Maintaining a stable economy is a piece of cake

Shyam Gharial

Senior Consultant

The bottom line:

There are opportunities for investors to take responsibility for managing some of the material risks their assets face from issues like biodiversity loss, wealth inequality and climate change, by taking a dual-objective approach of targeting market-rate returns and positive societal / environmental outcomes.

While the clock is ticking on systemic financial issues such as climate change, biodiversity loss and inequality, investors and other financial markets participants are in a great position to take personal responsibility to mitigate the material financial ESG risks they face by addressing these issues through capital allocations.

None of the systemic issues mentioned above can be tackled by focusing on any single one - they are heavily interlinked with each other and with other sustainability issues. So what clients often ask us for is a framework that allows these issues to be addressed in a consistent and rounded way. And when we consider sustainability, we often think of the UN’s Sustainable Development Goals (SDGs), which some financial markets participants are using to frame specialist sustainability strategies.

The SDGs created a way of framing some key sustainability issues of our time, and their scope is summed up beautifully by this instantly recognisable grid of 17 high-level goals. However, while the SDGs were agreed by nearly all nations in 2015, they have not seriously been pursued by those same countries' governments.

Sounds good, how do I use it?

The issue with this lovely picture is that these siloed boxes do not convey the aforementioned intimate interlinkages of economic, environmental and societal issues. For example, children and females in families in poverty (SDG1) are disproportionately responsible for collecting biomass cooking fuels and preparing food each day. This means children are deprived of education (SDG4) and females are deprived of multiple opportunities, including the opportunity to spend time more productively (SDG5). Biomass cooking fuels are used by over 2 billion people worldwide, predominately being burned indoors, releasing pollutants that lead to premature deaths amongst those most exposed (SDG3, 5). And without quality education, it is less likely that people will understand the impact human activities are having on the planet and the need to change our ways (SDG13, 14, 15). Therefore, climate action will understandably be less of a priority for poorer families even though climate change is likely to impact them the most.

Introducing the SDG wedding cake…

It sounds obvious but a stable economy and stable investment returns depend on a stable society. And a stable society, in turn, depends on a stable environment. This can be neatly illustrated by taking the 17 squares of the SDGs and rearranging them as a three-tiered wedding cake, where lower layers support the levels above.

Source: https://creativecommons.org/licenses/by-nd/3.0/ Image obtained from https://www.stockholmresilience.org/research/research-news/2016-06-14-the-sdgs-wedding-cake.html

A healthy biosphere (or environment) supports a stable society, which supports a healthy economy. And of course, the converse is true. Base layers in poor health will not support the layers above.

How does this relate to investors?

The current focus on climate change in financial services is likely to evolve quickly to consider broader sustainability issues if we are to achieve economic and financial goals in future. And this will need to include consideration of the impact an investment has on the environment and society, because these issues impact economic performance. In contrast, the focus of the Taskforce on Climate-related Financial Disclosures (TCFD), which is now being used by corporates and investors, is on the financial impacts caused by climate change on the reporting entity only. Jargon alert! The inclusion of both types of impact is known as 'double materiality'.

Why is it important?

We have neglected the base layers of the wedding cake for many decades. The financial services and business worlds have operated as if they existed in a silo. They clearly don’t. We are now seeing the negative effects of the 'economy-first' approach, through a destabilisation of the environment due to human activities (e.g. biodiversity loss and climate change). We have created a society that depletes Earth’s natural resources at a rate that exceeds its capacity to regenerate those resources. We currently need 1.8 Earths to sustain our current lifestyles – that number is much higher in developed nations. This means, for example, that by 22 July this year we had used all the resources the planet could provide during 2022 – this is known as Earth Overshoot Day and it has been creeping earlier in the year for some time.

We are beginning to experience and see some of the consequences of environmental breakdown now. And following environmental breakdown, the stability of society buckles. Without a stable society, the economy will not function and investor returns will be impacted. It is easy to see the role that changes in the environment can have in creating conflicts, causing mass migration and destroying economies. Just look at the catastrophic human, environmental and economic costs experienced recently by countries like Mali, South Sudan and Syria.

What can investors do about it?

Issues like biodiversity loss, inequality and climate change are systemic issues, meaning that the main ways investors can reduce the negative financial consequences from them is to contribute to mitigating and, if possible, reversing the damaging trends through company voting and engagement and by increasing their allocation to positive sustainable impact allocations.

To act as good stewards of long-term capital on behalf of beneficiaries who are expecting to receive and spend the invested money over the coming decades, investors should consider their asset allocation in terms of their positive impact contribution to sustainability-related issues. The SDG wedding cake can help frame what sustainability issues to target in impact investment allocations.

The good news is that there are funds out there focusing on areas that help address these systemic issues. There is a misconception that investing for impact means sacrificing returns. Impact funds often offer attractive returns and diversification (see charts below showing, firstly, that the objective for most investors in impact strategies is to achieve attractive returns and, secondly, that after investing in impact strategies most investors receive returns in line with or greater than expected) – an example of the type of strategy that could be invested in includes Ocean 14 Capital, which focuses on technology and ocean-related industry investments to improve ocean health. Further examples which use blended finance (see my previous article) include, amongst others, Allianz’s $1bn fund for climate solutions in emerging markets, and New Forests’ regional sustainable forestry funds.

Target financial returns principally sought

Source: Global Impact Investing Network, GIIN 2020 Annual Impact Investor Survey

Performance relative to expectations

My call to fund management firms is to consider using blended finance and partnering with development finance institutions to make impact investments even more attractive and entice those investors currently without an impact allocation.

My call to investors who believe they are not here to save the world is to consider the increasing evidence that attractive investment returns and saving the world are now actually two well-aligned issues. And using the SDG wedding cake can be a good way to consider which impact areas to allocate capital.