II. Introduction

    Founder of the Center for Blended Value think tank, Jed Emerson’s blended value theory posits a new perspective in which investments should be valued. Historically, the measurement of an investment had relied purely in terms of its financial returns, yet Emerson believes this to be disingenuous. He argues that not only should financial returns be considered, but they should be combined with considerations of social and environmental impacts — forming the basis of an emerging field: impact investing. Impact investing, also known as social responsible investing, places a greater emphasis on ethical behaviors compared to traditional investing. The Wharton School defines impact investing as “a strategy for generating positive social and environmental impact alongside a financial return,” paralleling those same beliefs from Emerson. Proponents of impact investing believe that the private sector can play a greater role in solving some of the world’s greatest challenges, rather than traditional governmental initiatives. This perspective has influenced the evolution of the field, shaping its principles and growing popularity.

    The basis of impact investing can be traced back to ancient times, with heavy alignment with religion. In the US, the origins of responsible investing can be attributed to Methodists and Quakers, who attempted to restrict the investments in industries which were deemed unethical to support, namely slavery, liquor, and war. While impact investing has existed in some form throughout existence, key changes in modern policy and regulation have promoted the development of the industry into what it is today.

    Although impact investing focuses on the impact capital markets and the private sector can have on addressing key issues of the time, the government plays an imperative role in shaping policies and regulations, in turn impacting the dynamics of impact investing. The Community Reinvestment Act in 1977, which attempted to address the issue of unequal lending practices in low-income areas especially played a vital role in shaping the intersection between policy and investment. Americans soon realized the power they wielded through the power of the purse, and would not fail to utilize the pressure they collectively could put on firms which pursued objectives contrary to their beliefs.

    As the 20th century progressed, political economics and policy emerged as significant influencers in impact investing behaviors. Governments began enacting specific policy tools, from social impact bonds (SIBs), to low-income housing tax credits (LIHTC), and clean energy incentives among others in order to direct the distribution of resources to firms and communities. While some policies fail, and others succeed in accomplishing its goal, each becomes a vital lesson in the most effective approach to promote the collective social good, through investments.

II. Different Policies

    Under the broader umbrella of environmental, social, and governance (ESG) factors, non-financial factors are incorporated into impact investing. Three main policies exist in influencing impact investing: subsidies, tax incentives, and regulatory frameworks.

Subsidies and Tax Incentives

    Subsidies refer to the distribution of resources to another firm with no expectation for repayment. In economics, governments often issue subsidies to alleviate various unwanted externalities, and pursue their goals from the private sector. In the impact investment industry, subsidies are crucial in incentivizing firms to invest in assets that contribute to greater societal advancement. These subsidies often drive investments in sectors that require significant capital, yet offer long term social and environmental benefits such as in renewable energy, housing, and healthcare. While not all subsidies are exactly alike, they often involve partial or full financial support for firms engaging in such activities, which incentives the firms to behave a certain way. Subsidies additionally work especially closely with tax incentives–another form of incentive through the reduction of traditional taxes.

    Similar to subsidies, tax incentives work to meet various societal goals, such as in hiring workers and creating jobs, or investing in equipment. Take the federal Investment Tax Credit (ITC) for example. Introduced in 1962, the Investment Tax Credit was originally intended under the objective of protecting domestic industries in the United States. However, the ITC has evolved overtime to incentivize renewable energy and other green initiatives, branching out into specific sub-categories. For instance, the Solar Energy Investment Tax Credit “reduces the federal income tax liability for a percentage of the cost of a solar system that is installed during the tax year” according to the Department of Energy. On the other hand, as the name suggests, the Reforestation Tax Credit focuses on reforestation effort–allowing expenses that pursue this goal eligible for a 10 percent tax credit. Regardless, these tax credits provide an incentive for firms to invest in initiatives to help the government pursue its societal objectives, and are facilitated through policy.

Low-Income Housing Tax Credit (LIHTC)

    In 1986, another piece of crucial legislation was introduced in developing impact investments. The Tax Reform Act of 1986 created the LIHTC program, which allocates capital to firms which help build or rehabilitate affordable housing units with the ultimate goal of encouraging investment in low-income communities. A deep examination of the LIHTC program reveals the potential for substantial impact, while also highlighting certain limitations in its implementation which highlight areas for improvement.

