The world is facing a “polycrisis”—a confluence of environmental and social issues that risk destabilizing the vital systems of human civilization. Our survival hinges on building resilience—the ability of systems to bounce back from shocks and ideally emerge stronger—within our ecological and social as well as economic and financial systems against the ramifications of the interconnected and mutually reinforcing challenges of climate change, biodiversity loss, and pollution on one hand and of poverty, food insecurity, and forced migration on the other. Resilience-building requires investing in physical, social, and institutional infrastructure.
The shocks emanating from multiple environmental crises are going to disproportionately affect the fragile systems in the Global South. However, the Global North cannot expect to remain unscathed; the impacts of food shortages, social unrest, fossil-fuel reliance, and forced migration will invariably reverberate through global supply chains and financial systems. Financial actors in the Global North must therefore recognize the importance of investing in resilience building initiatives in the Global South.
While the need to make resilience finance available to the Global South is being increasingly recognized, progress is severely hampered by a current market failure: huge amounts of capital are waiting for “conditions to be right to invest” but not moving towards the required needs in any meaningful way. This failure is manifest: global climate finance doubled to $1.3 trillion in 2022, with impact investing growing to $495 billion in 2023. Yet, the “missing middle” funding gap—the financing needed by small and medium enterprises in the global south to scale their projects—remains above $1 trillion (with some estimates over $3 trillion) and the Global South adaptation funding gap stands at $200 billion to $350 billion per year.
We believe that a neglected factor in this funding gap is the likely mispricing of risk. The “market rate,” the benchmark expected return against which the majority of solutions are anchored, may itself be incorrectly pricing our ability to respond.
A lack of scale
The difference between conventional investing and impact investing is the added element of intending to create environmental or social “impact” in the latter, often with investors accepting returns that are at below-market rates. Impact investing, however, seldom achieves scale. While large companies are able to attract financing at market rates and microfinance from such institutions as Grameen Bank is made available to individuals, affordable medium-sized loans for SMEs in emerging markets such as those of Sub-Saharan Africa remain largely unavailable – leading to what is termed as the “missing middle” funding gap.
While it is conventionally believed that the problem lies on the demand side, with not enough projects achieving bankability, we argue that the supply-side mispricing of capital could be the chief culprit.
The role of risk and the blended finance “solution”
It is important to consider the element of risk in the current paradigm of “market rate.” The market rate is the expected return demanded from investors for the risk they are taking. The higher the risk investors take, the higher the return they seek. Assets that yield returns commensurate with the risk taken by investor are considered market-rate returns, or investment grade, while those assets that do not deliver risk-adjusted returns remain unattractive to mainstream private investors—the most significant chunk of global capital.
This market rate (that is, the rate of risk-adjusted return) in the Global South is often high (much higher than in mature economies) because assets (including SME investments) are assumed to be highly risky. Mechanisms designed to lower this rate include a combination of providing technical assistance to de-risk assets or offering financing structures that allow for non-market funders to absorb the risk of market funders. Recently, a form of the latter, “blended finance,” has emerged. Blended finance combines concessional public or philanthropic capital with conventional private/institutional capital in a way that lowers the eventual cost of finance to the targeted asset, thus ensuring that conventional investors do not sacrifice return in the pursuit of achieving impact, and assets are able to access finance at a lower cost.
Expecting market-rate returns or “profit maximizing” does just that: it maximizes the revenue side, while ensuring the lowest possible cost. And at its most rampant, it ignores all positive and negative externalities, including the accounting of those necessary for a sustained future.
These methods and constructs are ultimately seeking to square the circle: they seek to create positive social and environmental outcomes while generating “market” returns for private actors. More crudely put, they allow conventional financial actors to make the same amount of money they have been accustomed to, and at the same time make the world a better place.
But this might not be possible, at least in the short to medium term: if the creation of these social and environmental outcomes in any specific system costs money, and the government is unable or unwilling to bridge the voids in these systems, the only other actor likely most able to do so is the private sector. If the private sector absorbs this cost burden, it simply isn’t possible to deliver the same return as in the instance where it needn’t have filled the systemic voids, because the creation of the societal and environmental outcome requires immediate funding but doesn’t yield an immediate increase in revenue.
Simply put, there are trade-offs involved. To position a market-rate yield as the aimed-for goal simply isn’t realistic if you require the asset to create impact outcomes.
It’s important to note that most assets, especially those that access any form of “impact” or “mission-related” funding, face the demand by investors to create social and environmental impacts. Most of them are required to report and disclose their impacts against the UN Sustainable Development Goals (SDGs) or other sets of impact criteria.
|
|
Conventional Investing |
Impact Investing |
Blended Finance |
|
Impact sought |
None, or incidental in the best case |
Direct and sustained |
Direct and sustained |
|
Expected Rate of Return |
Market rate |
Either at market-rates or sometimes below |
Below market rate for concessional partners and market rate for conventional partners |
|
Cost of capital for asset |
High |
High to medium |
Medium |
How conventional finance produces a downward spiral
Why is it important for the asset to create impact outcomes? Because that local system is likely to degrade, possibly sooner than later, as increasingly negative societal and environmental impacts, such as those of climate change, begin to bite harder. When this happens, the societal and environmental voids become starker, more severe, with a commensurate increase in the cost associated with rectifying them.
