The Emperor’s (New) New Clothes
A decade ago I wrote an article for Wealth Management Magazine about a nascent sector of the global debt market: so-called “green bonds”. Essentially, I predicted that the rise in demand for sustainable infrastructure would be met by two dynamics: an increase in supply and a spike in greenwashing. And I argued that in order to align one’s values with one’s investments to a high degree of fidelity, a deeper dive was required. It wouldn’t be enough to simply buy bonds labeled “green”. One would need to understand the “use of proceeds” to know if the bonds were credible… or if they had just been painted for St. Patrick’s Day.
In the intervening years, both predictions have proven prescient. Sustainable infrastructure has become one of the largest sub-sectors of the global debt market… and greenwashing has become so prominent that it threatens to undermine the credibility of the entire sector.
Which points to a deeper issue that (cynically) finds its roots in first principles, incentives (both perverse and enlightened), a clash of cultures, innovation, climate science and greed. Let’s unpack what I mean. And let’s use crypto as the tool to help us do that.
Like a lot of people in finance today, I am fascinated by crypto. In part, I am fascinated because crypto has given us the chance to witness the rediscovery of just about every facet of modern finance in a super public, sometimes absurd, often hilarious, occasionally brilliant, hugely accelerated way. All of which has revealed, in sometimes surprising ways, why modern finance works the way it does. (Note, this is NOT a recommendation to buy the next digital token, even if its name is a Taylor Swift anagram.)
Basically, the entire world of blockchain and crypto is a petri dish. And what’s growing in the petri dish are all the financial structures that have been tried, tested, rejected and embraced by conventional finance, just with an enormous amount of hoodies-and-wild-hair “Wall Street Sucks” vibe. As Matt Levine recently wrote for Bloomberg, “If you wanted a public demonstration of why, I don’t know, infinitely leveraged shadow banks were bad, you could wait 20 minutes and crypto would give you one.”
And because crypto has become so public and so fascinating - I presume Tom Brady harbors some regret for his paid relationship with FTX, for example - a lot of people have very strong opinions about the entire sector. Which matters a lot to a lot of people, for a wide variety of reasons, most of which have to do with the rather interesting dynamic that is currently emerging around regulation.
As an aside, the delicious irony is that when these shadow banks collapse (see: FTX) everyone crowing about the beauty of an unregulated currency are suddenly begging for… regulations.
But why, you might ask, does this matter to us, the growing community of investors who want to use our capital to catalyze positive change in the world? Well… it matters because climate investing is, sorta, if you squint a bit, a lot like crypto.
Before you start throwing rotten tomatoes at me for proposing such a grievous analogy, think about it this way:
Impact investors - specifically climate investors - are passionate about re-imagining capitalism. We are working to design a financial regime that will mobilize money to optimize for things like energy efficiency, climate resiliency, adaptation and mitigation, etc. Put simply, we are building what is, in effect, an alternative financial system that produces something different/more than simply maximized financial returns (hat tip to Matt Levine for this insight). And we are, basically, building it from the ground up, using the tools of traditional finance to scaffold up the armature that will facilitate the trillions of dollars the world needs to avoid climate collapse.
But crypto has reminded us that when you are building an alternative financial system, you are going to get some things naively, optimistically, wrong. You will unintentionally embed perverse incentives. You will trigger unintended consequences. You will miss critical checks. Regulatory oversight will be bewildered and lagging.
And over in the traditional financial sector, there will be an army of wildly smart people trained to exploit all of this in order to make money. Some of them will be more than happy to train their well-honed exploitation machine on your emerging alternative financial system, even if you think they are miserable cretins who should stay in their lanes while you do what you need to do to save the inhabitable world. They won’t care. They might actually be miserable cretins. But if so, they are also miserable cretins who are incredibly good at making money.
