Saker Nusseibeh - Hermes Investment Management
We are finally starting to realize on an official level that our economies, our industrial activities, and our financial decisions have a very direct and tangible impact on Earth, and the sustainable development of human civilization.
The Paris climate change agreement and the UN global sustainability goals are a testimony to this fact. All this is good and great. However, we have a much deeper challenge to face, and a more radical shift is required in our mindset in order to truly usher in the wave of change needed.
Money and finances are key to almost every type of new initiative. From software design to the latest app, from industrial manufacturing to the latest gadget, from agriculture to the latest genetically modified tomato, finance and capital allocation determine what gets done, and what stays in the realm of ideas.
Indeed, in order for an idea to be funded, its value has to be established for those who are considering investing or raising the funds.
The problem is that we seem to have a dichotomy between what we perceive to be solid economic and financial rules and our unease about the effect of our economic activity on the ecosystem we live in.
It is interesting that many investment houses are now moving to say that they now consider ESG factors in their decisions, as are companies. They are doing so because COP21, hopefully, has finally underlined the point that the impact of our investment and commercial decisions are both long term and profound.
Armen Papazian, CEO of Finoptek
However, it seems to us that in considering these factors, investors, like executives, are looking at it as an additional risk mitigation overlay to normal or standard economic and financial metrics. That to us is a profound problem in that it seems to separate out what are accepted ‘normal’ economic-based decisions and ESG considerations.
Under this scenario, for example, BP’s decisions were logical financially, except that the management failed to mitigate the possible financial risk of an ecological disaster. Surely, this artificial separation between ‘normal’ economics and ESG considerations is neither workable in the long term, nor logical, for ESG matters, then surely it has to be part of the economic and financial framework.
Traditional economics and finance has taught generations of company executives, investors and regulators to value money through the lens of two major parameters, risk and time. Open any finance textbook, advanced, intermediary, or beginners, and have a look at the two pillars of Value that these books teach. Across the planet, in almost all languages, when you are taught mainstream principles of finance, of value, you are taught Time Value of Money, and Risk and Return. This then forms the basis of all discounting models and asset pricing models used in finance today.
Adjusted, tweaked or not, these models derive their conclusions of value from the Risk Return and Time Return of investments, combining them into a rule(s) of decision making that treats the environmental and societal impact of the investment as exogenous. At best, the models deal with positive or negative externalities qualitatively, as an addendum to the core mathematically represented axiomatic relationships of monetary value.
We would therefore like to suggest that the current financial models are simply incapable of incorporating the environmental impact we seem to have agreed upon in Paris or the societal impact that was referenced in Davos. The current risk/time discount model is akin to a financial cyclops. Our contention is that a more robust financial model that can incorporate these ‘externalities’ financially in the calculation of risk and return is needed.
One that takes into account the impact of investment decisions on the environment and on society, (both positive and negative, so the impact on society might be positive if it creates employment for example). Professor Papazian is therefore proposing in his forthcoming book an amendment to the traditional time discount model to incorporate these outcomes financially. He calls this Spacetime, as opposed to our current Risktime limited model.
Such an amendment that incorporates the physical effects of investment decisions both on a company and investor level within the context of financial theory is sorely needed. Unless we are able to modernise our financial value models in this new ‘Spacetime”context, from the ground up, our ecological and environmental responsibility, which we say we are committed to, will have to be taken on outside the mainstream financial current.
Moreover, we will always feel we have to justify this concern outside of the accepted parameters of finance. We use the term ‘modernise’ here advisedly, for we note that while the ideas that form the basis of science are constantly changing and developing, those basic tenets that underline modern economic understanding have remained stagnant for well over a century.
The challenge for economists and investors therefore is, to evolve the theory and practice of finance, allowing its contextual modelling to shift, to embrace the impact of decisions of the ‘real’ world as opposed to remaining within the context of a ‘theoretical’ financial world and incorporate this impact in our financial value models, which we believe Professor Papazian’s formula does.
Indeed, from climate change, to waste, to debt, to increasing societal wealth disparity which is likely to lead to political instability, a creative adjustment is usually all that it takes to shift the mind from the position of needing a solution, to having a solution, and then living it. Consciously or not, individually, and as a species, we use creative adjustment all the time – we learn and evolve by making necessary changes to our own frame of mind.
The creative adjustment needed in finance and economics is crucial, and much depends on our ability to rethink our financial architecture and principles of value. We believe the-principle of the Space value of money, as proposed by Armen Papazian, introduces the missing context into finance, i.e., impact on the environment, the real economy, etc , and allows a shift in our contextual definitions.
Value creation in Spacetime is risky business, and as such, the assessment of risk remains relevant. Furthermore, space value and time value together allow for a better perspective and understanding of investments and their worth. As such, they are complementary.
When we choose to integrate spatial responsibility into the return and value calculations of an investor, we are in fact integrating space value and time value, entrenching our impact and our return into one holistic equation, where one cannot truly be achieved without the other.
We should be happy about the deal in Paris, we should also be delighted with the new global sustainability goals, but without a further push to transform the very core of financial value theory, and the subsequent education of our children, we are still flirting with change instead of implementing it.
Saker Nusseibeh, CEO, Hermes Investment Management