     To understand the extent of impact, an examination must be made on the context and specific entities the policy affected. According to the Office of Policy Development and Research’s “The Low-Income Housing Tax Credit Program: National Survey of Property Owners,” they present data from conducted telephone surveys of those that responded to the LIHTC incentive. Through their study, they found that a “majority of property owners are for-profit businesses” where “financial as well as civic or social reasons” motivated the development decisions of their owners. Moreover, they contend that “tax credits are essential to the owners’ deals.” Incredibly, a total of 53,032 LIHTC properties were placed into service, with a majority of them new, while the rest were rehabbed. Additionally, through 2022, 52.1% of owners received the 70-percent credit type, which is designated for new construction or substantial rehabilitation of property, while 32.9% received the 30-percent credit type, generally for projects involving existing buildings or do not need extensive renovations.

     These properties are mostly small, located in central cities, and are intended to serve those most at risk: families, elderly, and disabled persons. From a societal standpoint, the incentives from LIHTC significantly boosted investments into these communities which sought most help. However, from the investor standpoint, LIHTC made their impact investments viable financially and were able to successfully receive their tax-credit through “a syndicator, direct placement, or a combination of these. Development financing sources include tax-credit equity, below-market-rate debt, market-rate debt and various other public and private resources.”

The study found that the majority of times, the performance of the property met owner’s expectations and owners had no regrets as the program was able to make their deals financially feasible. In fact, a majority of owners reported an intention to continue the program in the future. In other words, the LIHTC was not only able to positively impact communities through incentivizing investment into housing, but also generated a financial return for the owner–upholding the key idea of impact investing. While impact investments may be made without government involvement, policies allowed a broader range of individuals to get involved, and started a cycle of development through the power of the private sector.

Inflation Reduction Act

    Most recently, the Inflation Reduction Act, or IRA, signed in 2022 by President Joe Biden marks a historic milestone in the nation’s undertaking of the clean energy and climate crisis. According to the United States Treasury, the tax incentives under the IRA aim to spur investment through “reducing the costs of building qualifying energy projects and equipment or by incentivizing the production of energy or manufactured goods.” This substantial investment into the US economy aims to invest in underserved areas, increase jobs, and incentivize a transition to clean energy. Alongside the Low-Income Communities Bonus Credit, and the Energy Community Bonus Credit, the IRA seeks to provide up to 30% credit for investments in renewable energy, given they meet a certain wage and employment threshold, with greater resources given on the basis of further qualifications of the project. These qualifications target areas in most need of investment, such as in energy communities, low income communities on Indian Land, and residential building projects for low income communities.

    The Labor Energy Partnership estimates that by 2030, 1.5 million jobs will be added due to the IRA, inflation will drop by about 2%, and the GDP will increase to $28.7 trillion ($250 billion more than the base case: projections without the Inflation Reduction Act’s influence). Additionally, the Rhodium Group and MIT’s Clean Investment Monitor reports that $284 billion in new investment was initiated in the past year, heavily attributable to the impacts of the IRA.

    Environmentally, estimates from the Labor Energy Partnership estimates that the IRA will more than triple the reduction of greenhouse gas emissions until 2030. Logistically, the IRA also included provisions which improve the Internal Revenue Service’s infrastructure, investing in an improvement of the ways everyday Americans do their taxes, and how the government can raise money to fund further projects.

Regulatory Frameworks

    Although policies aimed at incentivizing impact investments have proven to be incredibly effective, the establishment of clear standards and expectations for companies regarding their ESG factors also play a role in encouraging the adoption of impact investments during firm’s decision making processes.

    Globally, regulatory bodies such as the European Union have attempted to regulate the financial industry and their behavior to sustainability. For instance, the EU’s Sustainable Finance Disclosure Regulation (SFDR) promotes transparency by requiring the company to disclose information related to sustainability behavior. The EU directly attempts to influence impact investing by helping investors who wish to invest in companies with certain standards, such as those who support sustainability objectives. Seeking to transform Europe into a net zero economy, SFDR provides information to investors which give them the capability of determining the impact of sustainability risks in various decisions.

