Many sustainable investment funds tend to back firms that already have a low environmental footprint. The logic goes that this financial support should encourage laggards to improve their ways, but research from Yale highlights how the opposite can actually be the case.
This is because when more polluting firms are deprived of investment, they tend to become more short-termist in their approach, and therefore even more polluting. As such, providing investment in these firms can encourage improvement in a way that firms that are pretty sustainable from the very start are unlikely to make.
Sustainable behaviors
The researchers scrutinized the emissions records of more than three thousand major corporations spanning the years 2002 to 2020. To categorize these firms, the researchers segregated them into five distinct groups, accounting for greenhouse gas emissions while factoring in revenue to adjust for the inherent variance in emission levels between large and small companies.
Subsequently, leveraging historical data, the researchers evaluated the responses of the highest and lowest polluting groups to fluctuations in their capital costs, an impact similar to the objectives of the sustainable investing movement.
“What we find is that when green firms experience a change in their cost of capital, their emissions don’t change substantially,” the researchers explain.
Worse behavior
In stark contrast, brown firms exhibit a noteworthy trend of escalating emissions in response to an uptick in their capital costs. Surprisingly, instead of stimulating endeavors for improvement, depriving these brown entities of easily obtainable funds compels them to persist in their existing production methods.
This steadfastness towards high-pollution practices becomes their means of generating rapid cash flow, thereby evading the looming specter of bankruptcy. Consequently, subjecting brown firms to punitive measures through costly financing inadvertently steers them away from potential investments in innovative green technologies capable of mitigating emissions.
Moreover, even a marginal percentage increase in emissions from brown firms, already burdened by substantial pollution levels, yields a momentous environmental impact.
Astonishingly, the researchers uncovered that the average brown firm emits a staggering 261 times more greenhouse gases than its green counterparts. Hence, for green firms, whether confronted with a significant surge or reduction in emissions, the resultant environmental consequences remain trivial in comparison.
“If a brown firm changes in emissions in either direction by just 1%,” the researchers explain. “That is way more meaningful than a typical green firm changing its emissions by 100%.”
The wrong focus
Sustainable investing has a broader issue of placing too much emphasis on percentage reduction in emissions and not enough on absolute emissions. Even firms that have achieved small yet hard-earned percentage reductions in emissions are still perceived as toxic assets that do not qualify for inclusion in sustainable investment portfolios.
Such a stance creates erroneous incentives, encouraging green firms to undertake insignificant or greenwashing initiatives to enhance their green credentials.
Nonetheless, the authors believe that the overarching aims of sustainable investing are commendable, as climate change is a significant risk that warrants attention. However, she believes that there are more direct methods of effecting change.
For instance, instead of divesting from brown firms, investors could gain board seats and influence corporate strategy towards environmentally friendly practices. Alternatively, investors could direct funds to firms that are developing innovative green technologies, such as carbon dioxide removal.
