Next month will be the anniversary of the U.S. Business Roundtable’s 2019 call for a shift from “shareholder capitalism” toward “stakeholder capitalism.” Business leaders asked us to imagine a transformed world, but a bat virus in Wuhan had its own ambitious plans — and has, for the time being, transformed the world in quite another way. It has thrust government to the center, pushing business, whatever its approach to capitalism, to the sidelines.
Nobody could reasonably expect business alone to fix the pandemic. Nonetheless, some investors under the banner of “impact investing” argue that business alone will be able to fix the other big problems ailing the global economy, such as climate change or global female literacy, without sacrificing commercial returns. This view has garnered interest from major banks, consultancies, business lobby groups, and even former prime ministers. One of impact investing’s leading champions, Sir Ronald Cohen, believes that it could be the “revolution” that will save capitalism and solve many of the world’s greatest problems.
It is an enticing vision of an enlightened post-pandemic economy, and, as an impact investor and economist, we support its ambitions. However, if we really want to reform capitalism, then impact investing as it is traditionally conceived will not be enough. The pandemic is not a mere anomaly; there are profound limits to what business can do profitably in normal times too. We need to reform the rules that govern how our economy works — and impact investors have a critical role to play.
Why Impact Investing Is Not Enough
There are certainly examples where impact investment has been successful at generating both a commercial return and a positive impact. But there are also those who argue there is a trade-off between profitability and impact. Who is right?
The answer is “both.” An easy way to clarify the issue is by looking at a typical “carbon cost curve”, which shows the financial costs of investments that would reduce carbon emissions. Below is an updated cost curve recently produced by the Energy Research Centre of the Netherlands.
Each bar represents a different investment. The width of a bar shows how many gigatonnes per year of greenhouse gas emissions that investment would save, and the height indicates the cost per tonne saved. For the bars below the zero-cost line on the far left, costs are negative — i.e. these are investments that are profitable even without policy change. The bars above the zero-cost line, on the other hand, are investments that come with net costs and will only become competitive if investors are rewarded for the carbon they save. They need policies such as subsidies or carbon pricing, and those on the far right need a very high carbon price indeed.
The leftmost part of the curve shows there are some opportunities where it is already profitable to cut carbon emissions. Typical examples include household energy efficiency projects or the best sites for wind power. These represent opportunities for an impact investor (or a regular investor) to do good while potentially making a commercial return.
However, to limit global warming to 1.5◦C, as agreed by 196 countries in Paris in 2016, we must rely mostly on approaches that sit “above the line,” such as expanding wind energy to some of the unprofitable sites or using carbon capture and storage. To achieve the Netherlands’ 2050 target of a 95 percent cut in emissions on 1990 levels, all the investments in the area shaded blue need to be funded. The Energy Research Centre estimates that, even accounting for future technology change, it would take a carbon price of nearly €200/tonne to make these profitable.
If that carbon price isn’t in place, then the activities “above the line” remain unprofitable for private investors, even though they provide a positive return to society as a whole. Investing in them without a carbon price would mean a lower rate of return than investing in business-as-usual technologies. This is the fundamental trade-off that impact investors face across issues from pollution, to plastic in the oceans, to female literacy in Sub-Saharan Africa.
The key insight is this: If there really were no trade-off between profit and impact, then cost-curves for all these problems would be made up solely of investments “below the line” all the way along. If this were the case, then we wouldn’t need impact investors. Regular investors would already be investing in solving climate change, removing plastic from the oceans, and educating the world’s women.
But there’s another problem. Even many of the “below the line” actions often aren’t profitable because there are so-called split-incentives, transaction costs, and opportunity costs — economic jargon for the sort of barriers that block investment or involve extra costs beyond the price of the technology. These barriers explain why governments, not markets, have taken the lead with massive schemes to roll out energy-efficient residential LED lighting, for example.
Impact investors are right that it is sometimes possible to overcome these barriers, and it is sometimes possible to marry competitive returns and social good by tackling actions “below the line,” as they have in small energy efficiency or renewables investments.
