Martin Oehmke, Marcus Opp
Based on: Review of Economic Studies (forthcoming). DOI: https://doi.org/10.1093/restud/rdae048
The rapid rise of socially responsible investing has been one of the most significant trends in financial markets over the last decade. An ever-increasing number of investors are looking to put their savings into funds that incorporate ESG ratings (which aim to capture a company’s performance relating to environmental, social, and governance issues) or other sustainability criteria. The investment industry often advertises socially responsible investing as a win-win: By investing in socially responsible funds, investors can “do well by doing good”—they can make the world a better place without sacrificing financial returns on their investments. But is this proposition realistic?
Traditionally, investors have sought to change firm behavior through divestment. For example, a fund or endowment might threaten not to invest in firms that produce significant carbon emissions or other social costs. However, as socially responsible investors divest, investors who care less about carbon emissions will step in. As long as enough investors focus solely on financial returns and disregard emissions, these investors seamlessly replace the divested capital. Divestment, then, has little or no impact.
Rather than divestment, investment may therefore be a more promising way to change firm behavior. The most direct way to do so is via the primary market, where firms raise financing to fund their investments. If financing conditions offered by socially responsible funds are sufficiently attractive, this may induce firms to “do the right thing.”
The funding terms a socially responsible fund is willing to offer depend on the fund’s mandate, which specifies how the fund weighs social costs such as emissions in addition to its traditional focus on financial performance.
Under a narrow mandate, a socially responsible fund accounts for the social costs caused by firms in its portfolio. For example, in the case of carbon emissions, the fund would consider the portfolio’s carbon footprint in addition to its financial performance. The least costly way to achieve a carbon-neutral portfolio is to invest in firms that are clean regardless of the fund’s investment: For example, the fund could invest in companies like Patagonia or Tesla, or firms in industries with low pollution.
An advantage of a narrow mandate is that it does not require a financial sacrifice, given that the targeted firms do not need to make costly changes to their operations or strategy. However, a narrow mandate has the same weakness as divestment. Even though it would reduce the fund portfolio’s carbon footprint, the firms in the portfolio would have been clean anyway. Even worse, polluting firms can simply raise financing from profit-driven investors and continue to pollute. In short, the narrow mandate affects only the ownership of pollution, not the pollution itself.
The incentives to merely change the ownership of pollution may transmit to firms. When socially responsible funds follow a narrow mandate, firms can make themselves attractive to these funds by simply selling dirty assets to other (often private) buyers. While BP’s sale of the Oman gas fields to Thailand’s PTT reduced BP’s carbon footprint, it has not reduced overall carbon emissions. Similarly, the sale of its ice-cream division may allow Nestlé to market itself as a health-oriented brand, but the same ice cream is now sold by private equity–owned Froneri. In all these instances, the narrow mandate is an impediment to achieving real impact.
To have impact, socially responsible funds must follow a broader impact mandate that accounts for emissions unconditionally, independent of whether these emissions are caused by a firm they invest in. Assessing their investments in this way means that socially responsible funds internalize reductions in carbon emissions that result from their investment relative to the counterfactual in which they do not invest in a particular firm. Because they internalize this counterfactual, funds with a broad impact mandate are willing to provide funding terms not available from profit-driven investors, provided that their investment induces firms to change their behavior.
A key implication is that impact requires a sacrifice of financial returns: Win-win investment opportunities will be funded by profit-maximizing investors. Impact, therefore, requires socially responsible funds to finance investments that cannot attract funding from profit-driven investors.
The investment industry should be upfront about this tradeoff between doing well and doing good. Most importantly, achieving impact requires that socially responsible funds go beyond the traditional notion of fiduciary duty, which focuses only on financial returns. Instead, the fund mandate needs to specify the weight given to impact relative to profits. Determining this weight boils down to asking investors how much financial return they are willing to sacrifice to reduce carbon emissions or other social costs.
Once the impact fund has determined the weight given to reducing carbon emissions or other social costs, it can rank potential investments based on “bang for buck” when achieving impact. This can be done using a variation of the classic profitability index, the Social Profitability Index (SPI):
Whereas a traditional profit-driven investor would calculate the profitability index as the ratio of the investment’s NPV and the amount invested, a socially responsible fund with an impact mandate includes non-financial impact (e.g., emission reductions) as part of the payoff from investing, weighted by the fund’s “social responsibility parameter” g.
One important feature of the SPI is that it favors investments that lead to a significant reduction in carbon emissions or other social costs. A socially responsible fund with an impact mandate may choose to invest in high-emitting industries if this investment triggers a sufficient change in firm behavior. Therefore, investing in heavy polluters like Exxon Mobil or American Airlines is not necessarily a sign of greenwashing. Conversely, there is no point in investing scarce impact capital into firms that would be clean anyway. Finally, if a combination of profit and impact (the SPI) guides ex-ante investment decisions, ex-post performance evaluation of managers at impact funds should also be adjusted accordingly.
Given the fundamental tradeoff between doing well and doing good, perhaps the key question is whether individual investors will put their savings into a fund with an impact mandate. Even investors who value reductions in carbon emissions or other social costs may not do so due to a classic free-rider problem: Each individual investor takes the overall outcome as (essentially) given and relies on others to make the required financial sacrifice. Accordingly, the impact fund cannot raise any funds.
How can this free-rider problem be overcome in practice? One option is that governments sponsor impact funds. For example, rather than paying out resource income to citizens, government funds (such as the Norwegian Sovereign Wealth Fund), can invest directly on behalf of their citizens, facilitating impact that is in the citizens’ interest but, due to the free-rider problem, would not be achieved if citizens invested themselves.
Alternatively, individual investors’ preferences may depart from those of the typical self-interested “homo oeconomicus.” There is increasing evidence that investors care not only about the consequences of their actions for their own well-being, but also about “having done the right thing.” If this is the case, investors may contribute to impact funds even though they realize that, in the grand scheme of things, their own investment will not make a big difference.
Where does all of this leave traditional, profit-driven investors? Of course, they are still happy to fund firms not targeted by impact funds. They can also invest alongside impact funds in a blended-finance arrangement. In this case, the firm issues a green security at a premium to the impact fund (e.g., a green bond), while profit-driven investors buy an ordinary security at regular market terms.
Interestingly, purely profit-driven capital can be socially valuable even in the presence of impact funds. First, by investing alongside impact funds, profit-driven investors can partially substitute for capital that otherwise would have to come from impact funds, allowing impact funds with limited capital to target more firms. Second, and more surprisingly, the presence of profit-driven investors can motivate impact funds to provide more funding to targeted firms. This additional financing capacity arises because funds with an impact mandate try to head off the social damage that would be caused if these firms obtained funding from profit-driven investors only. In this case, profit-driven capital complements socially responsible impact capital by relaxing financial constraints for firms that invest in clean technology, thereby contributing to the common good.
In summary, socially responsible investment can make a difference. However, if fund mandates focus only social costs caused by firms in the fund’s portfolio, socially responsible funds affect the ownership of pollution but do not change the pollution itself. Impact requires a broader impact mandate that internalizes reductions in social costs relative to the counterfactual of not investing. Perhaps most importantly, impact is generally not a win-win but requires sacrificing financial returns. It thereby challenges traditional notions of fiduciary duty for investment funds
