Systems Change Financing Needs to Change

(Illustration by iStock/sombatkapan)

“Systems change” has become a ubiquitous topic of interest for anyone serious about addressing our multiple social-environmental-economic-governance crises. Yet for all its ubiquity, the term tends to be applied very loosely, to many different things. Sometimes it means changes to an old system, but it might also be used to describe the expansion of an old systems change that has since been superseded by a new approach. Diverse perspectives on systems change are valuable, but a cacophony of different meanings can confuse the issue and produce ineffective investment strategies, even contribute to deep problems in financing change.

In our view, systems change is best understood as comprising three distinct types of change: experimentation, redesign, and optimization. Clarifying these interconnected modes of change helps distinguish understand the different processes at work: “experimentation” means a change in goals and values, and defining what is possible, “redesign” means a change in rules and processes to create an enabling environment, and “optimization” means spreading the implementation of that change as broadly as possible. Each mode of change requires different financing approaches: experimentation is usually done by novel and alternative financiers. System redesign involves changing behavior and products of existing financiers whereas in the system optimization phase both alternative finance and altered financial products are scaled up.

 

1. System Experimentation

At the beginning of a potential transformation, a fundamentally new and disruptive activity or practice arises that will require broad economic, social, political, and/or cultural changes for its wide application. Whether or not those leading the activity may or may not have a transformational intent, the innovation is transformational if it requires an “opening up” of the traditional system’s assumptions, values, and fundamental goals. At this stage there are also, typically, alternative transformation models: with the invention of individual self-propelled vehicles, for example, steam and electric technologies competed with gas-powered ones, while wind and solar are only two of the numerous technologies involved in the clean energy transition.

2. System Redesign

After potentially viable prototypes are identified, a transformational innovation requires changes in the enabling environment that could support its widespread adoption. This is the “field development” stage of building new policy frameworks, as well as both organizational and physical structures to support the implementation of the transformational innovation. When the new enabling environment is destabilizing, habits, preferences, structures, and popular practices must also be changed.

For example, popularizing motorized vehicles required new regulations and laws, and a whole set of innovations in road design and associated infrastructure, such as auto associations and repair locations. By the same token, the energy transition has required investment in new transmission lines, electric charging stations, and laws such as those to support the sale of excess energy by homes generating energy through solar panels.

At this stage, when different options have arisen, values can provide a way forward. The 1991 German energy transition framework, for example, emphasized the values of resilience, decentralization, and greater spreading of economic benefit, which led to an emphasis on the use of solar panels on homes and wind turbines on farms. (It also severely disrupted the traditional energy industry: Germany’s top utility supplier, E.ON, moved away from its traditional coal and nuclear power businesses entirely to focus on clean energy, co-op structures increased in importance, and Siemens divested units relating to its gas turbine business). By contrast, the Americans and British never brought values into their clean energy plans, and have simply assumed the traditional corporate delivery structure, leading to a focus on large solar and wind turbine installations with vulnerable centralized structures and economic benefits staying with the traditional wealth holders.

3. System Optimization

The vast majority of financiers’ efforts focus on spreading and scaling the change as broadly as possible, though there are two basic kinds of activities. First, there is the widespread adoption of an innovation (the stage in the clean energy transition that is associated with the widespread use of electric cars and the availability of clean energy through new generation facilities and adapted transmission ones). The second is incremental improvements, such as the ongoing improvements with batteries to extend their storage capacity, and thus improve the efficiency of the innovation.

Financing Three Types of Change

Seeing systems change in this way helps clarify both the type of investment required and its optimum sequencing.

1. Private Capital

This sector focuses on system optimization rather than system redesign or transformation. Since private investors focus on their return on investment, they tend to rely on market structures and other institutions. Their need to quantify risk and for impact to correspond to their current business model (and a short-term investment horizon) usually means a desire to finance proven technology/solutions, meeting compliance requirements, and pricing risks appropriately. This group represents the largest available volume needed for scaling up production (for example, the huge amounts invested in battery production) and includes not only Environmental, Social and Governance (ESG) but also commercial (institutional) investors and mainstream banks.

2. Public Sector Capital

Public sector capital plays a key role in financing system experimentation and system redesign, because this group of investors mainly relies on societal return on investment as its key metric. Hence governments can sow the initial seeds for system redesign, enable the relational infrastructure by financing cooperative R&D and demonstration, and complement the creation of new structure (policies) with mission-oriented investments, as Mariana Mazzucato has argued for the last decade. For example, state investment banks such as the German KfW financed “first-of-a-kind” commercial projects and charging infrastructure.

3. Philanthropic Capital

Foundations and charities, funded by high-net-worth individuals, focus on societal return on investment only and in line with their (diverse) missions and sector knowledge. They can therefore act as specialized investors in the early stages of system experimentation, in niche areas such as the early developments of impact investing as a field. Their experimentation needs to be bundled to challenge existing paradigms in the financial sector and/or significantly influence energy or mobility regimes.