Here’s the thing:
If we believe that climate change is not a hoax, and if we believe that the capital markets must play a role (perhaps the central role, along with a sensible regulatory framework that spans the globe) in solving the climate crisis, and if we believe that impact investing represents the armature on which the future of capitalism will be built, we must then be ruthlessly honest with ourselves about a whole bunch of things. One of which is that wishful thinking won’t get the job done; just because an investment has a climate angle doesn’t make it a great investment. Another is the non-intuitive idea that because investors drawn to climate investing tend to be, in general, fairly ethical humans, this doesn’t mean that every investor drawn to climate investing is ethical.
Etc.
It gets nuanced, quickly.
Adding complication is the proliferation of terms describing the practice of climate investing. A recent Bloomberg Green article about one of those terms, “transition finance”, reveals just how difficult this all can be:
“Transition finance” is shaping up to be one of the new year’s most important subjects for anyone professing to care about the climate crisis. …
The phrase “transition finance” is loosely defined as investments mainly in industries and infrastructure that help drive efforts to achieve a net-zero economy. It’s distinct from green finance, which generally targets so-called climate solutions like wind farms or battery plants. …
The Glasgow Financial Alliance for Net Zero is proposing that the investment strategy include financing of traditional green activities, like renewable energy or electric vehicles, as well as polluting companies that plan to decarbonize and even high emitters like coal plants—as long as they’re on the way to being shut down.
What unites most proposals around transition finance is the belief that, instead of simply cutting ties with high-emitting companies, financial institutions should help polluters either phase out their activities or put them on a so-called emissions-light pathway.
“You’ve got to go where the emissions are and try to bring those down,” said Curtis Ravenel, a senior adviser to GFANZ. The group is co-chaired by [Mark] Carney, a former Bank of England governor who’s also chair of Bloomberg Inc., and Michael R. Bloomberg, founder and majority owner of Bloomberg News-parent Bloomberg LP.
For sustainability-minded investors, however, all of this begs the question: Do any assets fail to qualify? And for the polluters that do, how can investors be confident they’ll decarbonize at the speed and scale envisioned?”
Set aside, for the moment, the perplexing notion of someone actively wanting to own a high-emissions company on the way to being shut down. If you’ve paid attention to our stance on divestment vs. engagement, you’ll hear echoes of the central points in this extract. And you’ll understand why we think it is so important to get this right.
As Levine wrote: “A norm like ‘climate-focused investors should avoid coal companies’ is simple but possibly counter-productive [see below]. A norm like ‘climate-focused investors should buy coal companies and make them better’ is more nuanced but harder to police.” And, I would argue, virtually impossible to imagine; what, exactly would a post-coal mining company based in West Virginia do?
Put more directly, what is the best path for climate-oriented impact investors to follow? Here are a few orienting thoughts:
Screening public portfolio holdings is a powerful way to express investor values, but it has very little influence over corporate behavior. Worse, ownership could be passed into the hands of investors who specifically support activities that exacerbate climate change, with obvious consequences.
Owning “bad” companies and then trying to change their behavior is the proven way to shift emissions. But, if you run around buying coal companies, you’ll raise coal company prices and encourage more people to start coal mining companies so they could sell to you. Not the desired outcome.
Directly supporting businesses that engage in climate adaptation and/or mitigation is the strongest market signal for a decarbonized economy, but the illiquidity and unconventional risks associated with investments like this simply aren’t for everyone.
And if the theory of rising cost of capital holds true, the incentive for extractive industries would be to accelerate that extraction to offset the discount rates associated with high costs of capital!
Caveat emptor, my friends.
Further, the whole field, while developing rapidly, is still so new that there are bleachers full of market participants ready to find fault with whichever approach an investor takes. Accusations of greenwashing reveal that, unfortunately, perfect remains the enemy of good. The political vitriol swirling around ESG reveals that the culture wars are alive and well, even in the theoretically amoral world of finance. And the wide range of perspectives seen within the Impact community reveals that there is precious little consensus around a host of controversial topics.
At Align, we do our best to cut through the confusion by committing ourselves to clear, rigorous, self-honest thinking. And we harness that thinking in support of the impact portfolios we build. And we see those portfolios as the proof points that impact investing can serve as the model for the future of capitalism.