The liberal democratic, free market economy has generated significant wealth for the world. However, it also appears to tend toward an unequal distribution of that wealth. One plausible reason lies in the unequal scalability of inputs to production. Labour is weakly scalable, capital more so, and intellectual capital close to limitlessly scalable. Ownership of capital and intellectual capital, combined with the ability to bequeath such assets across generations, concentrates claims on future income and increases inequality over time.
Inequality beyond a certain threshold is undesirable, if not on social justice grounds, then on efficiency grounds. It unevenly weights the consumption and allocative votes of economic agents, leading to less than optimal outcomes. It also blunts economic analysis and policy formulation. Many economic models implicitly assume a zero Gini world by treating agents as identical, which is analytically convenient but descriptively false. In reality, inequality leads to over saving, as marginal propensities to consume decline with wealth. Over saving depresses the cost of capital and inflates the value of assets relative to labour, reinforcing the underlying dynamic. This helps explain why capital can feel abundant and scarce at the same time.
The purpose of financial capital, hereafter simply capital, is to finance economic activity, whether consumption or investment. What, then, is the purpose of impact capital? The distinction can only arise if impact capital funds things that broad or conventional capital will not fund. Since funding is only relevant to activities that people or societies want, impact investing may be sharpened to: funding things people want but do not want to fund.
Why might people not want to fund something they nonetheless want? The simplest answer is that they do not expect to obtain a reasonable return on conventional terms. This may be because the good in question is a public good. Everyone wants it, but no one will pay for it. Once supplied, no one can be excluded from consuming it, and consumption does not exhaust it. Someone else is therefore always expected to pay, which in practice often means no one does.
Alternatively, the activity may be privately supplied but subject to extreme uncertainty. Expected returns may be high, but the range of outcomes may be wide, or the time to exit long and indeterminate. Such projects fall outside the risk tolerance or time horizons of conventional capital, even if their social value is large. Early stage climate technologies provide a familiar example. Many promise enormous long term social benefits, but face uncertain regulatory environments, long development cycles, and unclear exit paths. As a result, they are often starved of capital precisely when additional investment would matter most.
Impact capital, then, exists to resolve capital allocation failures. If a project would have been funded anyway, at scale, on similar terms, without impact capital, then impact capital is not needed. High return, easily funded projects fail several tests of impact. Capital is not scarce, risk is not mispriced, and time horizons are acceptable. In such cases, impact capital has little or no marginal value. Its use crowds out conventional capital, risks subsidising returns that do not require subsidy, and misallocates scarce impact capacity. This is where much of what passes for impact investing goes wrong.
The contribution of impact capital can be understood in terms of an efficient frontier. Conventional capital operates along a frontier that maximises financial return for a given level of risk. Impact capital is justified only where it shifts that frontier, where, for a given level of financial return, it produces greater social value, or where, for a given level of social value, it accepts lower returns, greater uncertainty, or longer duration. Impact is therefore not defined by intent alone, but by the extent to which capital is deployed beyond what markets would otherwise provide.
Why should impact capital fund public goods and risky endeavours in particular? Risk aversion declines as wealth increases. An individual’s first million is risk averse, the next ten million less so, the next hundred million less still. Those with surplus capital possess a greater capacity to absorb volatility, illiquidity, delayed payoffs, and partial failure. If progressive tax systems are justified in part by diminishing marginal utility of wealth, a parallel justification exists for progressive risk bearing. Those with greater wealth are less harmed by failure and uniquely positioned to fund projects whose benefits are diffuse, long dated, or imperfectly captured by private returns. Put more bluntly, they can afford to be patient or bear losses when others cannot.
Impact capital should therefore be understood not as a substitute for conventional capital, nor as a moral overlay on profitable investing, but as a complement. It is capital deployed where markets systematically underprovide, and withdrawn as markets mature. Its purpose is not to maximise returns with a conscience, but to expand the set in which socially valuable activity can occur.