Below are two illustrative case studies, one from an as- The federal government of Canada and the government set owner and another from an asset manager, that show of Québec provide the Fonds’ shareholders-savers with a practitioners’ approaches to impact and SDG-Aligned in- tax incentive, as a demonstration of their support to the vestment. The inclusion of these case studies in this report Fonds’ economic mission. Combined with the Fonds’ size should not be considered an endorsement of these orga- and evergreen structure, this allows it to invest across nizations and their offerings. asset classes and sectors with a long-term horizon, and in some instances, to take on more risk. Another key dis- Case Study 1: An Asset Owner’s Journey to Impact tinction is the Fonds’ compensation structure, as its investment professionals are not remunerated according Fonds de solidarité FTQ74 (the Fonds) is a development to their individual performance. The Fonds believes that a capital investment fund which was constituted in 1983 by variable compensation structure is not consistent with the the Fédération des travailleurs et travailleuses du Québec values of a workers’ fund. (“FTQ”), one of Québec’s largest trade unions. Created in response to a severe recession that was affecting Québec The Fonds seeks to provide reasonable returns77 to its and causing significant job losses and business failures, shareholders-savers so that they can prepare for retire- the Fonds was conceived as a socioeconomic tool aiming ment while achieving its mission. While the Fonds’ share- at benefiting Québec’s workers, companies, and the econ- holders-savers receive tax incentives to invest in the fund, omy as a whole. they invest in the fund on a voluntary basis and are active participants in its annual shareholder meetings. During The Fonds’ main activity is to collect the savings of the last five years, the Fonds has received an average an- Québec workers and use these savings to make develop- nual contribution of around CAD 870 million from its exist- ment capital investments (both growth capital and ven- ing and new shareholders to invest. ture capital) in accordance with its mission75, which is to: As of May 31, 2020, the Fonds had: • Create, maintain, or protect jobs: Invest in companies impacting Québec’s economy and offer them • Net assets worth CAD 13,794 million services to further their development, with the aim of • Invested in 3,329 partner companies across all creating, maintaining, and protecting jobs. regions of Québec • Train workers: Promote economic training for work- • Supported 221,267 jobs78 ers so they can increase their influence on the eco- • 707,935 shareholders-savers nomic development of Québec. • Provided its shareholders-savers an annual • Develop Québec’s economy: Stimulate Québec’s compounded return of 6.4% for the last ten years economy through strategic investments that benefit both Québec workers and companies alike. Because the Fonds’ mission drives its investment de- • Prepare for retirement: Make workers aware of the cisions, it has adopted a Sustainable Development need to save for retirement and encourage them to Framework Policy, which overarches both its Investment do so, as well as encourage them to participate in the Policy (applicable to its development capital investments) development of the economy by purchasing Fonds and its Other Investments Portfolio Policy.79 The Fonds’ re- shares.76 sponsible investment approach is tailored to the nature of those two portfolios. As an example of its innovative

