Wednesday, November 12, 2014

Impact Investing and the internalization of externalities - an ailment for market failures

Trillions of dollars are invested in the fossil fuel sectors while still we bicker over the 100 billion USD per year Green Climate Fund, designed for adaptation and mitigation of climate change effects. Fossil fuel subsidies are at least 5 times the size of renewable energy subsidies. Smart? Moral? Financially sensible? In fact they are symptoms of a flawed investment paradigm that due to its inability to internalize externalities, negative and positive, produce market failures such as environmental degradation and dysfunctional welfare.The time has come for a transition to a more inclusive investment framework that highlight the true cost and impact of an investment. 

Negative and positive externalities 

Negative externalities occur when marginal private cost is less than the marginal social (public) cost. Clean air and clean water are to a large extent free assets, produced by nature. Use and abuse is widespread and social costs that arise because of it, for example increased health care costs, have for the most part not financially burdened the offending party. Mounting consumer pressure, increasing legislation and the introduction of "polluter pays" systems like specialized taxes and trading schemes imply a sea of change. 

The growing emphasis on externalities was confirmed by last year's inaugural World Forum on Natural Capital held in Edinburgh that spoke of the need to price natural assets such as water, air and soil and the ecosystem services we receive from nature. While it can be argued that nature is priceless, it is nevertheless valuable. The TEEB for Business Coalition published a report in 2013 which estimated that the world's primary production and processing sectors are responsible for 7.3 trillions of dollars annually in negative environmental externality costs.

In a world facing increasing resource scarcity, a population estimated at 9 billion in 2050 and the effects of climate change, businesses in particular will need to adapt to a new reality. A reality where the effects of their operations, previously kept off the balance sheet, will become increasingly internalized and potentially change the competitive landscape. The latest Living Planet Report from the WWF make it clear that globally we are already consuming 50 % more natural capital resources than the Earth can replenish, per year. As businesses rely on natural resources in their supply chains the risks are evident and easily translated into financial consequences. These externalities could for example manifest themselves in a market price for water or a tax on carbon emissions. Beverage and energy companies would see their bottom line altered and need to start preparing for such scenarios. Every business has to analyze their exposure to context specific externalities and their rate of internalization. Will for example logging companies bear the full social cost of deforestation as associated soil erosion causes loss of agricultural output and reduced resilience in flooding situations?

Internalizing negative externalities is only half the battle, to fully grasp the impact and value of an investment requires a deeper understanding of its positive impact. When the marginal social benefit exceeds the marginal private benefit it is indicative of positive externalities. These external benefits often go under valued by the market as they are difficult to monetize for the providers and suffer from the free rider problem. Therefore less of these externalities are produced than would be optimal for society as a whole. Governmental welfare systems targeting healthcare and education for all are case in point where the positive effects on society are obvious but costs act prohibitively. The advent of social entrepreneurship illustrates the situation well, the social sector needs new ideas, new delivery methods and new business models to offer citizens the best possible service today and for future generations. Collaboration between the public and private sector is crucial but governments need to lead the way, for example by transparently disclosing costs associated with social provision, as the UK government has done. For example; £64,819 is the cost of a child taken into care for a year; £39,472 is the cost of a prisoner per year; £11,972 is the cost of somebody being excluded from school (UK Cabinet Office, 2014). The positive effects of specific investments and companies are consequently easier to quantify and assess.  Internalizing positive externalities is the push that these investments need to better compete and multiply in occurrence. 

Impact Investing - a smarter choice

The absurdity of the situation we live in today is that it's cheaper to make investments that are bad for both planet and people. It's expensive to do the right thing. This has to change. Ultimately, even financial returns will collapse as nature says enough.

Can't we agree on a common valuation method and get going? A universal and easily comparable methodology is without a doubt a necessity for the process of internalizing externalities. Continued consumer interest, new policy and incentives for greener behavior are also vital pieces of the puzzle. But perhaps of most consequence, a new investment framework. Retooling our existing and out dated investment models will be an exercise in futility. The short term nature and single focus on financial returns make a successful change as unlikely as a 100 m sprint runner winning the marathon. While not a panacea, the growing phenomenon of impact investing can be a game changer in the endeavor to properly address externalities. Impact investing contrasts the ethical and responsible investment scene by going beyond the standard exclusionary approach and placing a premium on creating positive impact. Two of its main characteristics explains why it is up to the task;

Intention - investments are made to deliver positive social and environmental returns alongside financial returns, not as an afterthought but as a core objective for the investment. Heavy emphasis on metrics to measure the stated impact indicates an acute awareness of the effects associated with the investment. Transparently minimizing or eliminating negative externalities while producing more positive externalities are top priorities from the onset. Businesses that intentionally target positive social and environmental returns are poised to make smarter decisions and reduce risk. The question is; will actors that refrain from this process survive? Will they generate investor interest, get approval for bank loans or have their operations insured? 

Cross Sector Collaboration - to effectively tackle global challenges like climate change requires collaboration across borders, not only geographical but also sectoral. Each sector uses its particular strengths, for example in blending different forms of capital from public and private sources, an impact investing trademark. It makes it easier to cater to unmet needs in neglected market segments and close the gap between supply and demand in regards to positive externalities. Investing in access to to clean water in water stressed regions is an example where different forms of capital would be needed to effectively solve a problem that would deliver tremendous health benefits to the target group and productivity yields to society as a whole.

Impact investing is well equipped to supplant the prevailing yet insufficient "financial return only" paradigm over time. It's not only the just thing to do but pragmatically it is the right thing to do as we progress further into the age of the Anthropocene.