This blog is the first in a series about sustainable finance written by Jana Everett, a ‘22 MBA student, with Eka Ventures, a venture capital fund working with founders building category-defining consumer technology companies that positively shape the world. Jana was a Fellow with Eka Ventures through Saïd Business School’s Project Aspire from May through August this year, helping Eka navigate sustainable finance regulation and establish an impact KPI framework aligned to their investment thesis. This blog series will introduce the approach Jana and Eka took to framing the theory of change through systems thinking, alignment to EU regulation, and impact metric-setting.
How can we harness the increasing buzz around impact investment to power meaningful change in the relationship between business, society, and the environment? A systems thinking approach can help investors unlock maximum impact in critical sectors, from health care to consumer goods.
Systems thinking involves mapping the actors and flows of information in a system to identify interdependencies and the leverage points at which a ripple of change can lead to paradigm-shifting waves of influence. Leverage points can include the goals and rules of the system and information flows, including positive feedback loops, which are self-reinforcing and gain power as they work, and negative feedback loops, which self-correct when a system deviates from its goal.
Imagine a lemonade stand as a micro-system, with a goal to maximize profits. When the sweetest lemonade sells well, the owner will make more of it to meet customer demand; that’s a positive feedback loop. When a novelty green lemonade sells poorly, she may stop making it altogether; that’s a negative feedback loop. Both feedback loops are leverage points: if customers want to protest green food dye, they can stop buying green lemonade, thereby influencing the system’s demand for the dye. If an investor wants to shift the stand’s goal toward maximizing profits while addressing consumer health concerns, they might approach the leverage point of supply by supporting a vendor offering a cost-competitive, lower-sugar sweetener.
When it comes to anticipating and measuring impact, investors should deploy systems thinking by aiming to target leverage points at three levels:
- In direct investment,
- In evaluating ESG risk, and
- When influencing the investment ecosystem.
Ashoka uses the term “system change” to describe both an outcome of and an approach to social change. Impact investment and ESG risk management can be thought of as approaches which lead to an overall outcome of change in the investment ecosystem which, through the flow of capital, leads to change in other systems (like health care and consumer goods). Let’s examine the role of systems thinking at these three levels.
Impact through Investment
In developing and executing their thesis, impact investors should use a systems approach to identify the root causes of the issues they hope to solve. This is in contrast to the more common and reactive approach of identifying surface-level solutions to urgent issues. Consider the fashion industry and its response to the waste crisis associated with fast fashion. Many fashion brands now offer apparel made from recycled plastic bottles in an attempt to reduce their resource usage, but the process of upcycling bottles renders the polyester unrecyclable, sending the material straight to landfills and removing it from the circular system. A holistic analysis of the fashion system might identify material circularity as a primary leverage point and lead to a solution focused on improving recyclability of garments themselves, like Hylo is doing. Hylo uses a life-cycle assessment (LCA), which assesses impact across the supply chain. Systems thinking at a product level sheds light on impact from raw materials sourcing through production to sue and end-of-life.
Systems thinking can also help companies avoid causing unintended harm. While the EU sustainable finance disclosure regulation (SFDR) lays out criteria for what constitutes significant harm to its objectives (more on that in the next blog in this series!), the practice of systems thinking acknowledges that “the goal of foreseeing the future exactly and preparing for it perfectly is unrealizable.” The SFDR can’t anticipate and regulate for all harms, but by examining portfolio companies within a system, investors can anticipate potential unintended consequences.
Investors are increasingly required to consider and disclose ESG risk exposures, with the Task Force for Climate-Related Financial Disclosures (TCFD) recommendations influencing legislation around the world, including the SFDR in Europe. The TCFD recommends companies disclose their assessment of and approach to climate-related risks and opportunities, as well as Scope 1, Scope 2, and sometimes Scope 3 emissions.
Risk assessments are - or should be - approached via systems thinking, as ESG risks are “often intertwined and mutually reinforcing.” While it’s tempting to address the most obvious and urgent risks (by dropping a risky company from a portfolio, for example), this reactive approach to risk management is insufficient. Instead, investors can use a systems approach to think long-term, identifying key players and information flows to understand how a given investment might influence and be impacted by social and environmental factors. For example, the up-front resource inputs, carbon footprint, and high financial risk associated with the construction of an energy-efficient building may be unappealing until the project is considered in the context of the overall housing and energy system. And, of course, the measurement of Scopes 2 and 3 emissions requires specific awareness of the inputs and outputs to any business.
The Investment Ecosystem
Risk disclosures are intended, in part, to motivate the investment ecosystem away from support for businesses generating net harm to people and planet. By pushing companies to consider long-term and systemic risk, disclosures encourage investment in businesses with positive impact.
Similarly, impact investment can contribute to change in the ecosystem. Systems thinking experts Donella Meadows and Jay Forrester argued that growth is, itself, a leverage point - and that we’ve been pushing it in the wrong direction. There is plenty to say in the debate between impact-centered growth and de-growth. Eka Ventures believes in shifting the paradigm away from extractive growth, which maximizes profits at the expense of society and the environment, toward impact-centered growth, which prioritizes net benefit to consumers, employees, and the environment. Impact investors can build positive feedback loops in the investment ecosystem: by generating evidence that impact-centered growth can compete with extractive growth, they build the case for further investment in and an enabling environment for business models with positive impact. As these positive feedback loops lead to more investment in impactful businesses, other systems will change for the better.
A Look Ahead
Now that we have some familiarity with systems thinking, we’ll next review the sustainable finance regulatory environment in the second blog in the series so that in the third installment we can consider how to apply the two together to develop an impact KPI framework.