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The Right Way to Allocate Capital

October 23, 2017

 

The Sustainable Development Goals (SDGs) developed by the UN recognize that economic growth will not be sustainable if we do not preserve the environment, protect human rights and create a just society. We must insist that business enterprises have a purpose greater than pursuing financial returns at any cost. Investment capital must actively be used to pursue these goals. If it isn’t, our planet and society (and, correspondingly, that capital) will be put at severe risk.

 

Aviva is a London-based insurance giant with 33 million customers in 16 countries. It traces its origins back to the creation of the Hand in Hand Fire & Life Insurance Society, established in 1696. But despite its long history, Aviva has a steady eye on the future, as demonstrated by its recently released report, Delivering the Sustainable Financial System the World Needs.

 

Insurers must carefully invest their premiums in diversified holdings order to make sure they can pay off their liabilities, which extend far into the future. Along with pension funds, this makes them classic “universal owners,” who depend on long-term stable growth, as I discuss here and here. Corporate strategies that create profits by externalizing costs ultimately hurt universal investors, because those costs must be absorbed by the rest of the market.

 

No amount of profits will prop up a pension fund in a future where we cannot satisfy the need for clean water. … We must redefine the purpose of business.

 

The report from Aviva applies this logic to the Sustainable Development Goals(SDGs) developed by the UN — goals that recognize that economic growth will not be sustainable if we do not preserve the environment, protect human rights and create a just society. Investment capital must actively be used to pursue these goals. If it isn’t, our planet and society (and, correspondingly, that capital) will be put at severe risk.

 

The Wrong Way to Allocate Capital
 

Aviva recognizes that capital markets should be used to encourage the “integration of sustainability at every stage of the investment process,” and as “a mechanism to make corporate practices more sustainable.” Critically, their report recognizes that the capital markets are failing to correctly allocate capital, because they do not account for the environmental and social costs that business is able to externalize:

 

“The primary failure of the capital market in relation to sustainable development is one of misallocation of capital. This, in turn, is a result of global governments’ failure to embed environmental and social costs into companies’ profit and loss statements. As a consequence, capital markets do not incorporate companies’ full social and environmental costs. The consequences of this are that unsustainable companies have a lower cost of capital than they should and so are more likely to be financed than sustainable companies.”

 

This is a radical statement. It pinpoints just how completely broken our capital markets are, because they account only for financial capital, while ignoring human, social and natural capital. The report provides the following example:

 

“The challenge for the private sector is how to avoid a ‘race to the bottom’: for example, how can an investor be expected to reduce its exposure to water risk when most large companies in most sectors do not report their water usage, or do so using different standards and methodologies?”

 

But it isn’t simply exposure to risk: Our entire system of capital allocation ignores the costs that that an investment imposes on the natural capital we depend upon, even for the most basic of human needs. No amount of profits will prop up a pension fund in a future where we cannot satisfy the need for clean water.

 

Purpose Is the Key to Better Capital Allocation
 

While the report discusses better disclosure and firmer regulation as two ways to solve this dilemma, these are incomplete answers. We must redefine the purpose of business. A recent report from another universal investor, the UK Pension Insurance Corporation, reaches exactly this conclusion. The PIC’s The Purpose of Finance discusses how market failures plague the finance industry, and concludes that we cannot simply regulate our way out of the problem:

 

“Regulators have tried to intervene, but have done so by assuming that, after every failure of the financial markets, they can solve the problem with further regulation. In fact, what is required is behavioural change, so that the industry does the right thing in the first place, using its expertise to serve its customers and being rewarded for it. Instead, regulation has banned lots of practices, allowing industry participants, perhaps particularly the less scrupulous ones, to seek ways around the rules, in a costly game of whack-a-mole.”

 

We need to stop playing whack-a-mole with our capital-allocation system, and insist that business enterprises have a purpose greater than pursuing financial returns at any cost. We need capital markets and and businesses to utilize legal structures (like the benefit corporation) that recognize the value of adding to our stores of all critical capitals by contributing to the successful pursuit of the SDGs, and a correspondingly healthy planet and just and prosperous society.

 

 

 

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