Transformation capital - a new investment logic for catalysing systems change

Channels: Policy

Companies: EIT Climate-KIC

People: Dominic Hofstetter

In its 2018 special report on the impacts of global warming of 1.5°C, the Intergovernmental Panel on Climate Change (IPCC) called for the "rapid and unprecedented" transformation of the "socio-technical" systems that constitute modern human civilisation: energy, agriculture, infrastructure, industry, and cities.

This is a stark reminder that the world is not on track to avoid the most perilous impacts of a warming planet. What lies ahead is unparalleled in ambition and difficulty.

The way money flows and accumulates through the different parts of our economy will determine whether we can reduce greenhouse gas emissions and become climate-resilient in line with the Paris Agreement. However, today's financial industry is ill-suited to fuelling the type of real-economy transformation the IPCC is calling for. This is also true for investment approaches branded as "sustainable finance" such as environmental, social and governance (ESG), triple bottom line investing (TBLI), socially responsible investing (SRI), or impact investing.

Dominic HofstetterThis is why we invited more than 50 systems thinkers, innovation practitioners, investment professionals, and creative voices during this month's first-ever London Climate Action Week to design a new investment logic capable of catalysing systems transformation. The workshop helped us refine our understanding of the limitations of present-day capital markets and sharpen the contours around the building blocks of a systems-transformative investment logic.

The key to transformative investing is to recognise that the world at large—and the socio-technical systems nestled within it—behaves as a complex adaptive system. Such a system is constantly evolving but impossible to predict, and it therefore often behaves in a non-linear fashion.

In viewing the world through this lens, it becomes apparent that the finance industry's single asset paradigm—one stock, one bond or one project—will never be able to unleash transformative effects. A more promising approach is to construct portfolios for strategic synergies, selecting individual assets not based on their individual merit but based on how they reinforce the portfolio's potential to unlock transformative dynamics.

Take the electrification of transportation. Investors usually take bets on single investment propositions—an electric vehicle start-up, a manufacturer of charging infrastructure, a developer of fleet management software, or an installer of household-level power generation and storage systems.

By taking a systems approach and investing in all stages of the electric transportation value chain—for instance, through the strategic blending of different instruments and asset classes—investors can significantly increase the likelihood that a market for electric transportation will emerge. All that is needed is for asset owners and managers to abandon their siloed mindsets and structures, eliminating categorisation where possible.

However, economies are not just made up of technologies and businesses but also of people and institutions. To catalyse systems transformation, it is necessary to engage all levers of change in the system, including policy and regulatory frameworks, social norms and behaviours, skills and capabilities, individual and collective narratives, and production and consumption paradigms. Many of these interventions are non-investable under the traditional investment logic—but they create value for society at large. So systemic investors should align themselves deeply with actors interested in promoting public goods, such as governments, philanthropists, and multilateral institutions.

That still leaves the question of what to spend money on. Not all interventions in a system—whether investable or not—have the same potential to unleash transformative effects. This is why it is critical to identify sensitive intervention points—those places in the system where a relatively small change can trigger outsize effects and where non-linear feedbacks can act as amplifiers. Often, it will not be apparent where to act first, so the initial positions will represent a hypothesis. Investors must therefore be competent in observing the system and making sense of what emerges within it so that they can dynamically allocate capital to where the desired transition dynamics take hold.

Systemic investing relies on a multitude of additional concepts and capabilities. It requires that we map systems, hypothesise transition pathways, and design transformation strategies. It also means that we need to re-conceptualise risk and return, away from the self-referential paradigm of capital accumulation toward a coupling with the success and uncertainties of catalysing transformational dynamics. We can operationalise these concepts through new business models, adapted financial instruments, and innovative public-private investment partnerships.

EIT Climate-KIC has set out to develop and test these elements with its community of innovators. We believe that deploying capital for the transformative change that the IPCC is calling for requires that we re-imagine the role of capital in promoting a prosperous, sustainable, and inclusive society. This does not imply overthrowing capitalism, revolutionising the monetary system, or disregarding the interests and fiduciary obligations of asset owners. Much can be achieved by simply deploying capital in a smarter way and on a bigger playing field. If you are a challenge owner, innovation practitioner, and investment professional keen to address the most pressing and tangible problems of our time, we are keen to hear from you.

Dominic Hofstetter is director of capital and investment at EIT Climate-KIC – Europe's largest knowledge and innovation community focused on the rapid, broad-based systems transitions we now need to build prosperous, resilient, net zero-carbon societies in time.