What Does This All Mean?

1. Systems Change Is an Ongoing, Evolutionary Process

One form of systems change builds on another in spirals of transformation. The discovery of oil and gas as fuels spurred innovation that passed through the three types of change: developing extraction and power technologies (system experimentation); regulation, new production networks and skills (system redesign); and heating, gas-powered vehicles and electrical generation (system optimization). We are seeing the same process in clean energy technological innovation, as clean technologies are being identified (system experimentation); new regulations, transmission networks, and skills are developed (system redesign); and commercial electric vehicle production and heat pumps are optimized.

2. Optimization of the Old and New Occurs at the Same Time

Can systems change occur “incrementally”? That common question is really about the stage of system optimization. A new technology like clean energy takes time to adopt broadly, which is incremental, and the new technology is incrementally improved as it is adopted. However, incremental improvements are also occurring with the old technologies at the same time: with energy, this includes fracking, fuel efficiencies and carbon sequestration.

Systems change investors and funders need to ask if they are addressing social and ecological goals at a fundamental rather than a cosmetic level. In the short term, for example, a focus on energy efficiency with carbon fuels makes a positive contribution. However, it does not constitute investing in systems change; rather, it is simply optimizing the old system and extending its life. The same is true of many investments that may claim to support systems change but, in fact, simply produce modestly different triple bottom line impacts. A systems change innovation disrupts the inertia of dominant power relationships and gives life to a new set of values (such as sustainability).

3. Strategies and Tools Require Alignment With the Type of Change

Distinguishing between different types of change helps align the appropriate strategies, tools, activities, and goals with the qualities of the type of change in question. For example, system experimentation cannot be informed or guided by key performance indicators (KPIs), which is a measurement framework more suitable for system optimization. Other evaluation approaches—such as principles-based evaluation and formative evaluation—are more appropriate for system experimentation.

4. A Systems Change in One System Opens Up Possibilities in Others

When the Germans originally approached the energy transition, they realized that it presented a huge opportunity to make changes to the economic system to develop economic equity, resilience, and decentralization. Similarly, a narrow focus on increasing food production ignores the potential for a redesign that includes more locally grown food on more locally owned farms that address issues of energy transportation costs, environmental impact, wealth concentration and absentee owners. Systemic investing approaches reflect an understanding of the interconnectedness of systems with the scale of aspiration for change in multiple systems that is required to address the complex, large scale challenges and opportunities of today.

5. Financiers Must Undertake Systems Change, Too

Funders and investors are often reluctant to seriously address how their practices, values, and mental models generate the inertia that is a source of the many crises of today. Despite extensive critiques of how foundations’ policies, structures, and processes are inhibiting systems change, foundations are extremely slow to make their own changes. Similarly, private high-net-worth individuals continue to place importance on increasing their own financial wealth in the short- and medium-terms, aggravating negative externalities like economic inequity. Systems change is not simply a financial allocation question; it requires personal and organizational change and the courage to go against many cultural-economic norms.

6. The Blended Capital Conundrum Is Significant

Governments and philanthropic investors have good reason to ask whether blended capital arrangements simply subsidize conventional investors. The Chinese have been particularly successful in the energy transition because of massive government support and investment in system experimentation and redesign, but the West has become paralyzed by a market- and consumption-focus that starves financing of the system experimentation and system redesign types of change. Markets only invest in these sorts of systems change with significant subsidies and/or relatively short-term, simple, and low-risk physical technologies, such as those associated with computers. Of course, one avenue is to tax the profits from the system optimization of old systems more highly and channel the proceeds into systems change and redesign. Another is to create a new social contract with capital to lower return expectations.

7. Financing Today’s Many Crises Is About Financing System Experimentation and System Redesign

From a financing point of view, the traditional means of financing the first two types of change (system experimentation and system redesign) is being overwhelmed by the scale of our crises. The inadequacy of the investment structures for that stage is giving rise to calls for changes to the finance system that go beyond the ESG and impact investing approaches. A recent United Nations Environment Programme report commented that “realignment of the financial system is a critical enabler of the transformations needed” while the COP27 President called for
“a transformation of the financial system and its structures and processes.”

Systems Change Is a System That We Need to Change

Systems change financing must itself be developed as a system that finances the three types of change, at the scale and with the ease required to address today’s multiple and unprecedented crises. This involves a much more sophisticated understanding of the qualities and needs of the different types of change and a much greater commitment by all financiers—philanthropic, governmental, and private—to make that change possible. It requires, in short, taking a systems change approach to financing, itself.

Read more stories by Steve Waddell & Friedemann Polzin.