Whither Sustainable Investing?

Traditional Investing vs Sustainable Investing

Sustainable Investing SI has become a significant trend in the finance industry, with investors increasingly looking to incorporate environmental, social, and governance (ESG) factors into their decision-making processes. However, there is a critical distinction within SI that is frequently overlooked: the difference between investments aimed at enhancing risk-adjusted returns and those seeking to achieve broader societal and environmental outcomes.

On one hand, some investors integrate ESG factors simply as additional criteria that could potentially influence financial performance. This approach, while valuable in certain respects, is not fundamentally different from traditional investing. It essentially involves assessing ESG factors as another layer of risk or opportunity, with the primary goal being financial returns. On the other hand, there is a more ambitious form of sustainable investing that aims to create positive, tangible outcomes for society and the planet. This approach seeks to go beyond mere financial considerations to generate real-world impact through investment activities.

Effectiveness

Important questions are raised about the effectiveness of this impact-focused approach. Despite the growing popularity of SI, there is a significant gap between the aspirations of sustainable investors and the actual outcomes achieved. Investors often assume that their activities will lead to meaningful changes in the companies they invest in, which in turn will contribute to broader societal benefits. However, the evidence suggests that this is not always the case.

One of the key challenges identified is the limited influence that investors often have on companies. While certain investor actions, such as divesting from companies with poor ESG practices or engaging with companies to encourage better behavior, can have some effect, these actions tend to produce only modest changes. For instance, the impact on a company's cost of capital or share price is often minimal, and therefore, the broader influence on company behavior may be weak.

Even when companies do respond to investor pressure, the resulting changes are often small and focused on areas where improvements can be made with little cost or effort. These changes are typically aligned with the companies' long-term value creation rather than representing a significant shift toward more sustainable practices. In some cases, these efforts can even backfire, leading to unintended negative consequences.

Furthermore, the broader systemic impact of SI —such as industry-wide reductions in carbon emissions or substantial contributions to global sustainable development goals—remains elusive. There is a substantial lack of evidence showing that SI practices are leading to widespread, meaningful change. While there are certainly cases where positive outcomes are achieved, these are often isolated incidents rather than the norm.

The differences between public and private markets in the context of SI are important. While most available data and analysis focus on public markets, where the majority of retail and institutional investing takes place, private markets might offer better opportunities for impact. In private markets, investors often have closer relationships with company management and can exert more direct influence. However, even in these settings, the challenges of achieving broad systemic impact remain significant.

There is need for a more nuanced view of SI, with a realistic assessment of its potential and limitations. While SI has the potential to drive positive change, the outcomes are often modest, and significant challenges remain in achieving the widespread impact that many investors hope for. A more measured and evidence-based approach to SI should recognize the complexities and limitations of influencing real-world outcomes through financial markets.

Capital Allocation

In theory, capital allocation decisions by investors can affect a company's cost of capital, influencing its financial performance and potentially leading to behavioral changes. However, the practical implications of this are less clear. The evidence suggests that while SI investors can impact share prices and cost of capital, the extent of this influence is often minimal. For instance, the changes in cost of capital might be too small to drive significant managerial action. Additionally, there is a concern that these effects might even be counterproductive in certain scenarios. For example, increasing the cost of capital for companies with high environmental impact might lead them to reduce green investments and focus more on their core, less sustainable activities.

Engagement

Engagement, on the other hand, appears to be more effective than capital allocation in influencing company behavior. There is evidence showing that investor engagement, particularly collaborative efforts, can lead to tangible changes in corporate actions. However, the scale and significance of these changes are often questioned. Many successful engagements result in companies making low-cost adjustments or committing to actions they were already considering. These changes are frequently seen in the form of new disclosures or the adoption of policies that do not necessarily translate into substantial real-world impact.

Scale of Impact

A critical concern is the overall scale of the impact achieved through these SI practices. While some studies demonstrate statistically significant results from SI activities, the economic significance of these results is often limited. For instance, a small change in a company's cost of capital might not be enough to drive meaningful change, and expecting the entire market to adopt similar SI practices to scale up the impact might be unrealistic. It is important not to overestimate the potential of these strategies to solve large-scale societal challenges.

Strategic Use of Commitments

Another issue raised is the strategic use of commitments by companies in response to investor engagement. Companies may agree to certain demands or set ambitious targets primarily to satisfy investors and improve their ESG ratings, without any real intention of making significant changes. This raises doubts about whether these engagements lead to genuine, impactful actions or simply allow companies to maintain the status quo under the guise of sustainability.

Challenges in Achieving Systemic Change

Profit Incentives and Competition: What is profitable tends to get done, meaning that even if one company reduces its carbon footprint, the demand for fossil fuels might simply shift to another company or region, thereby negating the broader impact. This "squeezing the balloon" effect limits the ability of SI to drive real change.

Fiduciary Duties and Commercial Incentives: The primary focus of most actors in the investment chain is on financial returns rather than environmental or social impact. This focus is driven by fiduciary duties and the need to meet performance benchmarks, which are typically assessed based on financial metrics rather than broader societal outcomes.

Weak Accountability: The disintermediation of the investment chain, where each actor's incentives are aligned more with keeping the next actor up the chain satisfied than with driving genuine systemic change. This weak accountability structure allows for greenwashing (the practice of misleading consumers or stakeholders by falsely portraying a company's products, policies, or practices as environmentally friendly or sustainable) and superficial commitments without meaningful action.

Alternative Approaches to Achieving Impact

Despite this grim assessment, there are still avenues through which SI can contribute positively, albeit with more modest expectations:

"Limitations-aware" Engagement: Investors can still achieve meaningful changes by focusing on realistic, achievable goals within a company's "zone of discretion." This involves setting expectations that align with long-term value creation rather than trying to force companies into unprofitable or highly disruptive changes.

Private Markets and Blended Finance: Potentially, private markets and blended finance are more promising areas for impact. These approaches involve providing additional capital to projects that are not yet commercially viable but could contribute to systemic change if scaled. This might involve working with government agencies or philanthropic organizations to de-risk investments and make them more attractive to institutional investors.

Public Policy Advocacy: Public policy is critical in driving systemic change. While private sector initiatives are important, they are unlikely to succeed without the necessary regulatory framework. Public policy advocacy is crucial to push for the regulations and incentives that will enable systemic change.

Conclusion

There is skepticism about the ability of SI practices to make more than a marginal contribution to addressing major societal challenges. While there is evidence that SI techniques like capital allocation and engagement can have some impact, the significance of this impact is often limited. Without a clearer and more robust theory of change, which ensures that these practices can lead to substantial real-world effects, the potential of SI to achieve broader societal goals remains questionable.

While SI has the potential to contribute to positive outcomes, it is unlikely to achieve systemic change on its own. At the end of the day, we have to consider more radical solutions.