How the Tools of Impact Investing Can Undermine Resilience in the Global South

Why is it important to invest in resilience in the Global South?

Todd Cort: When we talk about resilience, what we’re talking about is whether a community of people can recover quickly when a shock to a social or environmental system occurs. With climate change, there are going to be more and more of these shocks. There are going to be more severe droughts and massive flooding events, severe weather that knocks out the grid for days or weeks at time. More migration between countries.

Resilience is inherently tied to physical and social and cultural infrastructure—the way that people can adapt and renew after these systems are knocked out. When we talk about the Global South, that infrastructure often does not exist, or there isn’t the money to rebuild it. If we have flooding in New York—which we’ll have more of—New York’s got billions of dollars to get things back up and running. But if the same thing happens in Jakarta, there’s just not that much money to bring it back up. If it happens in rural areas in Africa, there’s no way to recover.

Resilience is already part of the way that we invest. We move money to investments that have higher return-to-risk ratios. If markets identify that a system is not resilient, then the money stops flowing to that investment. If I know that this city is prone to climate impacts and if it’s flooded it’s not going to get up on its feet and running quickly, I’m less inclined to invest in a bond that that city might issue. And what that does is it chokes off investment into those regions where the investment is needed the most.

Clint Bartlett: If you simply look at it from an investment perspective, then you have to realize that if you are going to have increasingly fragile societies across the Global South, it will impact you in the Global North. You don’t want South Africa with its massive coal fired power stations polluting because it will impact you in the north. To the extent that we have conflict-created food shortages, that impacts not only the cost of food landing in Baltimore, but it also impacts across your entire outsourced supply chain, from supply through to labor costs. Sometimes the framing of the question itself already sets up an error of thought: that the Global South is separate from the Global North. And it’s not true. It’s all part of a series of concentric systems.

And then a final point is the question whether you reverting back to the status quo after one of these shocks? Of course, if the status quo is a negative status quo, then you’re not going to advance anything. We are trying to embed what some would call a transformative nature, where how we define resiliency has an incremental, positive aspect to it. Not just revert it back to what was, but revert to something that is better than before.

Todd Cort: This incremental approach is the reason markets are failing to address the challenge of resilience. It is usually insufficient for one person to invest in one thing. Usually a thousand other people have to invest in other different things in order to move society to a more resilient state. So what if I put a bunch of money into this place? Nobody else is doing it. I didn’t reduce my risk at all because I didn’t create a more resilient society. So I’m relying on this kind of collective movement into the space to create resilience in order for me to see the benefit that I’m hoping for from my investment.

This is how financial markets always work. There is no financial market out there where I could invest, say, in electric cars and expect to get a return on electric cars, without thousands of other people investing in battery technologies and charging stations and highways and logistics chains. It’s always dependent on an ecosystem of investors.

But there’s this challenge in mindsets. It takes not only a physical resilience, but a mental resilience for markets to move.

Clint Bartlett: And that is what we’re trying to do in this work: we are trying to change behavior. We’re trying to change behavior of entities that are invested into to become more resilient, such that they as assets become more resilient but also so that the systems in which they operate become more resilient. We’re also trying to change—and I think this is more difficult—we’re also trying to change the mindsets of the people who allocate capital. To better account for the change in resilience that these assets bring about.

Todd Cort: I think this gets to where Clint and I really started to work together on these areas where an individual investment can create resilience on its own. And our conversation quickly went to this question of, could an investor find a mispriced asset?

Say you were investing in loans to farmers in the Global South. What the markets tell you is that risk of repayment on those loans is really poor, and therefore I would charge a high interest rate for those loans.

What if you had data to suggest that by putting the loan into those communities, those communities also build social structures, they build healthcare centers, they invest in jobs training, they invest in education? What if there was data to suggest that in certain communities, by lending that money, the resilience increased and therefore the rate of default on those loans actually went down because they had more capacity to repay? Because the next time there’s a drought, they can still find ways to make money; the next time there’s a severe weather event, they regenerate their crops more quickly.

That ability would be “unpriced.” The market says that their rate of repayment is really, really poor. But in reality, if they get the money at lower interest rates, they’ll build resilient structures and they’ll repay at the appropriate rate. So that’s where I got really interested—that there might be mispriced information in the market, which is an opportunity for a bank or a lender to come in and say, we can undercut the market. The repayment rates are going to be much better than people think because of these resilience-building structures. And that doesn’t require movements of the mass market. That doesn’t require moral argument. All that requires is that you have data to show that resilience in small cases builds financial benefit.

Q: I want to try to make this a little less abstract for our readers. What kind of investors and what kind of operations are we talking about them investing in?

Clint Bartlett: Let’s think about a farm in the middle of Uganda. According to the conventional view, Uganda is a relatively risky system because it has political risks, it has economic risk, has climate risks. And so investors think that that farm is, say, a 25% interest debtor, because the return that we expect must be commensurate with the risk that we’re taking.