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approach, the Fonds has since its foundation considered Case Study 2: The SDGs as an Engagement Framework and integrated social aspects into every investment decision made in Québec (e.g., workers rights, health, and Federated Hermes (“Hermes”)80 is an active global asset safety, diversity, and inclusion). manager with US$628.8B under management and $1.1T in assets under advisement as of June 30, 2020. As a re- As societal issues have evolved since its inception in 1983, sponsible investor, its goal is to help individuals achieve from unemployment and business failure to the climate better risk-adjusted returns and to contribute to positive crisis, workplace disruptions, and rising health issues, it outcomes in the wider world.81 Hermes has been commit- was crucial for the Fonds to remain relevant and funda- ted to active corporate engagement since 1983 and has mentally engaged in tackling them. Following a strate- built a large team skilled in face-to-face engagement with gic review led in 2017 by the Executive Vice-President, corporate executives and directors. Investments, the Fonds took on the ambitious challenge of furthering its positive contribution to Québec’s society: The Hermes SDG Engagement Equity Fund launched in it decided it would aspire to become an impact investor. January 2018 in response to clients’ requests. The Fund has “the dual purpose of delivering attractive returns and The Fonds’ impact strategy presently relies, as of now, on measurable real-world impact by investing in publicly three fundamental – and related – pillars, which are 1) re- traded equities globally.”82 The Fund seeks to achieve its orienting its investments towards solutions (products, ser- purpose by outperforming the global small- and mid-cap vices, and technologies) that are aligned with the Fonds’ market “as well as aiming for positive social and environ- impact themes, 2) supporting its partner companies in mental change by engaging with companies to help deliv- their environmental and digital transitions, and 3) devel- er the Sustainable Development Goals (SDGs).”83 Hermes oping projects that will have structural effects on compa- core investment beliefs include: nies, communities, and local economies. • Public companies can contribute to and benefit from Even though the deployment of the Fonds’ impact strate- efforts to achieve the SDGs. gy is still ongoing, several milestones have been reached • Meeting the SDGs will be a primary driver of future over the last two years. The Fonds has hired new human economic growth, providing opportunities for firms to resources devoted to its impact strategy while reallocat- boost revenues and earnings. ing some of its existing resources to support its shift to • Companies are uniquely positioned to significantly impact investing. It has created an internal working group impact lives due to their integral position within of over 20 employees to ensure the success of its impact communities, direct relationships with employees, strategy’s deployment. The Fonds also joined the Global and connections with suppliers. Impact Investing Network (GIIN) in early 2020, connecting • The long-term commercial performance of companies its teams to the world’s most organized and advanced net- relates to the success of the environments in which work in impact investing. The Fonds is currently working they operate and in which their employees and on establishing measures and indicators to track its prog- customers live. ress on impact and is in the process of developing capi- • Firms that fulfill their responsibilities towards society tal allocation targets. Technical training is being offered, will be rewarded with greater brand loyalty, employee awareness among investment teams is progressively motivation, and more innovative products and growing, and many internal tools are under development. services. • Investors can influence companies to improve their For most asset owners, impact investing is a journey that operations in support of the SDGs, creating a virtuous requires taking incremental steps. Even for a mission-driv- circle of change, benefiting employees, communities, en entity like the Fonds, impact investing demands a supply chains, and other stakeholder groups. progressive culture shift because it requires a different • Engaging with companies on the SDGs provides approach to analyzing investment opportunities. As it is investors with valuable insights into their current strongly aligned with its core values, the Fonds believes its levels of sustainability and longer-term commercial impact investing strategy will lead to significant, sustain- risks and opportunities.84 able, and positive outcomes for Québec.

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For Hermes, “the 17 SDGs – and the more detailed 169 un- in the fund. If the investment or engagement case deteri- derlying targets – provide a common framework for gov- orates, the holding will be sold and better opportunities ernments, investors and companies alike to understand identified. the scale of the challenges being faced by the world and to work towards defined environmental and social objec- Hermes’ tracks the impact of its investments when it ap- tives.”85 Hermes identified which of the 169 SDG targets are praises, monitors, and speaks with investee companies.91 ‘investable’ and which are ‘engageable’ and concluded Hermes recognizes that “the real-world impact of our that less than 40% of the targets are either investable or engagements may not be immediately quantifiable, or engageable.86 Hermes increases the likelihood of achiev- comparable across companies in the portfolio.”92 To over- ing tangible, positive outcomes for investors, companies, come the challenges of measuring impact, Hermes uses and society by focusing on areas where firms can most ef- narratives to communicate how its corporate engagement fectively support the fulfillment of SDGs.87 The SDGs relate has generated real changes within companies. “Unless im- to the entire investment universe and are interconnected. practical, it also reports widely accepted and standardized As a result, by seeking to fulfill one SDG and avoiding a metrics, such as those from impact investment organiza- negative impact on the other ones, Hermes’ strategy helps tion IRIS, targeted to the individual company in question achieve that SDG and other Global Goals. From Hermes’ and around specific engagement objectives. To ensure the perspective, all companies have impact potential, not just integrity and add credibility to its claims of effective en- ‘purposeful’ companies. gagement and additionality, companies corroborate the narratives after meeting any of the SDG objectives.”93 Clean Harbors, the largest hazardous waste management company in the US and the largest collector, recycler, and “Altogether, the Fund returned 26.93% over 2019, outper- re-refiner of used motor oil, is an example of the impact of forming the benchmark by 156bps. This was driven by Hermes’ engagement. In 2018, Clean Harbors “committed stock selection in industrials, real estate, and healthcare, to reinvesting in its workforce to address issues around which outweighed detractions from consumer staples, fi- attracting and retaining its logistics workers. Since then, nancials, communication services, and energy.”94 Hermes’ it has invested significantly in its pay and benefits prop- fees for this fund are higher than those charged for other osition ($40m in 2018, and likely a not dissimilar figure in funds that do not involve the same level of engagement. 2019). The company has also expanded its recruitment of veterans who now comprise 6% of its workforce – compared to 1% of the general population – and has set clear internal targets to reduce voluntary turnover. The business continues to benefit from demand across the industry for more sustainable and ‘green’ solutions to waste management. To date, it has collected and re-refined more than 3.1bn gallons of used oil – the equivalent of avoiding 27m tonnes of greenhouse-gas emissions – and recycled 45m pounds of paint over a year.”88

