Sustainable Investing Is Booming — But Where Is the Impact?
By Florian Heeb (*) - 19. May 2020
The growth of sustainable investing is welcome news to those who believe a more conscious allocation of capital can cure society’s pains. A few years ago, sustainable investments were niche products. Now, almost every retail investing outlet offers a wide range of financial products marketed as sustainable. The increasing desire of investors to contribute to solving the world’s challenges is among the key drivers behind the trend. Accordingly, sellers of a large proportion of sustainable investing products make explicit claims of positive impact.
Truthiness abounds these days. The validity of sellers’ claims is less clear, however, for reasons ranging from inherent limitations in tracking consequences, to the real-world impact of investment decisions in generally efficient financial markets, to the vagueness and ambiguity of many claims, to, shall we say, cynical approaches to marketing. Start with the inherent difficulty with calculating the real-world impact of virtually any investment in the first place.
Capital for All That Ails
The Sustainable Development Goals (SDGs) are about as global a list of social and environmental issues as you’ll find. The SDGs include 17 development goals the United Nations has set for 2030 — for example, ending hunger and ensuring universal access to clean water, as well as mobilizing thorough measures to fight climate change. Moreover, the targets are ambitious, and reaching them will not be cheap. The UN estimates that every year until 2030, around $2.5 trillion in additional investment will be needed.
That sounds like a daunting figure. However, the Global Sustainable Investing Alliance recently estimated that almost $4 trillion is currently flowing annually into sustainable investments per year — much more than the annual financing required to reach the SDGs. So, why haven’t we solved the world’s problems yet?
Behind the Curtain
In a recent paper, my co-authors and I concluded that the current impact of sustainable investments is rather modest. There are two key insights into what impact means that help to explain why.
First, impact is the change that investors cause above what would happen anyhow. Having impact means that an action (in this case, an investment) results in real change — for example, a reduction in greenhouse gas emissions. It is crucial to think about what would have happened without that investment. Would greenhouse gas emissions have decreased as much (perhaps driven by market forces alone) regardless of the investment?
Second, an investor’s impact is not same as the impact of companies in the investor’s portfolio. Rather, it is the change in companies’ impact driven by the investment. It feels right to invest in companies that have an impact, but their impact is not your impact; distinguishing investor impact from company impact is critical.
For sustainable investing to make a vital contribution to solving the world’s problems, the focus needs to shift toward mechanisms that have a significant impact potential.
Company impact is the effect a company’s activities have on people and the planet — for example, by selling products that reduce greenhouse gas emissions. Investor impact is the change in company impact that is caused by an investor — for example, by enabling a company to sell more products that reduce global greenhouse gas emissions.
Unfortunately, investor impact and company impact are often conflated. Consider one self-proclaimed “impact mutual fund” that invests in public companies that contribute to the SDGs. One of the fund’s top holdings is Gilead Sciences, a large pharmaceutical company that develops and produces drugs for severe diseases such as HIV. Arguably, the company has a positive impact on Good Health and Well-Being (SDG #3). The number of HIV patients treated with the drugs produced by Gilead Sciences can be used as a proxy of company impact. The more difficult question relates to investor impact: What effect does an investment in the fund have on Gilead Sciences?
If I invest in the fund, do more HIV-positive patients receive treatment? According to our research, this seems unlikely: buying stock in a company of this size is not going to have a significant effect on its cost of capital or its ability to deliver life-saving drugs.
Three Ways Investors Do Matter
Our research shows that there are three fundamentally different ways of how investors can affect companies. In short, investors can support the growth of impactful young companies, use their influence to improve established companies or influence public agenda setting by signaling their values.