This framing and the consequent pricing means that the farmer has less spare money to fill in any of the societal gaps she may sit in. If there’s a large deficit in terms of healthcare there; the business consequences are quite apparent. There’s sick leave, there’s potentially labor unrest, people migrate etc. “Impact investment” and “blended finance” realize this to some degree, when it says to the farmer, “We’ll charge you less, but then we want you to act in an impactful way. We want you to bring about positive social outcomes. So we want you to put into effect a plan to create better access to healthcare to respond to your local societal void.” We’ll basically reward you up front if you’re able to build that social impact as the time goes on. But, because we don’t have an agreed way to understand resilience-building, the “market” rate would continue to expect a 25% return from the farmer, despite the fact that she would, through successfully accessing the impact funds, have brought about more resilience and less risk.

What we are working on is to try and understand the real (not perceived) risk that the farmer represents. Once this is done, a virtuous circle begins: Let’s say she gets a loan at 10%, leaving her an extra 15% buffer to build these kinds of societal outcomes. And so in one or two or three years’ time when in fact she has filled those voids she in fact is a much lower risk. And so the return that is now commensurate with her new risk is closer to 10% or 12%, not 25%.

The question is not whether the private sector can bring about positive social and environmental outcomes—that we all accept is a given. But rather whether finance currently works to help her build resilience and get to that point, or if it stops her from the get-go?

Q: Can you talk about a project where you’re testing this hypothesis?

Clint Bartlett: There are a set of coffee farmers in Uganda and very simply put, between the seasons of coffee harvesting, the farmers run out of money.

If you separate their business from their personal life, their business is actually making enough money. We’ve seen the numbers. It’s actually a profitable business. But because of societal voids, they have to pay school fees, they have to pay doctor’s fees, etc., etc. So halfway through the year, all their money is gone and they now have to survive. So then they go to loan sharks and eventually get into a debt trap. The loan sharks take over their farm and the farmers become in effect indentured servants farming their once-owned land.

That brings about not only personal wealth destruction but can also lead to migration, competition over decreasing resources, and eventually outright conflict. This happens all over the world where personal, granular desperation begins to manifest in systemic fragilities.

Our work, through highly experienced local partners, is to provide farmers with a much cheaper loan. With that money, they can get the necessary feed and seeds for their farm, they can plant and reap, and they can also meet their societal contract to fulfill local societal voids. They can do all of these things, sustainably and at a profit, because the initial cost of debt burden is commensurate with their real risk as an expert farmer, rather than the perceived risk behind what we think we know.

The project that I’m referring to is through the Global Resilience Partnership in collaboration with the UNDP and GEF, with our local partners Mountain Harvest in northern Uganda.

Why do we care about all of this? We care because global funders are deploying billions of dollars of “impact finance” into these fragile systems, but often at costs of finance that, unless these costs are able to internalize positive resilience consequences, are in fact destabilizing these systems. The reversion to “market rates” of the costs of funding deployed by these impact funds assumes the “market rate” itself is neutral. But, if the expected return (market rate) is based on an erroneously perceived risk, rather than a real risk, then the cost of capital squeezes each asset that accesses it and lowers resilience, not the other way around.

In other words, the current market rate does not result in a neutral occurrence. It’s actually a detrimental occurrence. We can’t hide behind this idea that the market rate is neutral if through information deficits it continues to overestimate a risk and then causes that actual risk through incorrectly priced capital.

Todd Cort: The market rate for interest repayment for loans is what I think of as a gatekeeper to the flow of capital. It dictates large pools of capital and how rapidly or easily they flow to potential investments. There are other gatekeepers that I think are really interesting. One of the gatekeepers that I’ve been separately thinking about is around public equities and how capital flows to publicly traded companies, headquartered or operating in the Global South. Another of those gatekeepers is ESG ratings. A lot of investors use this ESG data to ask, how much risk is that creating? And if there are really poor ratings, then it chokes off the flow of investment.

It turns out that a lot of these Global South companies don’t score very well on these ESG ratings, for a variety of reasons. Sometimes it’s lack of disclosure. They don’t have the money to put into reporting and communication. And sometimes it’s really fundamental challenges like that the laws of that nation preclude them from doing what is considered to be the right thing in the Western world—around data privacy, for example, or women’s rights. And so the question then becomes, should there be different rating systems for these publicly traded companies in the Global South that would reflect the realities that they operate in?

But I’m really interested because it is a gatekeeper and is a gatekeeper that is choking off flow of capital to investments in the Global South where it is needed. Is there a way to rethink these ESG ratings in a smarter way so that we can incentivize the flow of capital without compromising on what we think is the right direction to go for the world?

Clint Bartlett: One of the biggest risks that we face with ESG is that the gatekeeper becomes so outsized that it destabilizes what could have been a critical and necessary change in how capital is allocated. ESG is “environmental, societal, and governance.” I’ve met very few people who have a handle what S actually is, because it’s so difficult to measure. The reason why this notion of resilience is so important is we have lost the vocabulary to explain and measure and conceptualize how a private firm can meet its obligations to move beyond maximizing shareholder value.