“Hermes’ strategy is to identify good-quality companies and, through engagement, bring about positive change to create better businesses that are well-positioned for sustainable and commercial success in the years ahead.”89 Hermes’ strategy is not led by risk mitigation and, therefore, does not aim to invest in best-in-class ESG companies. The strategy is to focus on companies that can be improved through engagement and to go beyond the non-financial risk factors that an ESG strategy would. As a result, the portfolio is not expected to perform high on ESG metrics initially but may improve over time.90 Investment and engagement pillars are both needed for an investment to be

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XI. Endnotes

1 https://www.cnbc.com/2020/09/19/esg-sees-record-inflows-in-2020-top-issuer-talks-staying-power.html, https://www. ft.com/content/20f6c929-2fbf-47d5-973c-8c18607fc604, https://www.morningstar.com/content/dam/marketing/shared/pdfs/ Research/Global_ESG_Q1_Flow_Report.pdf 2 https://www.ft.com/content/733ee6ff-446e-4f8b-86b2-19ef42da3824 3 We define sustainable investment as any investment that considers environmental, social and governance factors in the investment decision making process. 4 Institutional investors include both asset managers and asset owners such as pension funds, endowments, foundation and sovereign wealth funds. 5 https://www.morganstanley.com/im/publication/insights/articles/Asset_Owners_See_Sustainability_as_Core_to_the_ Future_of_Investing.pdf?1602638057359 6 https://trust.cfainstitute.org/wp-content/uploads/2020/05/CFAI_TrustReport2020_FINAL.pdf 7 https://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/revolution-rising-expectatios 8 https://www.schroders.com/en/sysglobalassets/digital/insights/2019/pdfs/sustainability/sustainex/sustainex-short.pdf 9 https://unstats.un.org/sdgs/report/2020/The-Sustainable-Development-Goals-Report-2020.pdf 10 https://www.unpri.org/download?ac=11599 11 https://www.ussif.org/performance 12 Kölbel, J., Heeb, F., Paetzold, F., Busch, T., ‘Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact’ (2019) 13 https://www.responsible-investor.com/articles/covid-19-helps-put-sdgs-more-than-60-years-behind-schedule 14 https://www.tiiproject.com/wp-content/uploads/2020/10/Graduating_from-ESG_to_Systems-submitted- updated-10-12-20201.pdf 15 USSIF Trends Report 2020 16 According to the GIIN’s Annual Impact Investor Survey, almost all of respondents to the 2020 survey indicate that the aggregate impact AUM reflected an annual growth rate (CAGR) of approximately 18% since 2016. 17 Eccles, R., Kastrapeli, M. ‘The Investing Enlightenment: How Principle and Pragmatism can Create Sustainable Value through ESG’ State Street Corporation (2017) 18 In this paper, we don’t consider shareholder engagement as part of ESG integration. 19 Oxford University and Arabesque Partners, ‘From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance’ (2015) 20 ‘Kölbel, J., Heeb, F., Paetzold, F., Busch, T., ‘Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact’ (2019) 21 Creating Impact, The Promise of Impact Investing. 22 GIIN Annual Impact Investor Survey 2020, “A clear majority of respondents consider the market to be ‘growing steadily’ (69% Figure i) with 21% describing the market as ‘about to take off.’ Notably, no respondents see the impact investing market ‘declining.’ When asked a similar question on the 2011 survey, 75% of respondents indicated then that the market was in its very early stages.” 23 Id. 24 The IFC estimates that “[a]s much as $269 trillion -the financial assets held by institutions and households across the world - is potentially available for investment” and “that investor appetite for impact investing is as high as $26 trillion.” Currently, “private impact funds currently total $71 billion. Larger amounts are invested by development finance institutions (including over $700 billion by those following harmonized measurement metrics) and in green and social bonds (over $400 billion outstanding). In addition, a share of the $8 trillion dedicated to activist investing in public markets may be managed for