But their critics are also right that “sometimes possible” will not be enough to effect real transformation. In the case of climate change, economists estimate that meeting the 1.5◦C target will cost around $10 trillion by 2030. In other words, if private investors were to try to solve climate change alone, they will need to be content with losing about $1 trillion per year.
Of course, much more than $10 trillion would be saved by solving climate change, but because the rules of the game don’t reward carbon mitigation, private investors struggle to capture that value. To make these activities profitable for investors, the IPCC estimates we’ll need a carbon price between $135 to $5,500 per tonne. Let’s hope it’s on the lower end.
This is the new “inconvenient truth” of the impact investing age: There are simply not enough below-the-line options to invest in, and much of what we must do will be unprofitable without a change in the rules. This same truth applies to myriad other social and environmental problems that we urgently need to solve, from pollution to poverty to poor public health.
Our governments have wasted nearly three decades ignoring the IPCC and other experts on climate change. We cannot waste another decade — not even a year — ignoring these economic realities.
The Rules of the Game
Let’s turn to the rules that govern how our economy works. While the Business Roundtable urged a shift to stakeholder capitalism, the fact remains that the rules of the game firmly entrench shareholder capitalism and largely ignore stakeholders. As we’ve argued before, businesses must seek profits given the less profitable will tend to be muscled-out by the more profitable over time.
Under today’s rules, some harmful investments offer inflated profits because investors don’t have to pay for the damage they cause through, for example, carbon emissions or the health impacts of air pollution. Meanwhile, many worthy investments are unprofitable because investors are not rewarded for their associated benefits, such as improvements to health by reducing air pollution.
To bring about Sir Ron Cohen’s revolution, in which investment “does not require reducing profits in favor of impact,” our only choice is to change these rules.
We already know what we must do: “Lift the line” with carbon pricing, subsidies or regulations, so that more actions fall below it and attract investment. Economists have agreed that this is the way to deal with externalities — whether carbon emissions, ocean plastic or illiteracy — for more than a century. When investors pay the costs of their inputs and are rewarded for the value they create, then the gap between investing and impact investing disappears.
In other words, once externalities have been internalized, then all investing becomes impact investing. A baker can profit from feeding the community, a builder can profit from housing the community, and a forester can profit from sequestering emissions for the community. This was Adam Smith’s revelation two and a half centuries ago: when individual incentives are aligned with what creates economic growth for society as a whole, the “invisible hand” is free to work its magic.
The Future of Impact Investment
What does this mean for impact investors? We think they have three critical roles to play.
The first is in making the most of the current rules of the game, by discovering opportunities that have fallen “below the line” or finding smart ways to overcome barriers that block below-the-line investment. Tesla’s world first utility-scale battery in South Australia is a good example of investment at the innovation frontier. It showed that the technology is ready to be profitable, opening the floodgates for battery projects across the world. More than ever we need bold innovators to lead the way so that others may follow.
The second is in encouraging philanthropists to aim higher. Mike McCreless calls this working at the “efficiency frontier”: when seeking a given impact, always look for the highest-return way to achieve it. Returns may often fall short of commercial rates, but when they are as good as they can be given the limits of the rules, each dollar has more impact. The Swiss Agency for Development and Cooperation SDC and Roots of Impact have made similar arguments in developing the Social Impact Incentives (SIINC) framework. This is impact investing as smarter and more efficient philanthropy.
Finally, perhaps the most important role for impact investors is to lobby for changing the rules. Impact investors could be a powerful voice urging governments to internalize externalities and so turn all investment into impact investment. New incentives, whether a price on carbon or some other mechanism, greatly expand the horizons for marrying social return with profitability. In doing so, they greatly expand the opportunities for private sector innovators and smart philanthropists.
With a more nuanced view of how impact investing fits into our economic system, we might have a chance of realizing Sir Ronald Cohen’s revolution: a world where profit and impact walk hand-in-hand.
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Impact Investing Won't Save Capitalism - Harvard Business Review
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