By Julian Kölbel, Post-Doctoral Researcher, Centre for Sustainable Finance and Private Wealth, Department of Banking and Finance, University of Zurich; Fellow, Sustainability Initiative, MIT Sloan School of Management
The industry of sustainable investing — where investors consider not only the financial but also the environmental, social and governance (ESG) performance of their investments — is growing fast. This could be great news for the planet. Increasingly, investors express interest in sustainable investment products, hoping to contribute to a better world. Policymakers also increasingly look to the financial industry to help solve immense challenges such as climate change.
And yet, while there has been a lot of research into the financial performance of sustainable investing, there is surprisingly little research into its social and environmental impacts. This is a problem, since the growth of sustainable investing is great news only if it actually makes a difference. A recent study, ‘Beyond returns: investigating the environmental and social impact of sustainable investing’ – supported by the Luc Hoffmann Institute’s initiative on shareholder activism for sustainability – addresses this research gap by systematically reviewing what is known about the impact of sustainable investing.
One important source of confusion is the definition of investment impact. It is obvious that companies have impacts on people and the environment, and this is what most fund managers focus on: monitoring the environmental and social footprint of their investee companies. But this is just half of the story. The other half is the impact of the investor on the company. Thus, a comprehensive view of investment impact is the contribution that an investor makes to the positive impact of a company — and ultimately to solving major socioenvironmental challenges.
This impact perspective is counter-intuitive, because it looks much better to own a portfolio of companies that already boast clean technologies and flawless records. But sharing in the success of great companies is not the same as triggering change. In fact, helping to improve the most polluting and problematic companies may be vastly more effective from an impact perspective. What counts as impact in the end is the difference that an investor can make.
The study identifies three key mechanisms through which investors can have impact, and gauges their effectiveness based on available scientific evidence. The first and most reliable mechanism is shareholder engagement, where investors use their privileged relationship with the investee to push for reforms. An interesting example is the campaign by Jana Capital, a hedge fund, which succeeded in convincing iPhone maker Apple to introduce a feature that informs users about their screen time. Since September, this screen time tracker is a standard feature of the iPhone operating system, telling users exactly how much of their life they spend in front of the screen. The fund succeeded in convincing Apple that such a measure was a way to protect the health — and future spending power — of their young customers.
The second mechanism works via capital allocation, whereby sustainable investors support green companies by allocating capital towards them. The study shows that this impact mechanism depends crucially on specific circumstances. One factor is market liquidity: In liquid financial markets, capital allocations of sustainable investors can be quickly compensated by neutral investors. Another factor is capital dependency: not all companies depend on external financing for their growth, making them immune to the capital allocation decisions of investors. As a result, capital allocation impacts are probably most relevant for young companies that need external financing to realise their goals and operate in underdeveloped financial markets. In sum, capital allocation impacts could range between negligible and substantial, depending on the circumstances.
The third mechanism is that of indirect impacts that operate through a third party. For example, publicly excluding fossil fuel stocks may indirectly contribute to the political agenda around limiting carbon emissions. Similarly, demonstrating the feasibility of sustainable investing may animate other investors to follow suit. However, these indirect impacts are extremely difficult to measure, and currently only weakly supported by academic literature.
Taken together, the study provides concrete recommendations for investors to increase their impact. Currently, the sustainable investing industry as a whole is guided exclusively by footprint metrics. Typical sustainable investment funds strive for portfolios of companies with good ESG ratings, and avoid companies with poor ESG ratings. This practice is supported by rating agencies that provide increasingly sophisticated information on the impacts of companies, but so far do not reflect how investors contribute to these impacts. That means that fund managers lack the data to optimise their portfolios for impact. The study points to an urgent need to develop metrics for investor impact, so that sustainable investors can measure, report, and ultimately increase their contributions to global challenges.
In conclusion, the growing sustainable investment industry has the potential to change the world — if it can be guided by impact considerations. Not only should data providers strive to develop impact measures, policymakers should also tie interventions to impact. The European Union is currently debating how to regulate and support sustainable investing. If the concept of impact could be established as a guiding element in such regulation, sustainable investing could develop into a game changer — for climate change and other pressing global issues.
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