Introduction

 On 16 July, themed as "New Development with Sustainability”, the 2021 International Forum for China Impact Investment (IFCII) was successfully held in Shanghai. The 2021IFCII was sponsored by Chinese Academy of Financial Inclusion (CAFI) and co-organized by YICAI Research Institute and Shanghai Advanced Institute of Finance of Shanghai Jiao Tong University. In the keynote session under the theme of "Impact Measurement and Management", Professor Tzu Kuan CHIU (Professor of Finance at Shanghai Advanced Institute of Finance (SAIF), Shanghai Jiaotong University,Academic Director of Sustainable Finance Discipline Development Fund at SAIF) delivered a speech.

The Attributes of Three-dimensional Investing

1. Impact measurement and management (IMM) should be placed within a broader investment framework.

2. Three-dimensional investing is different from traditional investment. Traditional investment is two-dimensional, and the investor is concerned with risk and return, while taking little notice of the impact on people or ecosystem. The third dimension emerged when traditional investment evolved into three-dimensional ESG investing.

3. ESG investing is not a new domain, as it started its development in 1970s. But need to reflect the reasons of why ESG investing didn’t go mainstream until recent years.

4. ESG investing is a three-dimensional investment, where risk and return are no longer the only concern of the investor, but also the impact brought by the capital to the world.

5. The so-called independent third dimension is the ESG IMPACT dimension. From the ESG practice perspective, the "S" dimension of ESG was the first to be developed in the 1970s, and the first approach was called the Negative Screening Approach; the environmental and corporate governance dimensions were gradually developed in the 1980s and 1990s, bringing about more ESG investment strategies.

Three-dimensional investing from a theoretical perspective

1. The investment theories were developed in the 1950s, named as Modern Portfolio Theory, with two basic assumptions. The first assumption is that people are perfectly rational; there is no herding effects when making investment decisions, nor is there cognitive bias. The second assumption is that our investments are maintained by two dimensions, i.e. risk and return.

2. Later financial economists discovered that humans are not perfectly rational and some relaxation of this assumption had to be made; Behavioral finance was thus developed as a new discipline.

3. As for the second hypothesis, financial economists gradually learnt that investment was no longer only about risk and return, instead many investors, especially institutional investors, wish to drive society through capital and are very concerned with the ESG impact their capital could create. From the 1970s onwards, ESG investing was therefore developed, as the third dimension of investment.

4. Even though the theoretical development of three-dimensional investing is still in its infancy, we observed that it is moving steadily towards mainstream.

Three challenges of three-dimensional investment

1. ESG investing has high threshold. It is extremely knowledge-driven and value-driven, so there are cultural constraints and high knowledge requirements, which indicates the development of investor appetite is urgently needed. It is also essential to assist investors to transform from traditional 'brown investors' to 'green investors'.

2. What exactly is the relationship between social returns and traditional financial returns? How relevant is ESG impact and financial returns? When all empirical studies of ESG showed no excess returns, what would be the incentive to invest? The next question to be addressed is the relationship between financial returns and investors' pursuit of ESG impact. The empirical studies find that they are mutually offset. As a final step, we hope to formulate a comprehensive theory to address this issue.

3. Impact Measurement and management.

a) One of the biggest challenge is to obtain ESG data. There are two solutions: the traditional one is to get the data through ESG ratings, but this does not address the root cause of the data, which is related to the role the companies play in society.

b) Putting the ESG ratings aside, it is also possible to study impact-weighted financial statement, that is ESG impact data.

c) Cause and effect chain is usually quite long in company's operations, from its production inputs to output to the results and impact created by the products. Traditional financial statements only show the front end of the chain. New methods are needed to re-establish cause and effect chain, but how to identify it? How rigorous is the evidence?

d) Using different units when measuring ESG impact makes it difficult to sum. The ideal approach would be to use a monetary unit of measurement, which could ultimately be combined with traditional financial statements to bring together the financial and non-financial information of a company into a more holistic view of the value that a company brings to our society.

Findings

1. ESG tastes development. Investors’ preference ultimately determine the long-term price of assets. Experiments have shown that investors, especially double bottom line investors, are willing to make preemptive concessions between financial returns and social impact, rather than being forced to accept concessions afterwards because of poor investment results. To sell financial products to investors, especially individual investors, you need to first get the investor to do KYC (know your customer). Traditionally, KYC was done in two dimensions, asking only about the investor's risk acceptance and desired return. Evolving from two-dimensional investing to a three-dimensional one, it means KYC should be carried out in three dimensions. This was a very welcomed first step.

2. Scholars should continue to develop three-dimensional investing theory. Adding the third dimension to the two-dimensional investing theory, a modern ESG-adapted portfolio theory is then formulated. We need to do more research to uncover investor behavior and then interpret it via a more complete doctrine.

3. All stakeholders are making great strides in terms of ESG data and hopefully to establish a better data starting points as well as disclosure requirements. On the one hand, it is related to the rating of ESG and ESG disclosure of the enterprises. On the international level, the IFRSF has established the ISSB to promote the harmonization of ESG reporting standards. Yet why it has not been promoted until today, and the issues behind it are not as simple as they appear. On the other hand, for the first time, we noticed that government authority started to require disclosure the third dimension of financial products. The "EU Green New Deal" in 2019 clearly indicates that investment without a purpose other than pursuing returns will not take us to a higher and more ambitious future and that investment must help transform our economies, such development is highly appreciated. In this context, "Regulations on Sustainable Financial Disclosure" clearly presents the third dimension of ESG financial instruments.

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