The Sustainability Dilemma: Its Time to Put Impact on the Balance Sheet

Impact Investing

The investment landscape is about to round an historic corner. While traditional financial theory believe that optimal actions are those made in the best interest of shareholders, modern financial theory argues that optimal firms are those that make decisions in the best interest of all stakeholders. ESG is part of modern theory and is a framework for best business practices initiated by then general secretary of the UN, Kofi Annan. In 2004, he emailed 50 CEOs of large financial institutions inviting them to join the joint ESG initiative that stands for “environmental, social and corporate governance”. Ever since the father of value investing, Benjamin Graham, published his book “the intelligent investor” in 1949, traders and investors have emphasized companies’ ability to generate a high revenue, while disregarding other factors that make those revenues sustainable in the long-run. Emphasizing earnings per share might have been an optimal strategy in the past, but sentiments are shifting with the green new deal, the Paris accord and future regulations around the horizon. ESG is now cover page news for most political debate and those companies who will survive in the future are those that adapt to this new world of sustainable thinking, as governments and institutions may only invest in ESG approved companies. Buying a deep value company that shovels rain forests, drain earth’s oil reserves and treats employees like crap is no longer considered an undervalued company, despite having a low price to earnings ratio. Institutional investors are changing their attitudes and are no longer only seeking return, but also looking for those companies that add environmental and social value.

Antony Bugg-Levine author of impact investing and coined the term blended value. He currently serves as the CEO of the Noneprofit Finance Fund.

Blended Value

Recent public debate has placed the spotlight on investments increasing social value. As a result, leading institutional investors are figuring out how to achieve a dual objective of high risk adjusted returns in combination with world improvement. The concept of a dual investment target has appropriately been labeled as the blended value approach by Anthony Bugg-Levine in his book Impact Investing. His book outlines that most of impact investing has been focused on generating social value at the cost of lower returns, but this is changing. Worth noting is that blended value is not a new concept, as impact investing has been around since inception of human history. Recently, however, impact is something that have been pursued heavily by foundations, governments and non-profit institutions. Also, investors seeking profit are now seriously looking at blended value investing as well. For example, large public pension funds in the US have enormous power when it comes to shaping global markets. The main reason is that they have to be radically transparent about asset holdings to their beneficial owners. Other market participants therefore always know the strategic asset allocation of these pension funds. In 2018, US pension funds controlled around USD 22.4 trillion assets and if even a small portion of their portfolios have exposures to companies that are not following the ESG framework a government ban on investing in certain companies may create a huge shift in investment flows. We now know for certain that ideas such as the green new deal is being discussed, which has the potential of pushing the global investment landscape into an ESG world.

Blended value adds another dimension to the return target of investors. It makes researching managers and firms even more important, as maintaining two targets is more difficult than one.

Classic Analysis

The most difficult task for impact investors is measuring how their investments in companies increase social value. Leading financial researchers including University of Chicago cosa nostra professors have historically focused on fundamental factors when creating a framework for evaluating companies because it is mathematically easy! Fundamental factors are readily available as they can be derived from a company’s balance sheet and income statement. From the former of the two, analysts calculate asset liability ratios and the value of intangible assets such as patents, while the latter involves analyzing price to earnings ratios, enterprise ratios, price to book ratios, free cash flows and expenses. After the company analysis is completed, the portfolio manager will start building an optimal portfolio of companies. This optimal portfolio is most likely based on Markowitz mathematical framework for portfolio management with some proprietary twists by the portfolio manager. Similar to fundamental stock analysis, the Markowitz framework is popular in the investment community, as the approach relies public information including expected returns, volatility and stock index correlation as a representation of the market portfolio. Portfolio managers at hedge funds rely partly on the Markowitz framework, but they also incorporate other proprietary and soft factors in their analysis when building the optimal asset allocation. These proprietary factors include specific industry knowledge, proprietary fundamental valuation models and methods to evaluate a company’s management team. If a security has high expected return, low volatility and a low correlation with the appropriate market index in combination with an attractive valuation and story, a hedge fund has historically bought that security and sold companies for which the inverse is true. However, something is missing in the hedge fund investor’s valuation method of a company: a way to measure impact!

Harry Markowitz an absolute legend in finance and father of modern portfolio theory.

Measuring Impact

Institutional investors have now begun understanding their power when it comes to increasing social value and governments across the world are now reviewing how public pension funds can allocate more money to impact investing. In the future, government owned institutions might be unable to buy shares of companies that pollute the environment and inefficiently contributes to creating a society that works for everyone. When lawmakers create future legal frameworks or policies on how public pensions should invest, they will outline methods so that investment flows will go to those companies that have adapted their corporate mission to maximize stakeholder value rather than shareholder value. The next big thing within the hedge fund industry will therefore be a manager that is able to combine old school Chicago valuation methods sprinkled with some proprietary touch in combination with a method to measure impact. The latter is not an easy task because how does a company position itself as an environmentally and socially focused company. Well, here allocators have a lot of power because they hold the capital. If companies want to raise assets from allocators, they must adapt their business model to whatever allocators believes is important. These factors can range vastly depending on an allocator’s framework, but it is likely to include diversity in management positions, community investing and paying employees a competitive market salary. However, a global policy for how to measure impact is still up for debate and currently there are many smart people out there that are trying to create a ten commandments equivalent for impact investing.

