Analyzing the opportunity cost of investments from an SDG perspective

August 23, 2024

Investors want to be repaid, not necessarily immediately, not necessarily with a generous return on investment.  But not repaying a lender, or even giving the impression that a debt will not be repaid, can have serious consequences: first, in preventing a debtor from borrowing again, or in chilling appetite for lending altogether.  When this happens on a mass scale, as we saw during the financial crisis that began in structured credit markets in 2007, the consequences for an economy can be catastrophic.

In this context, understanding sustainable and unsustainable revenue models becomes crucial for both businesses and investors. Sustainable revenue models are those that ensure a steady stream of income while maintaining the ability to pay obligations over time without over-leveraging. These models tend to prioritize long-term growth, customer retention, and the development of value-added services. Conversely, unsustainable revenue models often rely on short-term gains, excessive borrowing, or speculative investments that may yield immediate returns at the expense of future stability. By recognizing the differences between these models, stakeholders can make more informed decisions that mitigate risks and support economic resilience.

At one point in history, a successful investment was perhaps seen as the realization of a significant project: constructing a bridge, building, manufacturing business or otherwise constructing an asset that would provide social and economic value for years to come, or at least until the initial investment is repaid with a return.  Indeed, the first corporations were Roman, and were exclusively devoted to managing investments of large-scale infrastructure such as local bridges, roads and sewers. 

In contemporary times, successful investments can take on a variety of forms, often extending beyond tangible infrastructure to encompass digital platforms, technology start-ups, and sustainable enterprises. And investors are not looking so much for participating in the realization of asset creation, but participating in the permanent monetization of an asset, and indeed seeking steady streams of cash flows, ideally for as long as possible.  There are certain inherent flaws with this model, which tends to be passive and delocalized from where assets are located. The value on an investment tends to be evaluated first on financial terms, seeking to limit negative externalities on people and the planet, but limited attention is given to evaluating the opportunity cost of an investment from a sustainable development perspective.

Let us look at the example of infrastructure assets.  Making the investment case to an infrastructure fund to invest in a five-lane highway in an OECD country that will be financed with a mix of debt and future toll revenues is fairly easy, regardless of where the investors are located.  The macro-level impact of such an investment will incrementally improve transportation and trade, but will likely not be transformational given the level of wealth that the host country has already achieved.  

However, making the investment case for a similar highway project in a developing country, where there is a pressing need for infrastructure development and potential for significant impact on economic growth and social well-being, may prove to be more challenging. This is even more difficult if the investors are located abroad.  How can the infrastructure assets in developing countries attract capital when investors can make so much more investing elsewhere, with a much lower risk premium? 

The investment landscape today, particularly in developed markets, is filled with an endless range of profitable and super profitable investments in real estate, software as a service and many other assets that will continue to provide strong cash flows for years to come.  Most of these assets are offered for rent, subscription or use, whether a rental car, streaming platform or driving application.   These investments are profitable, but many of them are not sustainable in the long run.

Sustainable revenue models may seem like common sense, but striking a balance between short-term gains and long-term stability can be challenging for businesses and investors alike. This is especially true in today's fast-paced and constantly evolving market.

At a certain point, we must ask ourselves, what is the opportunity cost of these investments?  Each investment in a tech unicorn or software platform that makes life incrementally easier in a developed economy is a tremendous opportunity lost for investment in the environment and human development elsewhere on the planet. This is a serious dilemma in sustainable finance today: not only reorienting capital flows to sustainable investment projects, but also avoiding over-saturation in developed economies. 

This dilemma highlights the pressing need for a paradigm shift in how investments are evaluated and prioritised. Stakeholders must move beyond traditional financial metrics and incorporate broader social and environmental impacts into their decision-making processes. Developing economies often suffer from a lack of investment not because the returns are inadequate, but because investments are seen through a narrow lens that neglects the potential for transformative change.

Despite regulatory changes such as the EU’s Sustainable Finance Disclosure Regulation, the world of private equity still remains somewhat opaque, and there is much less regulation and scrutiny on the macro-economic impacts of investment decisions, such as the one I describe above.  Supranational banking authorities will consider these issues to some extent, although rather from the perspective of protecting deposit-holders.  There may be some advocacy of these issues by international policy groups and think tanks, but there is no authority that will ask a private equity fund to consider the opportunity cost of another investment in over-capitalized asset classes in developed economies. 

