Introduction
In recent years, Environmental, Social, and Governance (ESG) investing has become a mainstream approach for investors aiming to make ethical and responsible choices. With about $35 trillion globally invested in sustainable investing and an expectation that it will grow to one-third of all assets by 2025, the influence of this approach is undeniable. However, a new study has ignited a debate over the effectiveness of ESG investing, particularly as it relates to the actual environmental impact of firms. This article aims to explore this discourse by examining the research and opinions of experts in the field.
The Dominant Strategy and Its Flaws
The prevailing strategy of sustainable investing involves directing capital away from “brown” firms (those with high environmental impact) and toward “green” firms (those with low environmental impact). This approach aims to reward green companies by lowering their cost of capital and punishing brown firms by raising theirs. However, the recent paper “Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms” (Hartzmark and Shue, 2023) challenges this strategy, arguing that it may actually be counterproductive.
Brown Firms: Scope for Improvement
The study finds that brown firms have a much greater potential for reducing their environmental impact than green firms. They are more sensitive to changes in their cost of capital, and if denied access, they are more likely to double down on existing environmentally harmful projects. In essence, the current strategy might make brown firms even more brown without making green firms greener.
Furthermore, the research shows that brown firms have approximately 260 times as much environmental impact as similarly-sized green firms. This means that they present an opportunity for significant environmental improvement. Astonishingly, many new green patents are originating from these brown companies.
The Counterproductive Effect on Green Firms
While green firms are the primary beneficiaries of ESG investing, they are not necessarily contributing to the development of green technologies. Banks and insurance companies, for example, are already in low-emission industries, and the influx of ESG investments often results in a continuation of current practices rather than innovative efforts to become greener.
A New Perspective: Engaging with Brown Firms
The authors of the article offer a new approach that instead of divesting from brown firms, investors should actively engage with them to drive change and incentivize them to become greener. This includes dialogues with senior management, pressing for improved governance, and crafting sustainability strategies.
Real-world Impact: Engine №1 and ExxonMobil
A real-world example of this engagement can be seen in the actions of investment firm Engine №1. By owning a fraction of 1% of ExxonMobil, they were able to win three board seats, leading to significant changes in ExxonMobil’s operations, including the initiation of a low-carbon-solutions business. This illustrates the tangible impact that can be made through direct engagement rather than mere divestment.
Conclusion: Striking a Balance for True Sustainability
The debate surrounding ESG investing is complex, and the takeaway from this research isn’t that ethical investing must be discarded. Rather, it’s a call for a more nuanced perspective, one that recognizes that making a real impact is more complicated than a simple “Green is good, Brown is bad” dichotomy.
Reducing emissions by even 1% from a large concrete manufacturer can have a vastly larger impact than a software company reducing theirs by 100%. As Chris James of Engine №1 puts it in a podcast directed by Stephen Dubner of Freakonomics, the energy transition should be viewed as a “humongous opportunity” rather than a threat.
Sustainable investing must evolve to recognize the potential for positive transformation within brown-sector companies and invest in solutions that create the most significant impact. By doing so, investors can transform ESG investing from a mere trend into a powerful driver of positive and long-lasting environmental outcomes.
References:
Hartzmark, Samuel M. and Shue, Kelly, Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms (November 1, 2022). Available at SSRN: https://ssrn.com/abstract=4359282 or http://dx.doi.org/10.2139/ssrn.4359282
Dubner, S. J. (Host). (2023, June 14). Are E.S.G. Investors Actually Helping the Environment? [Audio podcast episode 546]. In Freakonomics Radio. Produced by Ryan Kelley. [https://freakonomics.com/podcast/are-e-s-g-investors-actually-helping-the-environment/]