Why the conventional theory of change behind mainstreaming sustainable finance and impact investing needs an update

Young-jin Choi
11 min readJun 15, 2024


Photo by Javier Allegue Barros on Unsplash

The conventional theory of change for sustainable finance

I recently came across a letter to the EU commission with suggestions for improving the SFDR, co-signed by a numerous European impact investing organisations. It had been written with the goal to “accelerate the growth of European investing for impact markets”. Much like the promotion of sustainability reporting standards (such as the ISSB) as catalysts for more capital allocations with positive impact, the letter represents an example for a conventional theory of change (TOC) that appears to be rather common within the sustainable finance and impact investing community. Accordingly, it is believed that improved non-financial disclosure and transparency (including better data, reporting standards and labels), can somehow unlock sustainable capital allocations at a substantial scale. The conventional TOC basically assumes that institutional investors:

  • have access to a wide universe of (often overlooked but rather well performing) positive impact assets to choose from — if only they could identify them more clearly
  • have the power and influence to drive a company’s (or industry’s) transformation towards better and profitable sustainability performance, e.g through engagement — if they only were better informed

Therefore, if institutional investors are failing to allocate substantial amounts of capital into positive impact assets, or to drive the rapid transformation of negative impact assets, it is assumed to be mainly because they are not sufficiently well-informed. Unfortunately, these assumptions are misguided and urgently need an update.

Understanding the root cause behind the unmet need for sustainable finance

It is important to recognize that the main barrier to scaling sustainable finance and impact investing allocations to the levels needed to effective address the present polycrisis (most urgently the climate crisis) is NOT a lack of transparency, data, standards, or labels. Of course, improved non-financial transparency can be helpful to inform shareholder engagement within the constraint of economic feasibility. But the advocacy for it as a main driver of societal change efforts can be distracting and might untentionally facilitate the delay of more fundamental systemic design modifications. Instead (following arguments made by the IMF and a majority of leading economists) the key obstacle to an acceleration of sustainable/impact finance is market failure: The failing of current (and past) market price signals and profit margins to sufficiently align with an urgent unmet demand from human societies for a climate-neutral and sustainable economy, which has become a matter of survival for young and future generations.

Manifestations of market failure

Market failure is the root cause for the well-known SDG/Climate financing gaps (at a scale of USD trillions) being as large and persistent as they are. Inspite of considerable (and still continuing) cost reductions for climate solution technologies in recent years, too many societal welfare improving activities are still not profitable/cost-effective enough, while too many welfare-destroying business activities — most prominently conducted by fossil fuel companies — continue to be too profitable. At the same time, this market failure also represents a failure by governments to cooperate internationally and to effectively regulate welfare-destroying market price signals. A few examples:

  • The fossil fuel industry is not only excessively subsidized, but generates obscene profits at the price of the loss of our common future. These profits are undeserved and serve as a powerful perverse incentive to capture the democracies that we know today. Besides greater climate science literacy, a fossil fuel non-proliferation treaty and demand side climate policies are missing.
  • High GHG emission producing materials, goods and services — including e.g. cement, gasoline, heating oil, red meat and aviation — are far too cheap considering their contributions to planetary climate damages and losses for centuries to come. A proper global carbon pricing & CBAM scheme (outside of the EU) is missing.
  • Climate-positive nature-based solutions, sustainable afforestation and old forest protection, regenerative agriculture, and many unrealized (under current market price signals insufficiently “profitable”) decarbonization and renewable infrastructure projects are struggling to meet the minimum financial performance requirements of institutional investors. It is a pity. A Global Carbon Reward is missing.
  • Capital costs in emerging economies are too high. From the perspective of developing countries, it is more “cost-effective” to keep using fossil fuels (and generate export revenues) rather than leapfrogging with investments in renewable energy. Access to low-cost/catalytic capital at sufficient scale is missing.

The problem with the conventional theory of change

The difference between market failure and market inefficiency

It is worth noting that the understanding of the term “market failure” in the context of the climate crisis presupposes that the market is a social construction whose ultimate purpose it is to serve human societies and help generate societal welfare. This means that the market failure behind the climate crisis is not the same as the market imperfection known as “market inefficiency”. The term “market inefficiency” refers to suboptimal allocations of capital owing to misperceptions of the proper economic value of assets based on a given economic system design. These misperceptions result in temporary over- und undervaluations, which in turn can culminate into speculative bubbles and financial system crises. Yet, a market can be perfectly efficient within a given system design and still catastrophically fail to internalize externalities, such as future societal welfare. Indeed, a certain degree of market efficiency is actually a requirement for regulatory measures — such as adjusting price signals — to be effective. Currently, capital markets in the Global North can be assumed to be relatively efficient (although far from perfect, as the last financial crises demonstrated). However, the efficiency of capital markets in the Global South urgently needs to be improved, given overly high capital costs and financial return requirements for investments in improved sustainability.