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impact. This lack of clear boundaries and the thus far limited role of privately managed funds is not unusual for a market under development. “ IFC paper, page vii. 25 IFC, ‘Creating Impact: The Promise of Impact Investing’ (2019) 26 Id. 27 https://reports.weforum.org/impact-investment/4-challenges-that-institutional-investors-face/4-2-small-average-deal- size/#read 28 https://www.msci.com/www/blog-posts/assessing-company-alignment/02085389620 29 https://www.weforum.org/reports/measuring-stakeholder-capitalism-towards-common-metrics-and-consistent-reporting- of-sustainable-value-creation 30 https://www.spglobal.com/en/research-insights/featured/sustainable-development-goals-a-misunderstood-market- opportunity 31 https://www.impactprinciples.org/ 32 https://impactmanagementproject.com/ 33 https://iris.thegiin.org/ 34 https://www.tiiproject.com/ 35 Quigly, E., ‘Universal Ownership in the Anthropocene’ (2020) 36 Id. 37 https://www.cfainstitute.org/-/media/documents/protected/refresher-reading/2020/pdf/portfolio-management- institutional-investors.ashx 38 “A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service” DOL https://www.dol.gov/general/topic/retirement/typesofplans 39 https://www.dol.gov/general/topic/retirement/typesofplans 40 https://www.cfainstitute.org/-/media/documents/book/rf-lit-review/2020/rflr-esg-and-responsible-institutional-investing. ashx - PAG 14 41 https://www.cfainstitute.org/-/media/documents/book/rf-lit-review/2020/rflr-esg-and-responsible-institutional-investing. ashx 42 https://www.bis.org/publ/qtrpdf/r_qt1803j.pdf defined as “any rules-based, transparent, and investable strategy that does not involve identifying mispriced individual securities. https://www.cfainstitute.org/en/membership/ professional-development/refresher-readings/passive-equity-investing 43 https://theshareholdercommons.com/about/ 44 Alexander, F., ‘An Honorable Harvest: Universal Owners Must Take Responsibility for Their Portfolios’ (2020) 45 Quigly, E., ‘Universal Ownership in the Anthropocene’ (2020) 46 http://bostonreview.net/science-nature/madison-condon-climate-change%E2%80%99s-new-ally-big-finance 47 https://www.schroders.com/en/sysglobalassets/digital/insights/2019/pdfs/sustainability/sustainex/sustainex-short.pdf 48 Cheema-Fox, A., LaPerla, B., Serafeim, G., Wang, H., ‘Corporate Resilience and Response During COVID-19’ (2020) 49 Douma, K., Scott, L., Bulzomi, A., ‘The SDG Investment Case’ (2017) 50 https://trust.cfainstitute.org/wp-content/uploads/2020/05/CFAI_TrustReport2020_FINAL.pdf 51 “ESG and sustainability issues, in particular, often have systemic or long-term cost, risk and return implications. Proxy policies and analyses that do not take this into consideration are likely to raise the duty of impartiality and prudence concerns, especially in regard to identification and balancing of intergenerational risk, cost and wealth creation transfers. Analysis of the intergenerational effects of climate change, resource restraints, excessive income inequality, health and safety risks, reports on long-term strategic planning, executive compensation plan design, board succession planning and similar matters would help investor fiduciaries implement impartiality obligations.” Fiduciary Duty Guidance for Proxy Voting Reform: SEC Roundtable Submission 15 November 2018 By: Keith Johnson and Cynthia Williams, page 8. 52 https://www.forbes.com/sites/bobeccles/2020/01/17/dynamic-materiality-and-core-materiality-a-primer-for-companies- and-investors/?sh=500809032e6a 53 https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=OJ:L:2014:330:FULL&from=EN 54 https://www.un.org/development/desa/financing/sites/www.un.org.development.desa.financing/files/2020-08/ Renewed,%20Recharged%20and%20Reinforced%20(GISD%202020)_vF.pdf 55 SASB’s mission is to “identify the sustainability-related risks and opportunities most likely to affect a company’s financial condition (i.e. its balance sheet), operating performance (i.e. its income statement), or risk profile (i.e. its market valuation