    Furthermore, the EU attempts to reach its objectives in increasing transparency through regulation, ultimately encouraging impact investments through the EU’s taxonomy for sustainable activities. The EU taxonomy, in its most basic form, seeks to create a classification system for economic activities that are environmentally sustainable. Ultimately, the taxonomy seeks to mitigate climate change, adapt to climate change, implement a circular economy, deal with pollution, protect ecosystems, and allow for the promotion of sustainability in marine resources. One of these objectives must be addressed and other basic standards must be met to meet the definition of a sustainable economic activity. Using the information provided by the taxonomy, investors and companies are better able to determine their current status regarding sustainability in relation to the economy. Not only does the system seek to eliminate greenwashing practices, but also streamlines the process of supporting projects which significantly help the EU meet its green goals. Incorporating the taxonomy compass, calculator, frequently asked questions (FAQ) repository, and user guide, the EU attempts to educate and achieve its objectives in a user-friendly manner, allowing investors to understand the taxonomy in a practical way. This not only supports companies in meeting their obligations in disclosure, but encourages the process of investment from investors.

    Yet, as the S&P Global contends, the 550+ pages of the EU Taxonomy “can be daunting – even to the initiated.” The issue of accessibility and difficulty in understanding policy in the impact investment space has proven to be a major issue, as it inhibits the effectiveness of any initiative. ESG ratings attempt to address the issue of complexity, through a single, objective, measurement medium considering various ESG factors. Oftentimes, the ESG is an aggregate of all company ESG information, presented in a simple number score. Due to the enormous influence on decision making, the EU has deemed it necessary to regulate the ESG ratings market as well.

     Specifically, the EU has adopted their Regulation on the Transparency and Integrity of Environmental, Social, and Governance Rating Activities (ESGR). The ESGR regulates the ESG rating industry by requiring ESG rating providers to receive authorization from a body such as the European Securities and Markets Authority (ESMA), disclose their method of evaluation to the public, face no conflicts of interests, and comply with various other regulations on operations. Thus, these long, and tedious processes significantly restrict the formation of ESG rating providers, and ensure that the providers are objective in nature.

    Domestically, in the US, regulatory frameworks also serve similar purposes as those in the EU, in shaping the ESG landscape. Starting with the Community Reinvestment Act in 1977, the policy was enacted to address discrimination in lending practices for low- and moderate-income communities. Specifically, banks looking to receive favorable CRA ratings were encouraged to invest in projects that benefited communities, incentivizing the core concept of impact investing.

    The famous 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act was created as a response to the 2008 financial crisis. Although mainly intended to prevent excessive risk taking and to increase transparency in financial markets, the Dodd Frank Act also included protections for whistleblowers who choose to report misconduct related to ESG fraud. With increased attention to the ESG efforts of companies, many have been found guilty of fraud through falsifying data, greenwashing, and being dishonest. As such, the Dodd Frank Act protects those who report environmental, social, and governance violations. These may include illegal pollution, discriminatory practices, human rights abuses, or financial fraud cases among others. Notably, in 2022, Goldman Sachs was found liable by the Securities and Exchange Commission for inconsistent application of their ESG procedures, and was fined $4 million. Maintaining ethical behavior in the impact investment industry becomes increasingly important in a growingly ESG conscious world, and regulatory frameworks not only incentivize activity, but also protect against fraud.

Social Impact Bonds

    One of the newest emerging tools for socially responsible investing happens to be social impact bonds, or SIB. James Chen, former head of research at Gain Capital defines social impact bonds as “a contract with the public sector or governing authority, whereby it pays for better social outcomes in certain areas and passes on part of the savings achieved to investors,” adhering to the principles of impact investing. An important distinction regarding SIBs is that any return on investment relies on the successful meeting of the impact bond’s objectives, differing from traditional bonds.

    In 2012, Goldman Sachs, the City of New York, and Bloomberg Philanthropies came together to introduce the first social impact bond in the United States. Specifically, their social impact bond attempted at addressing the high rate of recidivism among young people at the Rikers Island prison. As reported by Goldman Sachs, “if the recidivism rate dropped by 20 percent, New York City would save as much as US$20 million in incarceration costs after repaying the loan with a return. If the intervention wasn't successful, the city would pay nothing. For investors, the greater the success of the program, the greater the return.” Furthermore, Goldman Sachs needed the re-incarcerated rate in the prisons to drop by at least 10 percent to receive any return on investment.  

    However, the results of the program were disappointing. Notably, while Goldman Sachs invested $7.2 million in attempts to decrease the recidivism rate among teens, half of the teens would ultimately be jailed again, with the program recognized as a failure in its attempts to reduce recidivism. Consequently, the program would soon come to its end. Although the investigation from independent auditors found that the program did not meet its goals, the program was able to provide valuable data and become the first step in addressing social challenges through the use of private capital.

