Converting goodwill into a return? Monocultures can contribute to alleviating the burden on forests and living systems. In this interview, Karen Wendt, acknowledged sustainable finance expert, shares her thoughts on how to structure real impact investing.
Why do we need impact investing?
It appears that in the face of climate change, sustainable finance has made it to the political agenda. Even if we assume the hype is not here to stay, we still see megatrends that will influence decision making in the future. Besides the EU Action Plan for financing sustainable growth, which will influence the financial markets on a longer-term let me talk about three megatrends, I am quite sure they are here to stay: First of all, do you know how much of the money supply created goes to the real economy? In Europe, the ratio is 20%. 80% goes to “financialization”, derivative products. So, if you are an investor in the real economy, you create something on the ground. Creating value for real people and addressing a need, this is something that impact investors do.
Secondly, Worldbank and multilateral finance agencies have a long tradition in analyzing the risks and impact on the environment and society connected to their financings. They differentiate between inside - out risks (risks and impacts that are triggered through their financing) and outside – in risks - how is my investment or financing affected by - for instance - climate change. Will the new shopping center or office complex withstand a one in 1000 years flood event? A hurricane?
Another topic is legacy issues. How was the site used? Has it been contaminated in the former time? Has rain forest been chopped for the project? Here we talk also about land-use conversion, a friendly term of destroying existing living systems like rain forests for monocultures. If you convert rain forest into monoculture like palm oil plantations you destroy the lungs of the earth and our dear planet.
So, do monocultures also cause harm?
Monocultures are not per se bad. When you cultivate and establish them on land which has not been a forest or destroy a biodiversity-rich site for it, monocultures can help avoid tree chopping in the forests and in biodiversity-rich regions. Of course, monocultures can never solve the climate issue. But they can contribute to alleviating the burden on forests and living systems in the sense that they help prevent the conversion of the biodiverse rich site. So, it this sense you do not destroy biodiversity, but try to alleviate the burden on the living systems. This is why I call this investment in living systems. Impact investors equate these factors in investment decision making. In an ecosystem approach monoculture, we can make a valuable contribution to the stability of the ecosystem.
“Impact investors are interested not only in the outputs but also the outcomes of their finance”
Inside-out-risks and impacts are harder to model. How will the construction of a wind farm affect living in the communities? We have the case of Eastern Europe, where we had so many wind farms at the coast, that the migration route for birds, in fact, was closed down. The birds did not find a safe route to fly anymore. They were caught in the rotor blades of the wind farms. This is what happens when a good project with good intentions turns into its contrary. The EU had to intervene. In finance, we, therefore, do a cumulative impact assessment. It makes a difference whether you have one wind farm at the coast or the entire coast is concreted with wind farms.
Which general aspects of risk management do impact investors consider?
Risk management – as always in investment – matters and impact investors extend risk management by environmental and social issue. Impact investors are interested not only in the outputs but also the outcomes of their finance. Have a look at the vaccination programs. The output is easy to calculate. How many children have been vaccinated? The outcomes - what does that mean for their education, the number of children per family and, therefore, the world population - is much harder to get. In general, we see that the number of children per family is decreasing. Families get so many children as long as they know that most of them will die. In impact investing questions about output and outcome are asked, analyzed and addressed in a structured manner. Let me pick up a societal trend and raise a furthermore salient aspect. People get fed up with the gross negligence we show in our economic system for the environment and for societies. In economic terms we are talking about market failure, the prices of the goods and services do not reflect the real costs: the costs of destruction of nature, rain forests, the costs for destroying the living conditions for entire societies (we call that friendly economic displacement).
Today, the consequences of this gross negligence have become very visible. Rain forests in Brazil are on fire, the meltdown of ice in the arctic, the plastics in the oceans, heat waves, entire land stripes that become inhabitable creating migration streams, people needing to leave their homeland in order to survive, the list goes on and on. What we see is the tip of the iceberg, the issues have become rather salient, the awareness of people is rising. More and more realize we have a problem. We are the last generation that can reduce the impact of climate change. We still have a very narrow window of about 20 years to do that.
But, how can goodwill be converted into a return?
Impact investors analyze their investments not only financially and legally, but also based on environmental and social risks and impacts. In a nutshell, we can state: Impact investors invest in the real economy, not into “financialization”. Impact investors consider the environmental risks and impacts of their investment. They do that for two reasons. First of all, they de-risk their investment portfolio. In the liquidity, risk-return triangle of traditional finance, this is quite material. If you can have the same return or with a lower risk profile, then you are rewarded better for your risk-taking. Risk management based on a broader basis – including environmental and social risks is key to impact investors.
“Investors are increasingly avoiding hot potatoes, companies with a bad reputation – which shows up in sentiment analysis.”
In addition - and this is forward-looking - you can ask what are the outputs and the outcomes of my investment? Why should you look for positive impacts on society and the environment? Yes, you can do it because you are a good person. You should also do it to maximize your return. What positive impact you can do for your investment is the following: they create goodwill. Goodwill is monetized when you sell. It does not show up in the portfolio engineering models (Markowitz, Fama French, and others). But, goodwill is getting more and more important. How does the community talk about my company? Sentiment analysis has become very popular. Investors are increasingly avoiding hot potatoes, companies with a bad reputation – which shows up in sentiment analysis.
Can investments in sustainable tree plantation for high-quality timber production be suitable for a sustainable investment?
In my view yes, as long as it is not coming from land conversion. It is an investment into the real economy, into a living system and based on a thorough impact assessment it has the capability to show probably positive impacts for the environment, the ecosystem, and society. It will attract investors who want to invest patient money and let nature do its miracles.
Karen Wendt is the editor of the Sustainable Finance Series with Springer Science Publishing. She merges 20 years investment banking with social and green economy finance, leadership 4.0, design thinking and ideation. Her research interests are positive impact investing, theories of change, social stock exchanges, ecosystems, smart cities, and blockchain. She also pioneers in extended methodologies in portfolio engineering, assessment-based impact approaches, and value-based decision making, Using academic research for applied science Karen advises on impact investing and Sustainable Development Goals Economics (SDG Economics) in her program scaling4impact. Karen co-created the Equator Principles, the First Global Sustainability Standard in investment banking – based on impact assessments, creating mitigation strategies and impact action plans. She won the Financial Times Sustainability Award together with peers for this pioneering and created the association “Responsible Investment Banking”. She is the president of the SwissfinTechLadies and the CEO of Eccos Impact.