1. Support impactful young companies. Investors can make a difference by allocating capital to companies that contribute to solving the world’s problems but whose growth (in contrast to, say, Gilead’s) is limited by access to external financing. For example, investing in a startup that has found a way to make solar panels more efficient could have a big impact if the venture is struggling to raise the capital it needs to scale. Of course, such investments are not easy to find, and can be risky. But that is the heart of the matter: if a company already has easy access to the capital market at reasonable cost, which is usually the case with large, established companies, an additional offer of capital is unlikely to affect its growth.
2. Encourage change in established companies. Investors can become active owners and use their voice as shareholders to convince companies to improve their business practices. A common approach is to enter into direct dialogue with top management. To this end, it may be more promising to target companies that have a lot of room to improve rather than current sustainability champions.
For example, after a shareholder engagement campaign, the Chinese oil major Sinopec introduced measures leading to a dramatic reduction in methane leakage. While the oil produced by Sinopec still makes a sizable contribution to climate change, the reduction of emissions caused by this reduction in leakage of this super-potent greenhouse gas is substantial.
Alternatively, investors can encourage change by excluding companies that breach widely accepted norms — for example, companies that are involved in human rights violations. If a broad coalition of investors act together, it can incentivize companies to improve — for example, by introducing strict policies to uphold human rights in their operations and those of their suppliers. As for active ownership, it is crucial to aim for verifiable changes that companies can implement at a reasonable cost. This will not cause a revolution. But many small improvements sum up on a global scale.
3. Influence public agenda setting by signaling values. A prominent example here is the coal divestment movement. Simply excluding coal stocks from a personal portfolio has no measurable impact. It will primarily result in a reallocation of coal stocks to investors who do not look beyond narrow self-interest. (And there are many of them.) As long as coal extraction remains a profitable business, shares will be largely stable in value, and coal extraction will continue.
However, if prominent investors are vocal about their decision to boycott coal, this can influence the public discourse — for example, on the question of whether the government should halt tax breaks to coal companies. This may give the necessary cover to politicians and regulators to withdraw support from politically active coal interests. The political dimension is essential; investment products that merely refrain from investing in coal stocks are not really contributing to the fight.
The answer is not feel-good investments in established companies with virtuous track records. It’s in investments that otherwise wouldn’t happen.
The Real Levers of Change
So, where is the aforementioned $4 trillion going? The vast bulk is allocated either to products that integrate environmental, social and governance (so-called ESG) data into their investment process in public equity markets — primarily to optimize financial performance — or in products that exclude specific industries, mainly tobacco and weapons. Our research suggests there is little evidence that these two product types have a relevant impact.
For sustainable investing to make a vital contribution to solving the world’s problems, the focus needs to shift toward mechanisms that have a significant impact potential. More investments need to go to effective young companies that need capital to grow and develop solutions. Here, venture capital, private equity and private debt can play a crucial role.
Given the limited ability of most investors to bear the risks associated with early-stage, illiquid investments, the majority of sustainable investments will stay with established companies in public markets. In these markets, there is a vast potential to expand active ownership and conduct-based exclusions that encourage companies to adopt sustainable business practices.
Investors can play a crucial role in solving social problems in general and sustainability problems specifically. But the answer is not feel-good investments in established companies with virtuous track records. It’s in investments that otherwise wouldn’t happen — and in challenging asset managers to use their muscle to deliver real change.
(*) Florian Heeb is a researcher at the University of Zurich’s Center for Sustainable Finance and Private Wealth.
Ethical investing will reign after COVID-19
Here’s how companies can prepare
By Jong Woo Kang - May 2020
As Asia and the Pacific emerges from the pandemic, companies must embrace principle as well as profit.
It’s variously known as responsible, ethical, or impact investing. Whatever the name, investing in pursuit of both financial return and socially desirable outcomes, or at least to avoid undesirable ones, has gained remarkable traction over the past decade or so. In the era of COVID-19 and its aftermath, it is set to become even more popular.
Environment, Social and Governance (ESG) investing, to use its most technical moniker, is gaining growing attention from governments and businesses partly due to increasing global recognition of the need to protect the environment—particularly by mitigating and adapting to climate change—through social responsible and accountable business activities.