    Across the Atlantic Ocean, the United Kingdom saw different results. Also one of the first social impact bonds issued in the world, the 2010 program targeting the Peterborough Prison raised money from 17 investors, totaling 5 million pounds. Similar to the Rikers Island prison program, the Peterborough bond also sought to reduce the rate of re-conviction. Through a study of relapse rates compared to a control group over the span of multiple years, the bond exceeded the initial target of 7.5%. In fact, the social impact bond had been found to reduce the number of prisoners who returned to prison by 9%, allowing the Ministry of Justice to deem the program a success. Unlike the New York City experiment, the investors who invested in the Peterborough SIB program saw a return on investment, around 3% per annum for the time invested.

    So why did the Peterborough bond meet its objectives while the Rikers’ bond “failed”? While it may not be possible to pinpoint the exact reason for a difference in results, the New York experiment may have been limited by its short duration and lack of initial results, which may have discouraged the persistence of the experiment. After all, social problems are often an extremely complicated issue, with numerous confounding variables impacting results, and thus a longer time frame is needed to mitigate such realities.

III. Comparisons

    This paper has sought to cover some of the emerging policy approaches to boost ethical, efficient, and impactful impact investments, each with their own approaches. Subsidies and tax credits such as the LIHTC have proven to be highly effective in driving investment into industries that require high upfront costs, yet promise significant long-term social and environmental benefits. However, although these tax incentives make projects such as housing creation in underserved communities financially viable, these programs are oftentimes extremely complex and difficult to navigate. As a result, opportunities to take advantage of subsidies and tax credits may not be accessible to a wide range of investors, instead concentrating on those who have the resources and knowledge to deal with intricate regulations. Additionally, the complexity of these programs disincentivize the regular investor from educating themselves on these opportunities, which make it difficult to have a wider appeal to those with less resources.

    Thankfully, the EU and their various regulatory frameworks attempt to address the complexity of the impact investment industry. Their efforts are not completely sufficient, however their focus on increasing accessibility to the typical investor becomes incredibly impactful in increasing the volume of investment into projects for social good. The EU disclosure requirements and taxonomy program seek to make information regarding the status of various firms in their ESG activities clear and easy to access, allowing investors to make informed decisions. Furthermore, there is a global trend in increasing accountability and maintaining ethical practices. The EU’s ESG rating regulations as well as the US’ Dodd-Frank Act are crucial in allowing investors to receive an accurate representation of firm behavior. This is significant as it not only prevents fraud and greenwashing practices, but also ensures other regulations requiring basic ESG standards are met accurately.

    Lastly, the extremely new social impact bonds have seen mixed results. In the US, the first experiment was overwhelmingly deemed a failure, while the first one in the U.K. saw results that exceeded their initial expectations. Compared to subsidies and tax benefits, which mainly seek to incentivize investment through reducing financial burdens, and regulatory frameworks which seek to provide objective information for ESG decision making, social impact bonds may become the future of how the biggest projects tackling societal problems are financed. The novelness of tackling societal issues through private capital, while also generating a return provides a promising medium for change. While many other countries other than the US and U.K. have followed suit in their own attempts to issue social impact bonds, the concept is still relatively new, and much research still needs to be done in order to successfully address the risk associated with them, and their effectiveness compared to other methods.

IV. Issues and Best Practices

    The issue that should be addressed first and foremost is the immense complexity and difficulty that comes with utilizing the various policy incentives already in place. The EU has started addressing such issues, however the current status of the impact investing industry overall lacks a streamlined process. In the US, the IRS is on the forefront of this innovation, through developing a more technologically relevant tax system and procedures. Combined with existing emphasis on the importance of accountability and transparency, a more streamlined process that allows more investors access to opportunities will increase the volume of impact investments, driving more capital into investments that solve the biggest challenges today. Legal and financial experts may forever be necessary to navigate the industry and various policies successfully, but text in more plain language for the non-professional investor will encourage their education on the process, and promote their investment in a way that is congruent with their means. For instance, ESG ratings are an emerging method in determining whether a firm aligns with certain values an investor may have. Currently, the United States does not have a regulatory system similar to the European Union’s taxonomy, and does not meet investor demand for ESG information. Recently, developments have been made to regulate the ESG ratings industry, allowing investors to gain access to this crucial information.