Shareholder primacy

The conventional theory of change overestimates institutional investors’ degrees of freedom. Its underlying assumptions don’t adequately account for real-world constraints such as hard financial performance mandates, ambiguously defined legal (fiduciary/corporate director) duties and a deeply integrated societal norm of shareholder primacy. Shareholder primacy is the greatest obstacle not only to corporate sustainability, but also — in combination with market failure - to more impactful mainstream capital allocations. In theory, the concept of fiduciary duty does seem to offer room for broader, long-term oriented interpretations. But in practice, in the context of a competitive environment, institutional investors consistently operate under rather narrow interpretations. These are limited to financial materiality within short-term oriented capital markets, and mandates that effectively prohibit asset managers from allocating capital outside a given norm of financial risk and return. In other words, the primacy of financial return and risk considerations for institutional capital allocations is not simply the result of lack of will, motivation, or intelligence on the side of institutional investors. It is largely the result of an inability of fiduciaries to invidually try to fix market failure by making voluntary concessions on financial performance without a corresponding mandate to do so. Milton Friedman’s (not entirely unjustified) doctrine that such philanthropic acts ought to be decided by the beneficiaries themselves and not their intermediaries/agents (who are expected to adhere to the rule of law) has become an integrated feature of the present system design. In addition, liability risks, career risks and competitive pressures serve as further deterrents for deviations from the norm of shareholder primacy.


Even if capital allocators personally wanted to consider “impact” with an equal decisive weight as “risk” and “return”, they couldn’t freely do so in practice. As the previous section argued, any voluntary surrendering of competitive advantage or economic value to prevent humanity’s downfall is currently outside the mandates of institutional investors and corporate direcors alike. The possibilities for institutional shareholders to force profitable portfolio companies into voluntarily reducing their economic performance are thus very limited. Shareholder resolutions on climate action can be supported by institutional investors only to the extent that they don’t jeopardize their company’s near-term enterprise value. For as long as fossil fuel companies are allowed to be as profitable as they are, it is very difficult for institutional shareholders to engage with them forcefully without exposing themselves to liability risks for breach of fiduciary duty (or competition law). To the extent that proper policy responses are predictable in the near-term, it might be reasonable for investors to push for anticipatory action. But the likelihood of specific policy responses 1) is a matter of perception and worldview, which currently diverges dramatically when it comes to the reality of the climate crisis, and 2) can be influenced by election results, corporate lobbying, political donations and disinformation campaigns — an institutional weakness which the fossil fuel industry has relentlessly exploited to date. With hardly any regulatory limitations on corporate/industrial lobbying in place, special interest groups are allowed to make every attempt at delaying climate policies and weakening current democracies through disinformation, lobbyism and corporate capture.


The signaling effects of public market divestments and capital allocations on a company’s cost of capital are subject to significant academic controversy. However, independently from the strength of signalling effects, it is usually the case that divesting fossil fuel assets has no real-world impact on GHG emissions as long these assets are not retired but keep operating under new (often private) ownership. Sadly, there is no shortage of unscrupulous bad actors, like EPH Group, for example, who seek arbitrage opportunities at all ethical costs. Since it cannot be a sustainable investor’s responsibility to voluntarily retire fossil fuel assets at substantial economic losses, it is necessary for market, technology and regulatory forces to drive the early retirement of fossil fuel assets. It is therefore an often overlooked but important upside of divesting that asset managers become free from conflicts of interest. Unencumbered by the obligations of fossil fuel shareholdings they can then publicly advocate for legislation that accelerates fossil fuel asset stranding. Moreover, considering the severe risk of future asset stranding — by regulatory and/or geophysical forcing — , the preferable position is not to be invested in fossil fuels at all.

The universe of investable assets

The possibility to shift capital allocations away from profitable and legal negative impact assets towards positive assets impact depends on the availability of a sufficiently large universe of investable investment opportunities. Under current market pricing conditions, the universe of investable high impact / high financial performance assets is confined to a relatively small niche that is not “mainstreamable”. Improved disclosure standards (including attempts at integrating non-financial impact accounting into financial accounting but with no cashable impact on the bottom line) cannot substantially change the size of this niche. This is because “investability” is essentally a function of expected cash flows and risks, while the Global North’s capital markets are already operating relatively efficiently: Most investable opportunities are rather quickly identified and exploited. Absent new mandatory guardrails (e.g. negative impact assets being phased out or exposed to prohibitive liability and stranded asset risks) and/or new sufficiently strong cashable rewards (or penalties) for positive (or negative) impact performance, there is little leeway for capital allocation shifts at a meaningful scale.