Measuring impact is so important because if we can measure social value, then it is possible to quantify sustainability. This in turn will force companies to hit key metrics in order to access capital from institutional investors with a blended value approach.

Why is Sustainability Difficult to Achieve?

The largest contribution factor for creating a sustainable world will come from changing the fabric of our society. Changing the fabric is derived from educating our children at a young age so that they can make appropriate long-term decisions when becoming leaders at large companies and investment institutions. However, the sustainability issue is an urgent now problem and current leaders in all industries across the globe must come together to create a unified approach by establishing policies and procedures for how to incentivize sustainable company creation. These policies and procedures must be done in such a way so that no country has an incentive to cheat. From the classic game theory game, prisoner’s dilemma, we know that the optimal strategy is to deviate and rat on the accomplish to avoid a strict punishment for committing a crime. A country setting up restrictions on CO2 levels will have an impact on industrial production. Like a thief playing deviate in prisoner’s dilemma, this restriction will incentivize another country to increase the CO2 levels to compensate for the loss of that country that is now producing less. Setting CO2 limits might therefore be irrational from a game theory perspective if there is no cooperation between countries. For example, if there are strict limits on carbon emissions for US car companies, then Chinese car companies might produce cars much cheaper. In the long-term, an educated population might choose to buy the more expensive cars from companies abiding by the rules, but in the short-term the economic gain to Chinese companies will vastly surpass those of US companies. Changing consumption habits is extremely important, but it is a long-term transition that will take place over many decades, but there are methods that can be accomplished by governments and institutional investors that are more effective in the short-term.

Countries and companies around the globe must set differences aside and agree upon a framework that creates fair rules for all market participants. Cooperation is difficult, but a key for a sustainable future.

What can Governments and Institutional Investment Institutions do?

There are two paths to incentivize companies to become sustainable other than consumption habits: government regulation and capitalism. On April 22 2020, a global initiative to pursue the former was established, as almost all countries signed the Paris Climate Accord to substantially reduce impact of carbon emission on climate change. Worth noting is that over the past 100 years higher economic growth has lifted millions of people out of poverty and more people than ever in history have access to services such as healthcare, education and electricity. The side effect of developing nations turning into developed nations is that it has increased our carbon footprint and perhaps created a warmer world. When people get access to a higher income level consumption increase. More consumption leads to higher economic growth, which increases the importance of oil and gas powering the machines creating the goods that are consumed. Stopping consumption is a difficult task as it requires people and nations across the globe to cooperate. A framework that allows fair environmental competition between companies in separate countries prevents companies from cheating for short-term gain. New initiatives such as the Green New Deal in the US and trade embargos on those countries known to release lots of CO2 will create more sustainability. Capitalism is the second way to create sustainability. If we can make sustainability profitable it incentivizes large institutional investors to invest in impact, as they have the power to not invest in those companies not following whatever rules are agreed upon. Just like countries must agree upon CO2 limits, institutional investors must set up a framework for what is a good versus a bad company. This framework will be imperfect, but building a system that can put impact on a company’s balance sheet is the future of finance 3.0. Microsoft founder Bill Gates brings up the concept of a green premium, which involves measuring the cost difference between fossil fuel and alternative energy driven cars. At the moment, electric cars are slightly more expensive, but with technology the green premium will shrink and at some point the premium will be so small that it will change consumer habits. However, many industries lack alternative energy sources for production. That is why the 46.8 billion dollar Gates foundation has a goal to provide capital for companies that invests in alternative energy sources for the purpose of industrial production like the creation of steel and cement. These type of allocator initiatives will force companies to reconsider their business models in order to get capital for R&D, which then ultimately will create a more sustainable world.

CO2 must be limited.

Conclusion

Finance 3.0 is about creating more efficient markets. A more efficient market equals greater resource distribution and supports innovation. A huge chunk of the finance 3.0 objective is to create a sustainability. Classic investing principles have focused too much on fundamental variables such as revenue without incorporating impact measures on the balance sheet and income statement. There are big things currently taking place in finance as concepts such as blended value and green premiums together with impact accounting is now being mixed in with the traditional Graham and Markowitz approaches. Allocators, governments and consumers have a great deal of power on deciding the type of society we want to live in. Allocators can create frameworks that will allow money to flow to sustainable companies, governments can legislate so that firms have an incentive to become sustainable and consumers can purchase goods and services from companies that care about all stakeholders. The future of finance 3.0 is bright!

//Stay adaptive!

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