Research & Insights

As the world emerges from the pandemic with high inflation, vast inequalities, and rising oil and gas prices, it seems timely to ask how much we can expect of investors and businesses in our current system. While individual investors — people and firms — are taking on climate change and other systemic risks like inequality and biodiversity loss, they are doing so in a system where the odds are stacked against them. The very nature of the system resists change in ways that non-financial disclosure and policy and regulation alone cannot solve. Financial decisions are based on financial analysis, and the current system lacks a mode for accounting for externalities in the calculation of returns. In our current economic system, companies and asset managers are expected to maximize their financial return to investors.

A recent article by Nathaniel Bullard on Bloomberg.com noted that heady valuations and investor fear of missing out, coupled with the need to fund planetary-scale innovation has provided a tailwind for climate tech. As Bullard alluded to at the end of his post, despite the positive headlines, high return expectations typical of venture capital and private equity investors could compromise portfolio companies’ abilities to effectively deliver strong results, both in terms of financial performance and positive impacts. Moreover, so many investors competing for the same investment opportunities with high-return potential can drive up valuations — some companies may end up overvalued, while other well-deserving companies who have slower growth trajectories may see no capital at all.

The Predistribution Initiative (PDI) is focused on ESG implications of investment structures and practices. There is growing concern that as institutional investors migrate up the risk-return spectrum for yield and allocate more to residential real estate (RE), they are driving up valuations and competing with potential individual homeowners, thereby exacerbating the affordable housing crisis. Institutional investors are typically not intentionally causing harm and likely want to avoid these negative impacts, so are there more regenerative investment structures that they can allocate to with exposure to residential RE and risk-adjusted returns?

High leverage is arguably making our economy more vulnerable to a solvency crisis in the event of a persistent increase in interest rates and/or should future increases in inflation prove difficult to control. It is also contributing to and compounding the various forms of systemic inequality trickling down to individuals and communities. This is why we are concerned that if the source of high returns for investors lies in leverage rather than fundamental factors, heavy portfolio allocations to certain securities in such asset classes (e.g. high yield bonds, collateralized loan obligations, leveraged buyout private equity) end up creating negative externalities that can systematically undermine institutional investors’ ESG and stewardship efforts.

As we highlight in our recent working paper, ESG 2.0: Managing & Measuring Investor Risks Beyond the Enterprise Level, there is strong evidence to show that both investors and companies engage in a range of activities that create negative impacts for the economy, which boomerang back to investors’ portfolios in the form of higher risk and lower return... Investors and their activities are the foundations of markets – comprising the “plumbing” upon which businesses and communities operate. Requiring corporate disclosure on ESG issues without also addressing structural issues relating to investor-level activity will leave markets with a “swiss cheese” style and incomplete understanding of risks.

ESG funds’ bias against workers is unintentional, but it is a feature rather than a bug […] A new paper by The Predistribution Initiative, ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise-level, foregrounds potential negative impacts from capital structures themselves, not just portfolio companies.

A new report translates the difficult questions we have on sustainability into suggested investment changes […] “Predistribution Initiative’s ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise-level tackles these systemic issues head on, providing a detailed analysis of problematic investment trends in recent years. The paper highlights the inherent contradictions of more ‘traditional’ ESG approaches to sustainable investing, applied commonly at the underlying enterprise or asset level, and the structural impact of asset allocation decisions at the level of the financial institution itself, particularly in relation to global economic inequality, increasingly recognised as posing systematic risk.”