Monday, June 04, 2007

Structural incentives for aligned investing

There really isn't a free market in the U.S., or anywhere. Government regulations, global trade agreements, and tax structures shape what gets made where, who can buy it, at what cost, and how things travel around the globe.

So, when you think about entrepreneurship, new markets, new fuels, new tools, and capitalism you have to think about the regulatory, legislative, and tax systems that shape them. Those who really understand how capital markets work understand, deeply, how these systems are shaped by government controls - the presence, lack, or tightness of those controls is what matters.

The structural systems of laws and regulations can be particularly powerful in sparking new products, companies, industries and markets. My favorite example is the investment and securities industry. Charles Schwab revolutionized brokerage services in May 1975 when brokers commissions were deregulated by the Securities and Exchange Commission. Discount brokerages are an industry birthed whole by an SEC regulatory change. In turn, brokerages such as Schwab, E*Trade, and AmeriTrade brought the securities markets to main street, at least partly resulting in an America where more than 50% of the population owned stocks in 2006, compared with 10% of Americans in 1929.

Here's another example of how regulations shape markets, for both vendors (See brokerages above) and consumers. Most Americans who own stock do so through 401K plans. These plansInternal Revenue Code - exploded in size and number in the last decades -
- created by and named for a paragraph deep in the where there were 17000 plans with 10 million participants in 1985, by 2005 there were 400,000 plans with 50 million participants and nearly $3 trillion in investments under management.

Why do these stories matter? Because the 1975 SEC regulation that gave birth to discount brokerages didn't suddenly come about - it was the result of lobbying and lawsuits. The 401K plan and the paragraph that underlies it (literally), as well as subsequent changes in pension laws get written because of deliberate support and lobbying by groups such as the American Benefits Council and the ERISA Industry Committee.

This is how laws get made, how markets get structured and - sometimes, as in the examples above, - how whole new industries (discount brokerages) or products (401k plans) happen. It is happening now with alternative energy - huge efforts are underway by everyone from electric car manufacturers to venture investors to the solar lobby to the coal (!) industry - to shape the regulations and incentives that will shape America's investments in alternative energy. These folks know that if you want to make a market first make the regulations.

So where are the advocates for socially responsible investing, new corporate structures, or mission-related investing in all this? They are active on the supply side - new products and investment vehicles and new structures or associations that foster social entrepreneurism are developing almost daily. This is wonderful. But what an irony that these folks, who the blue-blood portfolio managers of Wall Street often deride as a bunch of "underperforming shirkers of their fiduciary-responsibility" are trying to build a market without tax incentives, whereas "free market" activists hold nothing back when it comes to rewriting pension laws, estate tax precedent, and energy regulations that will benefit their pursuits.

When we think about the deployment of philanthropic capital and the creation of social capital markets, I recommend we take a page from the play book of those who have created widely successful financial products and markets before us. It is fabulous that more and more "blended value" product options and vendors are available to interested individuals and institutions. It is wonderful that new corporate structures such as the B Corporation are coming on line. These kinds of
disruptive innovations are great and they can build companies, they won't sustain whole industries or markets.

If we really want to catalyze a movement of investments and entities that promote and pursue sustainable values, products, and practices we need to do more than play as if there are free markets. We need to get smart - and active - about the structural regulations and incentives that can make these lofty goals viable, vibrant, market-changing mechanisms. In other words, we've got to think about tax incentives, structural supports, and regulations.

These things ain't sexy. However, history shows that they are what matters when it comes to building and sustaining new markets, new industries, and new financial practices.


Pete said...

Great point. The idea you posted earlier about modifying the tax-exempt treatment of returns from non-aligned investing would be a good start. Also, as your examples suggest, investment firms looking to offer aligned investment products may become allies of such a push (strange bedfellows), and may offset or overwhelm opponents. A tax or reg change would have the secondary effect, too, of legitimizing the aligned investing approach, and hand foundation staff some leverage to use in their internal debates with board members. In this way the monetary value of the incentive might be less important, though it must be real, not simply symbolic.

Sean Stannard-Stockton said...

Lucy, I completely agree with you. However, regulatory & tax action (either removing regulations, as with the Schwab example, or adding new regulations) is often like swinging a sledge hammer. It can get the job done, but it is hard to have the precise effects you want. I think your proposal to tax endowments if they aren't mission aligned, before a real market place of mission aligned investments exists, is too heavy handed and would have unintended consequences. But I would support regulatory or tax action to try and spur the development of mission aligned market places.