The local system is then sent into a downward spiral, and the assets tasked with reversing the decline face an ever-growing cost burden to do so. This “local” system can be a village in Uganda, a food system in the Philippines, the Mesoamerican Barrier Reef, or a collection of these, constituting a confluence of tipping points—the avoidance of which is necessary for human survival.
The higher the cost of funding, the lower the amount of money left on the table to deploy into plugging societal and environmental voids. Expecting market-rate returns or “profit maximizing” does just that: it maximizes the revenue side, while ensuring the lowest possible cost. And at its most rampant, it ignores all positive and negative externalities, including the accounting of those necessary for a sustained future. A slight change in wording, and “profit-making” allows for a move from a maximizing function towards something closer to optimizing, including for societal and environmental outcomes. Intuitively, this is a logical position to take, given that the provision of sustainable and sustained profits is the raison d’etre of an asset, and the most important fiduciary duty of its steward.
The question arises, what is the approximate level of return, given the need to create the social and environmental outcomes necessary for a sustainable (and growing) future? If the current benchmarked, “market” rate in effect profit-maximizes, then it follows the most appropriate, “survival” rate must be lower.
Rethinking “risk-adjusted return” to factor in resilience-building
What is the current market rate? How is it established? Theoretically, the market rate is the return generated by an asset that accurately reflects the risk of that asset—the so-called “risk-adjusted return.” Assets’ risks are a function of their own behaviors and decisions, and of the impact of changes in the system they inhabit. An accurate risk assessment needs to account for this complex interplay between individual asset activities and system factors. Ideally, such a risk assessment should take into account the risk of the asset now, as well as into the future, and shift as the risk changes.
Herein lies the problem. For such dynamic pricing, the change in risk of the asset should be accurately known. Yet we currently have no way of measuring the change in risk brought about by the creation of positive societal and environmental outcomes produced by an asset. An asset might be producing significant positive outcomes, but because this is not measured and linked to a change in risk, the asset’s risk profile remains the same. Its expected level of return remains high, and thus so does the cost of capital it can access.
Therefore, our ability to set an accurate expected return is severely hampered by our inability to accurately assess real risk. As a result, the positive impacts are simply ignored, and the market rate becomes in fact a perceived-risk-adjusted rate, not a real-risk-adjusted rate. This market rate, when deployed into systems of any size, actually disincentivizes the creation of the very societal and environmental outcomes that the asset requires in order to be sustainable and profitable in the long run.
If we accept this line of argument, the market rate then is a) wrong in its assessment of risk, and b) actually making things worse by overcharging the assets and leaving less money on the table to create positive outcomes. If this is true, what are the implications? From first principles, an asset should be profitable, yielding a return that is sustainably generated to ensure the long-term growth of the asset. This is symbiotic with the system in which the asset sits, implying the congruent thinking of an asset creating positive societal and environmental outcomes that benefits it and its system. As has been argued, there is a cost to do this, and thus the return generated cannot maximize profit, but should optimize across profit, environment, and society.
Measuring resilience building
How can one then link this “survival,” or socially appropriate, rate of return with the current market rate of return? We argue that this could be achieved by measuring resilience and resilience-building. By pricing resilience, and by ensuring that the returns generated by assets are done so by taking into account the necessary cost of creating positive outcomes, these assets bring about more resilient systems, and thus lower risk of all assets in the system.
Currently, though, the difference between the market rate and the real-risk-adjusted rate is unknown due to lack of data and information. What is needed is the ability to accurately define what resilience is, to understand and evidence how to build resilience, to transparently identify in which system the change is occurring (within our multi-systemic world) and to measure the change of risk of said system. Once we have this information, we can calculate a return that is commensurate with the risk taken, producing a real-risk-adjusted return and a true market rate.
We must rapidly work on creating better pricing for resilience. Investors can then calibrate the cost of finance, internalizing the price of the far-reaching benefits of system resilience and creating a positive feedback loop. The immediate effect of the lower cost of debt is to ensure sufficient free cashflow to cover the cost burden of creating the resilience outcomes. The second effect is that the growing investment renders the investment environment incrementally less risky. This second effect, in turn feeds back to the first effect. As risk in the market lowers, it creates an increasingly stable environment, and the investments continue to generate profits and sustainable outcomes in the long term.
The authors wish to thanks Divya Narain for her writing support.
“The Yale School of Management is the graduate business school of Yale University, a private research university in New Haven, Connecticut.”
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