Tesla and the future of impact investing
Consider the following scenario:
Oil prices are down 70%.
Unemployment is up by 10 percentage points.
You sell high-end electric vehicles.
Where do you expect your business to go?
In one of his books Ben Bernanke talks about the “marginal propensity to consume”. The professor is clear about it, if people lose their jobs they spend less. Not surprising. Economists also talk about the price elasticity of demand. Wikipedia lays it out in simple terms: people desire things less as those things become more expensive.
Cratering oil prices made Tesla cars more expensive relative to vehicles with internal combustion engines. Also, buyers of Teslas face the risk of job loss or income reduction like all of us. If those premises are right, you would expect the propensity to consume Teslas to go down.
Yet, Tesla reported 90,650 car deliveries for the second quarter of 2020. In a period in which the rest of the industry suffered a 30% reduction in volumes, Tesla was roughly flat relative to its first quarter and the same quarter of 2019. Flat in this case was extraordinary. Participants of the stock market expressed this happy view with their bidding and asking.
What’s going on?
This blog will make the case for consumer decisions, rather than the dynamics of the capital and labor markets, as the main driver of growth in impact and ESG investing. I’m going to argue that providers of labor and money are faced with trade-offs that make life difficult, while consumers don’t have to make any compromises.
Let’s look at capital first.
Impact and ESG investing: more intention than reality
Capitalism has worked very well for investors in the past 40 years. Declining interest rates and corporate taxes have led to higher profit margins and increased present values of expected cash flows. Stagnating wages didn’t hurt either.
That couldn’t go on forever. The social and political instability that we’ve seen in the last decade reflects a discontent around the world. It’s calling for a profound change in how we use and reward capital. The finance community has come up with a well-intentioned answer. ESG stands for environmental, social and governance, and the big idea is that capital allocation should now optimize not just for economic returns, but also for societal benefits in a much broader sense.
I’m biased in seeing this as a good response. I left Goldman Sachs in 2006 to join the International Finance Corporation, the unit within the World Bank that pioneered what we now call impact investing. Bias aside, if we agree that capitalism is the most effective economic system, it’s only logic to upgrade it every now and then.
If you do a Google search on ESG investing you’ll see progress measured in trillions of dollars in just a few short years. It looks impressive. Unfortunately it isn’t. It can’t be.
I spent the first week at IFC doing a full time training on ESG. IFC was rolling out brand new standards at the time. As a finance professional this was all new to me, and it felt like too much. It was too much to ask of the companies I’d be financing and too much to ask of me as the person running deals. Making good investments is hard enough without all of these additional requirements, I thought. And I was right about that, but wrong about not embracing ESG.
As the years went by, I worked on financing projects for many companies in emerging markets, and as part of every deal we asked them to improve their ESG game. And they did that, but slowly. Why? Because these standards are hard to implement if taken seriously. Let’s use environmental standards as an example. A company with an existing physical footprint of installed capacity can’t just flip a switch and upgrade to the new standards. It takes money, time, training and leadership to do it right.
Even if you’re starting from a sound base of existing practices, it’s hard to improve them. My sister is an MIT-trained environmental engineer who has worked at US, European and Japanese companies -no resource constraints. She has spent 100% of her professional time upgrading and improving environmental and safety standards, and yet she’s never done. The point is, this is a process not a finite destination. You never “achieve” ESG standards, you move towards ever stronger practices.
Which brings me back to the trillions of dollars now invested with ESG considerations in mind. If you take CNBC at their word, this is a “$30 trillion dollar market just getting started”. In that same article you can read about the “tsunami of assets” going into the strategy. At face value you could interpret that as saying that $30 trillion are now invested in companies that comply with some type of ESG standards. In reality, it’s just not possible to change that much in a few years.
This isn’t to say that ESG and impact investing aren’t real or should be discarded as a fad. What I’m trying to say is, joining the gym doesn’t make you an Olympic athlete. These are good steps and necessary steps, but it’s just a beginning. The fundamental shift to a more sustainable economic model hasn’t taken place yet. But the intention to do things well is encouraging and with proper commitment it could turn into something meaningful.
Having said this, the motivations of the system haven’t been revoked: capital seeks to maximize economic benefits. Some pioneers might sacrifice performance in the pursuit of a bigger mission. But capital as a whole will not. If for instance it turns out that ESG focused funds materially underperform that rest of the market, they will disappear. If you’re managing a pension fund or saving for your kid's college, you just don’t have the luxury to give away your investment capital in pursuit of the greater good. You can do that separately through grants and donations, but for your investment portfolio you’ll demand a reasonable return for the risks that you take.
