Earth and humanity’s balance sheet is not in equilibrium, and the cracks have started to show.
In our global, financialised economy, investment mandates typically prioritise financial capital in ways that are largely divorced from the values of human, social, and natural capital. As a result, negative externalities are driving imbalances and systemic challenges, including market concentration, inequality and social unrest, geopolitical conflict, as well as climate change and biodiversity loss. The disconnect between financial markets and the real economy has been evident in record-high equity valuations – especially in the U.S. – and growing global debt levels, despite ongoing environmental degradation and rising inequality.
Even with longstanding efforts toward reform from the responsible and impact investing communities, trust in institutions is deteriorating. The pressing question remains: how did we get here, and what can be done to fix it? Now more than ever it is clear we need to build a more regenerative and inclusive economy that supports the long-term wellbeing of people and nature.
Systemic and structural changes to the financial system
The financial system funds all economic activity and therefore has a strong influence over positive and negative impacts on people and nature. Impacts can aggregate into externalities, thereby influencing the performance of the economy. Among financial actors, institutional asset owners and allocators such as pension funds, sovereign wealth funds, and endowments sit atop the value chain. Their incentives and investment decisions cascade through asset managers, companies, and actors downstream.
These investors are highly diversified, which have earned them the moniker, “Universal Owners.” Given their exposure to nearly every industry, geography, and asset class, the financial performance of their diversified portfolios is dependent on the health of the economy, which is dependent on the health of human and natural systems. They therefore theoretically have incentives to reduce negative externalities and perhaps even pursue positive externalities. However, traditional financial tools and incentive structures are often outdated, leaving investors ill-equipped to do so.
A new paper published in partnership with Earth4All, the Predistribution Initiative (PDI), Beyond Bretton Woods (BBW), Africa Investor (Ai), and Generation Foundation reviews opportunities and challenges relating to these dynamics and offers a proposed roadmap that can be fine-tuned by diverse stakeholders into a blueprint for action. Investing to reconnect financial value with people, nature, and the real economy offers recommendations for institutional investors, standard setters, financial intermediaries, and policymakers.
Intergenerational fiduciary duty: the foundations for change
Institutional allocators are typically bound to intergenerational fiduciary duties that consider long-term versus short-term financial performance. As highlighted in the Freshfield’s report, A Legal Framework for Impact, this should be better reflected in official interpretations of fiduciary duty laws and regulations, as well as in investors’ own governing documents, such as investment belief and policy statements.
Furthermore, investment teams are expected to meet or exceed financial benchmarks which do not consider externalities, resulting in misaligned incentives with a world where markets operate in harmony with stable human, natural, and economic systems. The paper encourages the review and modification of such incentive structures, for instance through forums like the emerging Responsible Financial Benchmarking Lab (RFBL).
Development of commonly accepted accounting and financial analysis methodologies that better value people and nature is needed, as well as a critical mass of peer investors taking similar action, to avoid resulting in a “tragedy of the commons” situation. To that end, asset owners and allocators can encourage the co-creation of tools and advocate for government intervention to level the playing field.
Accounting and financial analysis tools that value people and nature
In turn, standard setters, accountants, actuaries, ratings agencies, business schools, and researchers can take leadership in the refinement and uptake of accounting, valuation, and financial analysis methodologies to better value human, social, and natural capital. Such reforms disincentivise companies and investors from actions that have negative externalities, while incentivising those that have positive externalities.
New approaches to accounting – like those of the Capitals Coalition community, Rethinking Capital, and Social Value International – can be complemented by methodologies for investors to systemically risk-adjust financial returns and evolve discount rate methodologies to consider the value of the future as opposed to primarily the present. Examples of latter solutions are being advanced by the emerging Externalities Investment Research Network (EIRN). Effective valuation methodologies will consider planetary boundaries, social norms, and tipping points and be developed through diverse stakeholder input.
New interpretations of value change the terms of a transaction
These new tools enable investment teams, banks and financial intermediaries to assess externalities’ financial impacts on their diversified portfolios and integrate improved values of human, social, and natural capital into their investment decision making.
If workers and communities are more valued in a transaction – such as investment in a manufacturing company or infrastructure project – they are better positioned to be compensated more for a given level of risk that they take, as well as to advocate for what level of risk they are willing to take. If nature is more valued in a transaction, there is less incentive to exploit it. Examples of resulting investment structures include employee ownership models that enable workers to build wealth alongside executives and investors, community ownership models (i.e., of real assets like infrastructure or natural resource projects), as well as debt-for-nature swaps. These structures result in a predistributive economy that is more equitable and regenerative for people and nature.
Creating an enabling environment for reform: the role of policymakers, regulators, and international organisations
To level the playing field and support change, governments can elevate these issues to discussions about international financial architecture reform and facilitate opportunities for their constituents to contribute to the co-creation of solutions. They can support improved clarity on meanings of fiduciary duty and materiality, as well as corresponding data production and business school training to account for system-level risk and return and more adequately value people and nature. Governments are also positioned to offer incentives for multistakeholder governance and ownership structures. And central banks are best positioned to consider values of human, social, and natural capital in setting the foundational cost of capital. New approaches to valuing people and nature can lay the foundations for alternatives to GDP that consider externalities, wellbeing, and the values of people and nature.
Next steps
While systemic and structural changes to finance often seem theoretical and out of grasp, this paper identifies key roadblocks in current investment practices and provides tangible, practical, and actionable recommendations to overcome them. Pieces of this puzzle already exist, and actors are advancing change. But more support, coordination, and awareness is needed.
Achieving meaningful change requires practical steps and adequate resources from global actors, including both governments and private institutions, as well as participation in the co-creation of solutions by workers and communities. The strongest solutions with potential for widespread buy-in and effectiveness will be those co-created, including with those who feel disenfranchised – both progressives and conservatives. This paper serves as a call to action for all financial institutions and their stakeholders to engage in co-creation, ensuring a more resilient and inclusive global economy for future generations.
As next steps, the partners of this collaboration plan to convene roundtables for various actors to come together, fine-tune recommendations, and accelerate change together. We hope you will join us.
