Transformation Capital: A Systemic Approach Towards Sustainable Finance

Over the past decade, dozens of sustainable finance initiatives (SFIs) have set out to mobilize climate finance at the trillion-dollar scale, a welcome and important effort. Yet even if they succeed at closing the investment gap, most are still bound to produce incremental outcomes at best in the place-based systems that matter for human prosperity. The root cause is that many SFIs remain steeped in traditional finance orthodoxy, are vague about the issues they address, and lack a robust theory of change that links their actions to their objectives. The consequence is that many SFIs act to preserve the structural fabric of capital markets, making small improvements on a status quo that is incompatible not only with environmental and social sustainability but also with the intent of long-term wealth preservation.

What we need now is a radically new approach to investing with the explicit aim of systems transformation — one that deploys capital with a broader intent and mindset; that is anchored in different methodologies, structures, capabilities, and decision-making frameworks; and that moves away from a project-by-project mentality to a strategic blending paradigm.

Transformation Capital is that approach, a holistic investment logic guiding the deployment of capital for the purpose of catalyzing sustainability transitions while generating commensurate financial returns. It recognizes the world as a complex adaptive system and embeds systems thinking, human-centered design, and sensemaking in all stages of the investment process.

Defining Transformation Capital

Put simply, Transformation Capital is a systemic investment approach for catalyzing sustainability transitions in the real economy. It is an investment logic at the intersection of systems thinking and finance practice. It aims to build a bridge between the Paris Agreement’s goal of realigning financial flows and the IPCC’s call for transforming socio-technical systems. It guides challenge owners and investors in the real economy in deploying capital for transforming place-based systems, thereby contributing to the global effort of building a future-proof version of capitalism.

This investment logic perceives “Blended Finance” not only as a risk transfer but rather as generating combinatorial effects that arise when a portfolio is constructed in a way that generates strategic synergies amongst its assets. The point is to turn positive correlation from a risk to avoid into an opportunity for driving change.

Researchers from University College London have modelled the benefits from such an integrated portfolio approach in the context of mission-oriented urban development. They were able to show that combining projects with different typologies and risk/return characteristics not only converts some projects from non-viable to investable (through cross-subsidy effects) but also maximizes non-financial benefits at the portfolio level.

Building strategic portfolios also offers an opportunity to address two structural issues of climate finance. One is the aggregation problem, the notion that the single-asset approach causes large transaction costs and limits scalability. By combining several assets across multiple asset classes, strategic portfolios offer a practical pathway to scale and thus address the trillion-dollar SDG investment gap.

Strategic portfolios also offer an opportunity to rethink the role of the public sector. By framing subsidy schemes, tax benefits, and other public finance instruments as investments in public goods, public sector bodies (and the taxpayers on whose behalf they act) become a more integral part of capital markets. This creates an opportunity to forge contractual arrangements that share risk and return more equitably amongst those who finance the change.

Impact Investing vs Transformation Capital

The Global Impact Investing Network (GIIN) defines impact investing as “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return”. While Transformation Capital falls under this broad definition, it differs in important aspects from traditional approaches to impact investing.

First, it intends to catalyze deep, structural, and irreversible change at the level of whole socio-technical systems. The scope and ambition of this intent surpass those of most traditional impact investors, who tend to focus on specific, and often localized, outcomes.

Second, whereas traditional impact investing tends to follow the single-asset approach, Transformation Capital puts strategic portfolios and nesting, the deliberate synergistic alignment of an investment portfolio with a broader system intervention approach that encompasses non-financial levers of change, at the heart of its investment logic.

Finally, whereas traditional impact investing tends to adopt current capital market orthodoxies, with the (incremental) addition of non-financial metrics to selection and accountability frameworks, Transformation Capital seeks to change the paradigms, practices, and structures of investing, bringing innovation to almost all stages of the investment process including value models, methodologies, analytical frameworks, partnership structures, financial instruments, and learning protocols.

cf. Friedman, A., and Hatheway, L., How Capitalism Must Change to Survive the Pandemic, published in Barrons on 20 April 2020, available here

cf. World Economic Forum (2019), The Global Risks Report 2019 – 14th Edition, available here

Dominic, H. (2020), Transformation Capital – Systemic Investing for Sustainability, White Paper, Klimate-KIC, available here

Matti, C. (Editor) (2020), Challenge-Led System Mapping – A Knowledge Management Approach, published by EIT Climate-KIC, available here

Medda, F., et al. (2013), Assignment 29 – Strategic UDF Investing and Project Structuring, submitted to the European Investment Bank, published by Mazars LLP, available here

Mazzucato, M. (2015), Mission-Oriented Finance for Innovation: New Ideas for Investment-Led Growth, Policy Network