
6 minute read
CHALLENGING OUR CAPITALIST IDEALS
By Jon Duncan, Head of Responsible Investment, Old Mutual Investment Group
Jon Duncan, Head of Responsible Investment, Old Mutual Investment Group L ooking around the world today, it’s clear that we are currently in the midst of a major transformation of our capitalist system - one driven by deep recognition of the interconnectivity between the markets, society and the biophysical systems. The need for this shift is well-motivated on a scientific basis. Think, for example, of climate science or the latest thinking about Covid-19 mutation rates and vaccine deployment. At the same time, there are clear signs of human behavioural change, some of which challenge foundational capitalist ideals:
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• Venture philanthropy, which questions the profit motive
• Open Source, which redefines and challenges competition
• Sharing economy, which challenges ownership rights
• Shared value, which places stakeholder primacy over shareholder primacy
This transformation is also evidenced in the investment industry’s shift to an approach that seeks to balance not only risk and return but also impact. The risk-return trade-off is an investment principle that links high risk with high reward. Investors demand a higher reward from investments where the chance of permanently impairing capital is high. Balancing this trade-off is determined by differing investor risk tolerance levels, retirement ages, liquidity requirements and earning potential, among others.
For the most part, this is how markets have operated since inception and it is the basis of free-market capitalism. In 1952, Nobel Laureate Harry Markowitz introduced the theory of the Efficient Frontier, the curved line that most efficiently connects the risk and return axes on a graph. The efficient frontier theory is a cornerstone of modern portfolio theory (MPT) and is used by asset allocators and investors alike.
Markowitz’s work is an important example of how capitalism and its operations can and do, evolve. History shows that capitalism has shifted over time and across continents in ways that are neither uniform nor complete. In fact, capitalist structures have morphed according to the times, from the emergence of the 19th-century debtors’ prison to the limited liability company, through to the protection of intellectual property rights. Alongside this, so have the methods through which we contract and trade. From the barter systems through to the evolution of money and the shift from open outcry markets to electronic exchanges. To view capitalism as a static thing fundamentally misses the point.
IMPACT ON CAPITALISM
Ideas around a green economic growth path are not new and are evidenced in the growing number of national green growth strategies. Intentionally targeting low-carbon, resource-efficient and socially inclusive outcomes, these strategies balance both the quantity of growth and the quality of growth. In this evolving form of capitalism, investors choose to balance out risk, return and impact. By introducing impact into the investment framework, the paradigm shifts from a two-dimensional risk and return line into a three-dimensional space that provides an array of new growth vectors for capital allocators and investors.
Theoretically speaking, the intentional consideration of ‘impact’ should result in different decisions regarding capital allocation. The challenge, as the industry well knows, is that standardised impact metrics don’t yet exist at the level necessary to drive change in the main listed markets around the world. The challenge of impact reporting is being tackled on many fronts. With the deployment of artificial intelligence (AI) and big data solutions, we should anticipate a gradual standardisation of this approach to investing across all asset classes and geographies in the coming years. In the past 12 months alone, there have been several important innovations and progress steps. These include:
• HYBRID METRICS
Connecting shared value to shareholder value was the title of a joint working paper from the Shared Value Initiative, ENEL Foundation and Harvard Business School. The paper introduced an approach that explicitly combines companies’ social and environmental impacts with standard measures of financial performance. This work included input from Prof Mark Kramer, regarded as one of the founding thinkers by the Global Shared Value movement. The work is grounded in systems thinking and aims to support investors to identify “companies doing the most good the most profitably”. Such companies sit at the ‘new’ efficient frontier of capital allocation.
• IMPACT-WEIGHTED ACCOUNTS PROJECT
This project, also from Harvard Business School, aims to drive the creation of financial accounts that reflect a company’s financial, social and environmental performance. The aim is a standardised accounting approach that transparently captures external impacts in a way that drives investor and managerial decision-making. The project uses publicly disclosed data and industry-wide assumptions to derive monetary estimates of a company’s product reach, accessibility, quality, optionality, environmental use emissions and end-of-life recyclability.
• IMPACT TOKENISATION
The International Institute for Sustainable Development (IISD) released a report in 2019 on ‘impact tokens’, which set out the use of blockchainbased solutions for impact investing. In the two years since, several use-case applications for impact reporting have been demonstrated in areas of access to healthcare and medicines, small-scale agriculture, micro-insurance and micro-grids. Innovations in AI, robotics, machine learning and the Internet of Things (IoT) present opportunities to cost-efficiently evidence and scale impact.
• HARMONISING ACCOUNTING STANDARDS
Over the past three decades, International Financial Reporting Standards (IFRS) have been central to increased global comparability and unification of accounting standards. In March 2021, IFRS formed a working group to focus on harmonising global sustainability reporting standards in preparation for a potential international sustainability standards board. This initiative is supported by all the prevailing industry sustainability standards bodies and there now genuinely appears to be global support for harmonising frameworks and standards.
THE ROLE OF CAPITALISM IN SOLVING FOR LONG-TERM SYSTEM RISK
We are in the early stages of this transition to an economy where every asset, company and investment can and will be assessed through the lens of risk-return-impact. While capitalism has contributed to many of the environmental and social problems we face today, the shift towards the consideration of impact now means that capitalism can begin to play an active role in solving for long-term system risk. We need to keep asking ourselves: Are the long-term stewards of capital, asset owners, consultants and managers playing their part to balance both the quantity and quality of growth?
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