To address these challenges, it is essential for investors to adopt a more holistic approach. This involves assessing investments not solely on multiplier effects or immediate financial returns but also scrutinising their potential to contribute positively to local communities and the environment. This is more than just investing for impact: it is investing for continued growth of an economy, as opposed to simply a project or company.

How can we compare the value of a highway in Sierra Leone versus the value of a highway in the United States?  In the short term, the latter will be much more valuable to the investor, as the toll payments will be immediately recognized as revenue.  But in the long term, it is the highway in Sierra Leone that will jump start trade and exports, and will, in the long term, create greater transformational growth for the country.

Investors must come to understand that the metrics for success cannot solely hinge on immediate financial returns but must also factor in the broader implications of poverty alleviation, economic empowerment and environmental sustainability. The European regulatory approach to sustainable finance to date has been about studying and identifying ways to reallocate capital into projects or activities that are deemed better for the environment, and requiring actors in the financial sector to disclose those elements.  This approach has its merits, but it also has limitations. Sustainable finance is not just about reallocating capital; it's also about changing the way we think about and assess investments.

These regulations are all disclosure-based, focusing on the process of information collecting and sharing, but not necessarily reallocating investment in a significant way.  It remains a fact that most U.S. pension funds are still invested in the same listed equities that they were a decade ago.  If there are changes, they are mostly superficial, with far too much time spent explaining and justifying small reallocations.  At the end of the day, is it the same countries and the same sectors that are the most capitalized. 

In some cases, the pressure (often unjustified) to exit fossil fuel industries will cause a company to exit certain operations.  For example, listed companies that do not want to be involved in coal operations often sell those assets to companies that are not subject to the disclosure requirements.  But does that mean the coal operations cease? 

Of course not, they simply go off the radar of the international investment community.  There are still many investors that want to participate in such projects, many of whom are located in jurisdictions with little regulation over private funds.  The pure demand for coal-generated power plants is so strong, profitable and necessary in some countries, that it will continue to thrive regardless of what regulatory measures are proposed in Europe and the United States.

This raises significant questions regarding accountability and transparency in investment practices. As private equity funds navigate these complexities, there is a need not only for disclosure frameworks, but guidance on how to evaluate and prioritize investments.  An investment is sustainable not because we call it so, but because of its impact, direct and indirect. 

I would argue that a truly sustainable investment must be producing measurable outcomes, not simply KPIs, on attainment of the SDGs.  It is only by taking an outcome-based approach, including looking at the opportunity cost of an investment, that we can measure whether an investment is truly sustainable in its ecosystem.  In doing so, we can ensure that funds are directed towards projects that genuinely foster sustainable development, rather than merely shifting assets around within well-established markets.

I consider that energy investments are inherently sustainable for several reasons.  First, there is no doubt about the impact of the project; energy is measured in universal and harmonized units, backed by markets and regulatory agencies. In addition, the energy sector has made so many advancements in renewable technologies and innovative solutions. Even a fossil fuel investment can be structured in a way such that net zero emissions goals are attained, and indeed in parallel with a strong reforestation program, can be transformative for nature and biodiversity.

Like infrastructure investments, energy investments require revenue models that include a stream of paying customers. Indeed, most energy investors are looking for economies that have already reached a tipping point in terms of development. A solar farm or an LNG terminal will help a growing economy scale, and a coal-fired power plant remains a safe, bankable investment in Africa, Latin America and China.  Although there are so many other investments that are more critical from the perspective of meeting sustainable development goals, these projects are not necessarily suitable for investment funds due to their size or risk profile.

So how does one invest in energy where there are no paying customers? Or, more basically, how do you create an economic ecosystem that lays the groundwork for investment in a medium-sized energy project?  Creating a long-term conducive economic ecosystem for such energy projects is really more about supporting the local environment than simply buying solar panels.  I argue that all ecosystems for investment start with incremental investments in education and agriculture, but that the philanthropic and microfinance models have not achieved the scale needed to meet the sustainable development challenges of our time.

CPM