An updated theory of change for mainstreaming sustainable finance and impact investing

The previously described constraints support the need for an updated theory of change, one which targets the systemic root causes of the current economic system’s unsustainability. This update is based on the general premise that the economic system is not following a direction set by the financial system, but that it is the other way around: the financial system is following the dealflow of investment opportunities that are compatible with a given mandate. It is therefore necessary to expand the universe of investable positive impact assets while simultaneously downsizing the universe of investable negative impact assets. To this end, an updated theory of change recognizes three leverage points as key accelerators of a sustainable transition in the near-to mid-term:

  1. Legal mandates/duties and mandatory standards
  2. Incentive structures/market price signals and
  3. Targeted (catalytic) public spending

Legal mandates/duties and mandatory standards

Legislative measures can change the “rules of the game” in favor of positive impact. Examples include establishing effective liability risks and penalties for unsustainable business activities, a duty to protect the public interest, strengthening of the legal standing of nature and young/future generations, or extending the current definition of fiduciary/corporate director duties by a clear mandate to avoid severe social or environmental harm. Similarly, mandatory sustainability standards for real-economy business activities can ensure, for example, the timely phase-out of high carbon intensive technologies in favor of low carbon substitutes.

Incentive structures/market price signals

Changed economic incentives and market price signals represent another potential game changer. The IMF argues in favor of carbon pricing as one of the most promising measures to manage the climate crisis. Indeed, the more profitability patterns and price signals can be improved and re-aligned with the actual needs of human societies, the more the current SDG/climate financing gaps (going into the trillions of EUR) can be closed. In contrast to the rather benign SFDR, the EU’s emissions trading system (ETS) and carbon border adjustment mechanism (CBAM) are examples for regulatory measures that significantly modify current economic inventives structures and proftability patterns. They represent effective system-transforming and transition-accelerating government interventions.

Targeted (catalytic) public spending

Finally, the important enabling role of public investment and procurement (which has more degrees of freedom to prioritize the public interest over financial performance) tends to be underappreciated. A recent scholarly article, for example, offers an insightful summary How outdated economic beliefs are holding back public investment” (section 3). The case for a mission-driven entrepreneurial problem-solving state has been convingly made by Marianna Mazzucato, for example.

A transition into a sustainable economy requires a redesign of the economic system

Behind the escalating climate crisis and humanity’s insufficient response to date are deep flaws in the economic (and financial) system design. In the end, the financial system can be only as sustainable as the economic system’s design permits. This means that the current failure to internalize externalities, to properly reward sustainable societal welfare creation, and to properly penalize societal welfare destruction through unsustainable business activities, can and must be fixed at the economic system level. Structural economic system reform and mission-driven public finance utilized to its full potential are the key to mobilizing those “2% more” sustainable/impact-driven capital allocations that the world so desparately needs right now. If the economic system transformation fully succeeded this way, a deeper financial system transformation wouldn’t even be necessary any more: As reaching net zero by 2050 sustainably and equitably becomes increasingly cost-effective and investable, and as fossil fuel production/use becomes increasingly costly, capital would increasingly flow to where it is actually most needed. There would be no more economic tradeoff between financial performance and preserving humanity’s future. The climate finance (and SDG finance gaps) could be quickly closed.

A new agenda to mainstream sustainable finance and impact investing

In essence, the conventional theory of change represents an apolitical worldview, in which the economic system design is assumed to be static, and the rule of law primarily exists to protect social order and enforce contracts in an efficient market. Both retail and institutional investors alike are seen as consumers, who need better information to make better decisions. But financial markets are fundamentally different from consumer markets, where human consumers make purchasing choices based on perceived utility and personal preferences. Instead, the main purpose of the financial system is to provide companies in the real economy with access to capital as efficiently as possible, which necessarily limits the choices that can be made by institutional investors. In reality, the “rules of the game”, the legal mandates and market price signals under which economic agents operate, are not set in stone: They can be deliberatly modified by virtue of legislation and international cooperation. Employees and decision makers are not only consumers but also citizens, on whose support climate policy making crucially depends. In this context, investors and companies represent political stakeholders with a considerable voice and influence, too. As the window of opportunity for rapid and urgent climate action keeps getting smaller with every passing year, it is to be hoped that sustainable finance and impact investing organisations soon begin to throw their full collective political weight behind an updated theory of change: One which prioritizes the advocacy of systemic measures that aim to effectively address market failure in the real economy.