Forty or fifty years ago, you had corporate social responsibility—CSR. CSR was that stuff that the company did that was not profit maximizing; it most often wasn’t core to what the business did. And I think we have jettisoned this idea of CSR too quickly. We see it as passé. But I think that’s a mistake, because many of the companies that are supposed to be creating positive societal outcomes, their business models in and of themselves are at best neutral. If you look at a renewable energy company, you could make the argument that the business model in and of itself is socially impactful, probably, but for every one company that has that kind of business model, there’s probably a hundred or a thousand that are just making or selling little widgets every Tuesday morning. It’s those entities that we need to scale and need to create social outcomes, not the former, because there’s so little of the former and there’s so many of the latter.

So then if you look at the latter, then you ask, well, how are they going to create societal outcomes? Sure, paying people more and ensuring supply chains are environmentally positive are both critical first steps—but it doesn’t end there. There are many links in the chain from those points to overall system resilience and then flourishing. And that’s where jettisoning CSR, I think, has happened too early. Because when you remove CSR, you are asking a company to innovate to the degree where their fundamental business model changes. It is possible, of course, but we don’t have the time. If we can’t get it right in Silicon Valley, how on earth are we going to get it right in Mumbai, Johannesburg, or Nairobi. Or, for that matter, Zurich, London, or New Haven?

Q: What are the structural changes we need to make this transition? It sounds like one is to create examples on a micro level and diffuse that example out into the impact investing world. And then another is to think about how the ESG standards affect investment on a larger scale. Are there other structural changes that we need to correct the incentives for investment at the right risk level?

Clint Bartlett: If we could see the proof of resilience-building and we could assess and measure risk objectively, then we could make sure that the return expected is in fact risk-adjusted—that the return has the proper relationship to the risk. So in some sense, it’s actually very simple; it’s an information problem. We need to show the evidence of what we assume it true. Our work focuses on creating the proof for what we already think is the case. With this, then we can make the really big changes in how money flows. So it’s the risk side of the risk-return equation, not the return side, that needs to be changed or tweaked.

Todd Cort: If you come up with information that demonstrates a more accurate risk-adjusted return, then the money will move. Are we addressing all the gatekeepers? No, there’s lots of them out there. We haven’t even talked about governments, regulations, incentives, etc. So we don’t want to oversell that we’re going to save the world. There are way too many actors.

Clint Bartlett: I agree, and personally I often have to resist a rising level of desperation, because I don’t believe that governments are going to step in to do what we need them to do. And I don’t believe that civil society is big enough. So the only gorilla in the room is the private sector. I’m focusing on the private sector and hoping because if you can get the private sector to work properly in the way that we’re talking about, it’ll drag the rest of the actors with it.

Todd Cort: We haven’t talked much about the relationship between impact investing and, call it mainstream investing for lack of a better word. It’s a bigger fish to fry, the question of whether traditional investing can create positive impact while achieving market level-returns is a really interesting one. And there’s suggestions that in some cases, impact investing will be the better investment. In some cases, it won’t be. But the situations would dictate whether an investor that’s looking for social and environmental benefit would produce more financial return.

So we can’t, at this point, create generalizations to say, if everyone would just do this resilience and impact-type investing that we would create better returns overall. There’s evidence that suggest that it would, but there’s evidence just there would be losers in that investment to the world as well. In terms of opening the gates for capital, that is a very relevant conversation.

An article came out yesterday in the Wall Street Journal that essentially is saying that any investment in environmental social benefits is against fiduciary duty and will lose you money. Meanwhile, there are tens of thousands of articles out that would argue the exact opposite. But for this conversation, it’s like the elephant in the room. Does impact investing only create financial returns in isolated circumstances? Or is it kind of a global reality that creating beneficial impact would also create financial returns for all of us over time?

Clint Bartlett: Potentially I have a different view here. I believe impact investing is a temporary construct to bring about financial flows in a way in which they wouldn’t naturally flow. I hope that in 10 or 15 years time, there’s no such thing as impact investing; there’s just investing. Because at that stage we would be able to account for both negative and positive externalities. For example, in 15 years’ time we would know that for every $1 invested in coal-fire power generation, there would be a $5 negative externality cost (and would increase the risk of the asset). Likewise, for every $1 we invested in resilience-building Uganda farm operations there would be a $3 “resilience surplus” brought about (which would decrease the risk of the asset). Overall, “investing” wouldn’t need to be impact or not; it would merely be deploying capital at a risk-adjusted return, with the risk being fully accurate of all negative and positive consequences.

If you invest in two assets and they both yield the same return, but one is less risky than the other, then portfolio theory dictates you should allocate more capital to the less risky asset. It doesn’t make it impact investing. It just makes you a good investor. And that’s actually all that we are arguing here—that an asset that sits in a more resilient system is less risky than another one.