Could an investment in a gas engine manufacturer yield as much impact as an investment in an electric motor manufacturer?

It’s Climate Week (as of writing), and so thematically (if not nominally), I’ll discuss something climate-related in this essay: reducing emissions resulting from the combustion of petroleum-based fuels in internal combustion engines. Or, more simply, let’s talk about reducing CO2 production.

Here’s the general direction I’d like to take this essay: First, I’ll describe the scenario of measuring the impact associated with investing in an electric motor manufacturer. Second, I’ll explain why you could theoretically achieve the same level of impact from investing in a gas engine manufacturer. Lastly, I’ll describe why having a set of impact investors pursuing this strategy may be necessary.

Investing in an electric motor manufacturer for social impact

Let’s assume you are a middle-market, private equity firm with an impact mandate. Your favorite banker — he is your favorite because he describes businesses in simple, unexaggerated terms — sends you a marketing document for a company called MotorCo. MotorCo manufactures electric motors used in the production of electric vehicles and makes money by selling these electric motors to traditional car OEMs and electric vehicle manufacturers alike (e.g., customers ranging from Toyota to Tesla). You are interested in MotorCo because, under the forecast you’ve developed and believe to be reasonable, you expect the business to be able to yield financial returns something to the tune of 25% IRR.

However, because you have an impact mandate, you need to forecast the social impact returns that each dollar invested in MotorCo will yield to society as a whole. For the sake of simplicity, you assume that for each additional electric motor that MotorCo produces using your investment dollars will eventually be used in a car that would otherwise use an internal combustion engine. You crunch the numbers by valuing the emissions that would otherwise be produced without your investment in MotorCo, and determine that an investment in MotorCo will yield an IMM of 25%. Super! You have just found another example of a company for which you don’t have to sacrifice financial returns to pursue strong social returns, and the impact investing asset class is all the better for it.

This example is pretty vanilla. When people think about impact investing, they think about things like clean energy all the time; they don’t think about internal combustion engines, and for good reason. Internal combustion engines are half the reason we are so worried about impact investing in the first place! (Among myriad other reasons, I’m aware.)

Investing in an internal combustion engine manufacturer…for social impact?

But could you achieve the same IMM from investing in an internal combustion engine manufacturing company? It’s not so farfetched to imagine. Imagine moments after receiving the MotorCo marketing document from your banker, you also receive a marketing document for EngineCo. You build a financial model for EngineCo to estimate expected financial returns and find that you can reasonably expect an IRR of 25% — comparable to MotorCo.

However, you are an impact investor! What about your impact mandate? Well, you get an idea that maybe you can achieve the same IMM with EngineCo as you can with MotorCo. You talk to your private equity firm’s operational team (your private equity firm has an operational team) and ask them to look at the manufacturing capabilities. Your operational team has all held former titles like “CEO of Honda” (Chief Engine Officer) and so on and determine that these engines could actually produce 50% less emissions with this one weird trick!

You also hire some former consultants and ask them to look at the supply chain of EngineCo. The consultants all have deep vendor sourcing experience and find that the business has been doing numerous CO2-related no-no’s:

• They have been buying from an international parts manufacturer rather than a domestic supplier of equal price and quality, creating undue CO2 emissions due to aviation required for parts shipping.
• The parts manufacturer uses extremely inefficient metallurgical processes that not only produce undue CO2 emissions from excess smelting but also waste a high volume of raw inputs (e.g., iron, coal).

And so forth. I don’t actually know anything about supply chain efficiencies, but the point is to understand that myriad opportunities for decreasing CO2 output could exist and in areas other than supply chain and engineering design.

Regardless, you, the private equity sponsor, return to your spreadsheets and tell your analyst to crunch the numbers. Then you begin to value the volume of emissions associated with a 50% reduction in emissions and various supply chain efficiencies you expect to realize. Before long, you learn that you could achieve an IMM of 25% due to reduced emissions! Now, when you compare the feeling of investing in MotorCo with the feeling of investing in EngineCo, one surely feels better than the other (I’m sure you know which one is which). But if they both have an IRR and IMM of 25%, as an investor with an impact mandate, aren’t you perfectly neutral?

Should there be impact investors dedicated to this strategy?

I am still working through this one because it doesn’t feel right to be able to say, “I am going to invest in things like internal combustion engines, and pharmaceutical companies that sell overpriced drugs, and for-profit, student-loan-funded diploma mills.” But it feels a little better to say, “I am going to invest in all of these things and make them better.” And it feels a little bit better than that to say, “I am going to invest in these things, make them better, and do so to a degree comparable with investing in transformational businesses and technologies (like MotorCo).”

Why would someone take this approach to impact investing? It seems like it would be thankless, misunderstood, and difficult to market to prospective LPs. I think it makes sense for several funds to eventually capture this part of the market and then stay in their lane. It’s a poorly understood niche and one that could be marketed well with proper education to capital allocators interested in expanding the share of their wallet devoted to impact.

Additionally, while it might not be as sexy as delivering game-changing impacts to the world (such as changing all vehicles from internal combustion engines to electric motors), it still could generate as much impact in a more subtle way. And the benefit of such impact change is that it doesn’t necessarily have to occur in a mutually exclusive fashion with step-wise changes towards technologies focused on creating positive impact rather than reducing negative impact. Both could be happening simultaneously, which would allow for a significant overall volume of impact in general.