The rise of ESG also reflects intensifying controversies around modern capitalism, which has been criticized for sacrificing stakeholder—consumers, employees, communities—interest over those of shareholders. Global institutions such as MSCI and Thompson Reuters are publishing indexes to help such investments. Large corporations are publishing reports on ESG not only as a business record but to win good PR. Globally renowned consulting firms are establishing or expanding their ESG channels to entertain increasing market demands for firm-level diagnosis and prescriptions.
COVID-19 has exposed many public and private corporations to unprecedented risks due to crashing demand, an inability of employees to come to work due to lockdowns or illness, and disruption of supply chains. This has triggered a global stock market plunge, although the financial market fallout was contained in March with the help of central banks’ swift and massive interventions into treasury, mortgage, municipal and even the high-yield corporate bond market.
ESG funds have weathered the storm better than traditional investments. According to Bloomberg, the average ESG fund has fallen by around 12% in the year-to-date, about half the decrease in the S&P 500. The oil price plunge due to uncertain consumption and demand recovery prospects has contributed to this outperformance, as by nature ESG funds have limited exposure to fossil-fuel industries such as oil and gas, as well as energy-intensive industries like airlines and maritime transport.
Furthermore, these funds invest more in renewable energy, telecommuting, distance learning and telehealth. They also focus on companies with high transparency and a socially conscious approach to their workers and communities, thereby connecting with the need for better social protection to shield people and society from the worst depredations of the pandemic.
Many firms are coping with the pandemic-induced crisis through efforts to minimize job losses and pay their suppliers—mainly small and medium-sized enterprises— out of their own working capital. Not all companies are so far-sighted. Some sit on free cash flows but don’t deploy them to support their workforce and suppliers.
The post-COVID world is a place better suited for the former type of company. Investors will become even more conscious about the importance of public goods like sustainability and disaster risk management, and the value of stakeholder protection. ESG funds can play a key role in the recovery from COVID-19 by making large-scale stimulus packages more inclusive and more focused on the environment. ESG investing to prompt positive social change, pursue sustainable and green growth, and enhance resilience against disasters, both health-related and natural, will receive renewed attention in the global financial market.
Businesses will come under mounting pressure to adjust to this reality, and those which proactively embrace environmentally and socially responsible business models will be rewarded with rising profits as well as the loyalty of a socially committed investor and customer base. Developing countries are not immune to this trend. Commitment to Sustainable Development Goals and climate change action through initiatives such as the Paris Accord will become even more important policy priorities for governments, given the pandemic has exposed and further worsened levels of inequality, vulnerability and marginalization.
This trend will be deeply entrenched in the financial markets. Companies need to be prepared to incorporate ESG metrics into their business and operational goals as well as their risk management toolboxes. Foreign investors might start turning their backs on companies which lag on social and environmental consciousness. Reinforcing this trend is the reality that investors will become more wary of reputational risks if firms they’ve invested in don’t live up to desirable environmental and social norms.
To avoid these scenarios, companies can take three initial steps. First, they need to recalibrate their business goals to encompass mid-to-long term environmental and social achievements beyond short-term earnings and profit targets. Second, they should adopt an appropriate evaluation and reward mechanism to enhance corporate governance that safeguards workforce welfare, customer and supplier relationships, and engagement with the community.
Finally, companies can strengthen accountability towards various stakeholders by employing accurate and transparent accounting and outreach programs so they can also effectively monitor their needs and priorities. International institutions, including multilateral development banks, will also face growing expectations to proactively adopt ESG principles.
COVID-19 has exposed humankind to so many challenges. A key lesson is the importance of sustainability, resilience and social responsibility of businesses and investments. After the pandemic, a duty of care for the natural environment, communities, and their employees, will be key metrics of business success.
Companies must embrace principle as well as profit, and they need to start doing that now.