Introducing Impact Returns
A next-generation approach to combining finance and impact
Contribution is about assessing the difference between outcomes given an actor's action and what would otherwise happen. For investors, this difference is 'investor impact'. For companies or other organizations, it is 'enterprise impact'.
To assess investor impact it is necessary to look at the contribution of each actor in the impact pathway from the investor to the end outcomes. If an investor didn't make an investment or didn't engage with a company, it's likely that other investors would have stepped in to replace most of their investment or engagement. The expected difference is the investor contribution to the underlying enterprise.
Next, consider that if the enterprise didn't receive this extra investment or engagement, competitors may have stepped up their efforts, leading to similar outcomes. Thus, the investor's contribution only matters if it causes the company to change its enterprise contribution by generating outcomes that wouldn't otherwise be expected to occur.
It is important to assess contribution in a way that represents positive-sum thinking. This means using a contribution methodology that answers the question 'What way of assessing contribution is going to lead to the best outcomes in the long-term?'. You can consider this question in many ways. Crucially, this question has precise answer within formal economic models and this answer is the basis for the contribution methodology that we have developed.
This approach offers a welcome break from circular discussions about how to do 'attribution', which usually comes from zero-sum thinking with little direction to guide it other than a vague notion of 'fairness' and avoiding 'double counting'. It also differs from the binary, all-or-nothing definition of 'additionality' that seems all too common (i.e. 'this investment is additional only if the entire project wouldn't have otherwise happened').
With our granular, non-binary approach to contribution, we have found that many investments have a 'contribution multiplier' somewhere between 1%-30% (see our case study report for examples). Acknowledge this is positive-sum because it helps avoid 'El Farol bar'-like problems where either investors crowd into the same investment because they all think they are making a huge contribution, or no one thinks they are making a contribution so nothing gets funded. The reality is that, most of the time, investing alongside others can be impactful, but not enough to justify the greenwashing, crowded investments and false hopes that have been promoted in the past.
Furthermore, there are good reasons to expect financial performance to be correlated with contribution. In this light, it's surprising that many investors and analysts are scared of these concepts. Whether due to historical political baggage or fear of new ideas, this is a missed opportunity. By honestly assessing and communicating their contributions, investors can enhance their reputations.
The 'strategic price of impact' (SPI) is not a normal price at which you can buy or sell. It's a strategic tool to help you make decisions in a way that is consistent across all your investments.
How do you determine the right 'price'? Similar to Key 2, first you have to ask the right question. In this case the question is: 'What SPI, when applied consistently across all opportunities, will yield the best combination of financial and impact results?'. The answer will partly depend on your subjective beliefs and values, but it also has objective constraints.
Setting the right SPI is key to not leaving impact or financial returns 'on the table'.
If you set the SPI too high, your impact return estimates will drown out the signal in the financial returns. If you followed through on this, you would end up with a portfolio that only makes sense if you're looking to give all your money away as fast as possible. This might be fine for your impact, but it leaves plenty of financial returns (and future impacts) on the table.
If you set the SPI too low, your impact returns will be insignificant. If you followed through on this, you would end up with a portfolio that looks identical to that of an investor who ignores impact. This may not hurt your financial returns, but it leaves plenty of impact on the table.
Even if you believe financial results and impact are positively correlated, you should still have a positive willingness to pay for impact. First, this 'cost' doesn't have to be about charity - it can be a risk-adjusted cost associated with making bigger bets on profitable, impactful enterprises than you would if these enterprises weren't impactful. Second, a strict zero willingness to pay would imply that there is no amount of outcomes, no matter how big, that would compel you to accept lower risk-adjusted financial returns to make it happen.
The upper bound for the SPI should be informed by your opportunity costs - the best alternative opportunities you have to generate impact and returns. It's highly unlikely that these best alternatives will imply an upper bound that is at or above the social costs used for cost-benefit analysis, social returns and SROI.
Indeed, the social cost is the maximum that society should be willing to pay for a given impact. For better or worse, there are usually many opportunities to generate impact at costs that are significantly lower than the social value created. Only in an ideal world where all net positive impact opportunities are fully funded would the marginal price of impact equal the social cost.
The SPI can be seen as a generalization of the 'internal price of carbon' that many organizations have adopted. A key difference, in addition to being applicable to impacts beyond carbon, is that consideration of 'contribution'. Contribution isn't relevant for businesses that are just thinking about their financial risks and opportunities (due to climate policy), but it is a crucial nuance to get impact right.
Another simple way to think about the SPI is: 'How much would I need to donate to a charity to replicate the impact of my investment?'. This is as close to a 'market price' as we can get when it comes to impact. Similar to how your accountant wouldn't allow you to value investments based on the maximum price you'd be willing to pay, you shouldn't use social costs to value your impact. It would be odd to pay a charity the social cost for creating an impact when you could find another charity generating the same impact at a lower cost. The amount required by the latter charity should set the upper bound for your SPI.
The charity framing is just a particularly simple way to think about the SPI. In general, great 'impact investment' opportunities can also set bounds on your SPI.
Impact Returns are a Middle Way
Impact Returns are a 'middle way'. They avoid the extremes of common views that don't treat impact with the nuance that it requires.
Link to Gates Foundation's 'Risk Share'
Impact returns are related to the Gates Foundation's concept of 'Risk Share': the expected financial trade off on a program-related investment that is charged to the Foundation's grant budget. Impact returns are the maximum 'risk share' that the grant team should be willing to pay from its budget.
Impact returns are useful even when there is no grant budget—thinking in terms of a hypothetical grant budget makes good, economic sense. This also means impact returns are useful even when there is no or little financial trade off–all else equal—investments with higher impact returns should be preferred because they are creating more value.
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About the Total Portfolio Project
We started the nonprofit Total Portfolio Project to help accelerate advances in how capital is allocated for impact and as part of this project we developed the concept of impact returns.