Facing Hidden Costs Of Going Green, Investor Indifference To Level Of Impact, And Unachievable Climate Commitments

Climate change remains the greatest challenge of our time. At the same time, to stave off the growing backlash against sustainable investing, including Texas Comptroller Glenn Hegar’s list of ten financial firms and 350 other funds from which Texas-based funds need to divest due to their stance on climate-investing, sustainable investors must continue to acknowledge and address uncomfortable truths.

New research reveals the hidden costs for corporates of going green and investor indifference to the level of impact, and net zero commitments become more challenging as climate goals become more elusive.

Institutional investors can adjust three aspects of their approach to sustainable and impact investing. First, they can more carefully consider the tradeoff between environmental and social issues when mandating climate action and which climate commitments to demand from which industries and companies and at what social cost. Second, asset owners can hold asset managers accountable for their level of impact. Third, asset managers and asset owners can ensure that their beneficiaries understand and consent to any risk-return tradeoffs associated with climate commitments.

These adjustments should help to reconcile the investment thesis of sustainable and impact investing with the conflicting ideas in the backlash to sustainable investing to form a new and more scalable version of sustainable and impact investing.

Let’s explore the research and its implications in greater depth below.

The Hidden Costs of Going Green

New research from Arshia Farzamfar, Pouyan Foroughi, Lilian Ng, and Linyang Yu shows that firms pressured to improve environmental performance do so at the expense of social status, committing more compliance violations related to employment, healthcare, workplace safety, and consumer protection.

The researchers find that, on average, firms balance a 100% reduction in environmental penalties by a 23% increase in their social violations, with the magnitude of increase varying due to internal and external pressures imposed on firms from financial constraints, organized labor, and product market competition. Firms under financial constraints and operating in more competitive product markets are more likely to sacrifice social status when pressured to be environmentally responsible. Pressure from both the degree of unionization and presence of unions can limit firms’ attempting to shift their strategies in social and environmental policies. Similarly, firms with poor social performance are less likely to reallocate resources from social to environmental in response to environmental penalty. The propensity to reduce social responsibility is larger when firms operate in high emission industries. Furthermore, socially responsible firms are also inclined to compromise their social status when required to reduce the negative impact on the environment.

This research reveals a hidden cost of going green for companies. The broad and complex nature of sustainability requires intricate attention to all stakeholders, especially when firms implement environmental or social regulatory policies so that they do not adopt pro-environmental policies at the expense of their social responsibilities. Investors must be clear-eyed about the tradeoff between environmental and social issues when mandating climate action. Investors should also carefully consider what climate commitments to demand from which industries and companies and at what social cost.

Investor Indifference to the Level of Impact

These tradeoffs between environmental and social issues are confounded by investor indifference to the level of impact. New research by Florian Heeb, Julian Kolbel, Falko Paetzold, and Stefan Zeisberger suggests that while investors have a substantial willingness to pay for sustainable investments, they do not pay significantly for more impact, even when the impact is increased by a factor of 10. This also holds for impact investors. When investors compare several sustainable investments, their willingness to pay responds to relative but not to absolute levels of impact. Regardless of investments’ impact, investors experience positive emotions when choosing sustainable investments. These findings suggest that the willingness to pay for sustainable investments is primarily driven by an emotional rather than a calculative valuation of impact. This dovetails with an earlier finding of Arno Riedl and Paul Smeets, who show that pro-social preferences explain whether investors invest in sustainable funds, but do not explain the percentage of their wealth allocated to sustainable funds.

These findings of investor indifference to level of impact suggests the need for greater dissemination of methodologies to calculate impact, like Impact Weighted Accounts and Impact Multiplier of Money among the investment community, particularly among asset owners. By way of background, impact-weighted accounts are line items on a financial statement that supplement the statement of financial health and performance by reflecting a company’s positive and negative impacts on employees, customers, the environment and the broader society, and the Impact Multiple of Money is a forward-looking methodology to estimate the financial value of the social and environmental good that is likely to result from each dollar invested. It’s also critical for asset owners to hold asset managers accountable for their level of impact.

Fiduciary Duty and Climate Commitments

According to Edelman research, while 94% of US investors expect companies to establish and communicate a Net Zero plan, 92% are concerned that companies are not effectively executing on their climates pledges. “It is almost inevitable that we will at least temporarily overshoot 1.5,” Jim Skea, an energy expert at Imperial College London and co-chair of the Intergovernmental Panel on Climate Change (IPCC) working group. The IPCC is the part of the United National responsible for advancing knowledge on human-induced climate change.

Responsible business expert Tom Gosling astutely writes that as 1.5-degrees becomes a less likely scenario with every passing month, investors investing on the basis of that scenario risk misallocating their clients’ capital: overinvesting in companies benefiting from a rapid transition and underinvesting in companies benefiting from a delayed transition. This could have significant economic impacts for clients. Although research suggests that investors in impact venture capital funds are willing to accept 2.5-3.7% lower returns per annum, experienced investors in more conventional investments may be prepared to sacrifice a little over 1% pa of return for a more sustainable fund.

Current climate models predict a 3.0-4.0°C increase in temperatures by 2100, rendering low-lying islands, many coastal regions, and most of the low and mid-latitudes uninhabitable. 2100 is only 80 years away—approximately the life expectancy of a child born today in North America. Climate change pose existential threats not only to investment portfolios, but also to the human race. Although this systemic risk argument makes incorporating climate change-related risks and opportunities into investment portfolios fundamental to fiduciary duty, investor knowledge and consent to any risk-return tradeoffs associated with climate commitments are critical. Gosling suggests that it may be time to reframe initiatives like Glasgow Financial Alliance for Net Zero (GFANZ), a global coalition of more than 450 financial institutions with more than $130 million in assets under management committed to aligning business activities to 1.5 degree Celsius pathways and net zero, to allow investors to support politically determined goals on climate while meeting the expectations of clients.

Thesis-Antithesis-Synthesis

As sustainable investing approaches $30 trillion in AUM and impact investing approaches $1 trillion in AUM, institutional investors can adjust three aspects of their approach to sustainable and impact investing to facilitate both scale and compliance with fiduciary duty while limiting greenwashing and impact washing. First, they can more carefully consider the tradeoff between environmental and social issues when mandating climate action and which climate commitments to demand from which industries and companies and at what social cost. Second, asset owners can hold asset managers accountable for their level of impact. Third, asset managers and asset owners can ensure that their beneficiaries understand and consent to any risk-return tradeoffs associated with climate commitments.

These adjustments should help to reconcile the investment thesis of sustainable and impact investing with the conflicting ideas in the backlash to sustainable investing to form a new and more scalable version of sustainable and impact investing, which too shall adjust and evolve. This remains a space to watch.