How I think about impact
Capital markets are very efficient at resource allocation. Investors maximize risk-adjusted returns by investing in companies producing the most valuable products and services.
But there's an invisible cost.
Capitalism inherently prioritizes short-term gains over long-term sustainability. And worse, it encourages businesses to externalize environmental and social costs onto society rather than internalizing them as a cost of doing business.
For example, a United Nations study found that the 3,000 largest publicly-held corporations in the world caused $2.2 trillion in environmental damage from greenhouse gas emissions, other pollution, and water degradation. If they had internalized these costs, it would have reduced their profitability by a third.
As shareholders, we legally own parts of these companies. And the extra 33% profit was distributed to us at the expense of society.
These unaccounted-for costs are invisible because they don't impact near-term profitability (they actually enhance it) and may not ever impact shareholders. But that doesn't mean they don't exist – someone must pay the bill.
I think of impact in terms of these costs.
The ESG movement tries to minimize these costs by investing in companies meeting certain environmental, social, or governance standards. While these efforts reduce the amount of profit you receive at the expense of society, they also make non-compliant companies cheaper and more profitable for non-ESG investors, creating a perverse incentive.
Instead, I like investing in companies with a negative externalized cost.
For example, a solar energy project might produce electricity that offsets the need for carbon-intensive electricity, resulting in a net reduction in greenhouse gas emissions. In addition to avoiding externalized costs, you disincentivize people from investing in fossil fuels by chipping away at demand and lowering the margin cost of electricity.
The addition of these negative-cost investments to a portfolio can help reduce an entire portfolio's externalized costs.