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and cost of capital) in the near, medium, or long term.” https://www.sasb.org/wp-content/uploads/2020/06/SASB. NFRDWhitepaper.FINAL-005.pdf 56 https://www.sasb.org/wp-content/uploads/2020/06/SASB.NFRDWhitepaper.FINAL-005.pdf 57 https://corpgov.law.harvard.edu/2020/05/16/purpose-with-meaning-a-practical-way-forward/#more-129818 58 https://corpgov.law.harvard.edu/2020/05/16/purpose-with-meaning-a-practical-way-forward/#more-129818 59 Whelan, N., Hansen, O. Lund, Hughes, M., Rosenberg, A., ‘SDG Ambition: Introducing Business Benchmarks for the Decade of Action’ (2020) 60 Statement of Intent to Work Together Towards Comprehensive Corporate Reporting, September 2020, Facilitated by the Impact Management Project, World Economic Forum and Deloitte 61 https://impactmanagementproject.com/investor-impact-matrix/ 62 Berg, F., Kölbel, J., Rigobon, R., ‘Aggregate Confusion: The Divergence of ESG Ratings’, MIT Sloan School of Management (2020) 63 “ Global Investors for Sustainable Development Alliance, GISD, ‘Renewed, Recharged and Reinforced: Urgent actions to harmonize and scale sustainable finance (Report of the Global Investors for Sustainable Development Alliance to the European Commission)’ (2020) 64 Kölbel, J., Heeb, F., Paetzold, F., Busch, T., ‘Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact’ (2019) 65 “The mechanism of “minimum safeguards” under Article 3 requires an environmentally sustainable investment to comply not only with environmental profiles but also with those essential principles explicitly recalled by Article 18. Indeed, by the term “minimum safeguards” the Regulation refers to those “procedures implemented by an undertaking that is carrying out an economic activity to ensure the alignment with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights.” Moreover, when implementing such procedures, undertakings shall adhere to the “principle of do no significant harm”, as described above in the analysis of EU Regulation 2019/2088.” https://www.lexology. com/library/detail.aspx?g=befb9df7-2e88-4f03-bd62-c541b88590a3 66 https://theshareholdercommons.com/guardrails/ 67 Kölbel, J., Heeb, F., Paetzold, F., Busch, T., ‘Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact’ (2019) 68 Id. 69 Id. 70 https://www.cfainstitute.org/-/media/documents/article/position-paper/esg-issues-in-investing-a-guide-for-investment- professionals.ashx 71 “a form of innovative finance focused on using catalytic capital from public or philanthropic sources to structure investment opportunities with acceptable risk-return profiles for private sector investment that further the SDGs in both emerging and developed markets.”source: https://tideline.com/wp-content/uploads/Tideline_Catalytic-Capital_Unlocking-More- Investment-and-Impact_March-2019.pdf 72 “debt, equity, guarantees, and other investments that accept disproportionate risk and/or concessionary returns relative to a conventional investment in order to generate positive impact and enable third-party investment that otherwise would not be possible.” source: https://www.macfound.org/press/article/catalytic-capital-work/ 73 https://www.ifc.org/wps/wcm/connect/Industry_EXT_Content/IFC_External_Corporate_Site/PPP 74 Unless otherwise noted, this case study is based on interactions with representatives of the Fonds. 75 https://www.fondsftq.com/fr-ca/a-propos/qui-sommes-nous.aspx 76 https://www.fondsftq.com/en/a-propos/qui-sommes-nous.aspx 77 Short Form Prospectus, Continuous Distribution, 37th edition, June 2020. 78 https://www.fondsftq.com/en/a-propos/qui-sommes-nous.aspx 79 The Other Investments portfolio policy is designed to optimize the risk-return profile of the Fonds, diversify the Development Capital Investments portfolio and ensure that the Fonds maintains a sufficient level of liquidities to meet all of its obligations. Management Discussion and Analysis, May 31, 2020. 80 Federated Hermes has provided information for this case study through interviews, unless noted otherwise in this case study. 81 https://www.federatedhermes.com/about/ 82 SDG Engagement Equity Fund, 2018 Annual. 83 Id.

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84 SDG Engagement Equity Fund, 2019 Annual. 85 SDG Engagement Equity Fund, 2018 Annual. 86 Id. 87 Id. 88 SDG Engagement Equity Fund, 2019 Annual Report 89 Id. 90 Id. 91 Id. 92 Id. 93 Id. 94 Id.

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