For ESG and impact investing to have a future they will need to show good performance. Capital lives in the world of trade offs, so progress from this side of things will happen, but slowly. We can celebrate the initial steps taken so far while keeping realistic expectations. Decades of uneven progress -not years of smooth sailing- is the most probable way forward.
Empty tech and underperforming hedge funds
If capital will not drive a rapid change, what can we expect of labor?
Much has been written about young talent migrating from finance to tech. The argument goes something like this: bright young minds used to run to Wall Street in search for money. Nowadays they’re going to Silicon Valley to create the future.
I wasn’t old enough in the ‘80s to understand how the narrative about finance was developed. But from books and Gordon Gekko, I get the gist. Money and status provided a powerful combination. That lasted for a while, until the Great Recession that wiped out fortunes and reputations. It also regulated bonus pools. Worst of all, it left Ivy League graduates with a difficult puzzle. If Wall Street is no longer the destination of choice, then what is it? Silicon Valley came to the rescue.
Stock options replaced cash bonuses. Building life-changing features elevated us from financial monstrosities. Hackers ruled over small-minded traders and the world was finally in order.
While some of this might be true, it is not the whole truth. As you read this some of the brightest minds in the world are working hard to improve algorithms that keep our kids addicted to a screen. This type of tech is just as empty of moral value as the hedge fund guy who tests the limits of insider trading or simply underperforms while charging his 2 and 20.
Before: bright young minds typing on a Bloomberg terminal, optimizing for money.
After: bright young minds typing on a 15” MacBook Pro, optimizing for money.
If there is an improvement, it is not about motivations. Top talent in this digital era is following the money and the best career prospects -as it should. The stampede is creating excesses in tech, just like it led to excesses in finance. Human nature at work.
We can agree to the argument that creating things -tech things or any things- is probably better than shuffling paper. But there’s nuance even in that. An investment banker at Morgan Stanley helping infrastructure clients meet their financing goals is adding great value to society -bridges are getting built.
So what am I trying to say here?
My point about labor is that it’s full of trade offs, just like capital allocation decisions. People can choose work driven more by purpose than money, but it’s usually a tough choice with limitations. It takes conviction and patience to do something like that. At this point it seems like only a fraction of the labor force can take this path. Which brings me to a conclusion about us as workers: we might be moving in the right direction but motivations and systems haven’t changed much, therefore progress will be slow.
Impact investing, or any kind of sustainable finance, will have a hard time expanding rapidly if it depends on large quantities of top talent going into purpose driven endeavors. This is not where the “tsunami” will come from.
Consumers have the power
Having made an argument against labor and capital as the leading agents of transformation, I’m left to talk about consumers.
A clarification first. We are all workers, investors and consumers. We make decisions as best as we can in each of these dimensions of life. This is to say, there are no good guys and bad guys in this story. There are roles and incentives. This is not about judging, it’s about trying to understand what’s going on.
Having said that, my closing argument is simple. Consumers don’t have to make trade offs, like investors and employees. When they buy a Tesla Model S, they are not buying the best EV, they’re buying the best car, period. The same applies to Patagonia jackets, healthy snacks and a huge wave of new sustainable products. No trade offs.
So it’s only logic to expect that we, the consumers, will lead the way to a more sustainable economy. Entrepreneurs and investors will do their part in creating attractive products, but it’s the consumers who will vote with their wallet and decide who thrives and who doesn’t.
And that’s where I see the explosion, the tipping point.
The path of least resistance is the one that consumers can take. When we are acting as savers or as workers there’s simply too much at stake. It’s a different story when we buy things. We’re used to making statements through our consumption. My hypothesis is that the new generations are about to make a civilization-altering statement.
The force and speed of change will be surprising, if my view proves to be right. The pandemic we are enduring provides the perfect blank slate. Out with the old, in with the new.
What this means for investors
Investors who are now wondering how ESG and impact investing might evolve will be playing catch up. Some might be driven into the space by external pressures while others will see it as a new “product” they can sell. These will not be the leaders of the new investing landscape.
Purpose driven companies embraced by consumers will be the engines of change. Demand for their products will generate growth and with it the need for capital. Investors who can see that now will be able to participate actively and at scale.
This new era of sustainable economic prosperity is far from guaranteed. But I’m optimistic. The chance to make a historic shift is within our reach. We know capitalism is not a perfect system, but it’s a system that can be improved. This is the time to do it, and the best part is that we don’t have to make any real sacrifices. A rational revolution is on offer, what more can we ask for?