How Investment Capital Could Induce Polluting Companies to Change for Good

Every day, thousands of companies interact with employees, suppliers, and customers around the world. But their activities can indirectly affect other people, too—people who have not been consulted nor have agreed to anything—sometimes in negative ways. These so-called negative externalities of economic activity include contributing to global warming via Greenhouse gas emissions.

Negative externalities generated by corporations are a recurrent theme in policy debates. The traditional economic prescription for this problem has been regulation. One example is cap and trade schemes that allow companies to pollute a certain amount during a fixed period or sell their allowance to another firm. Another is taxing activities that generate CO₂ emissions. However, establishing processes can be cumbersome and slow, and even when in place, they often deliver variable results.

Curbing poor environmental performance via targeted financing

Investors who want to do something about reducing the negative impact of economic activity can choose to put their money into funds that use ESG criteria to determine which companies they want to invest in. 

These ESG investment funds take the environmental performance of companies into account. Companies can attain higher ESG scores by generating lower CO₂ emissions. Many high-scoring ‘green’ companies have operating procedures that enable them to slash their emissions.

If we want to see further emission cuts – a stated policy goal of the European Union – we need to consider how ESG-based investment schemes work and where they fail. At first glance, a reasonable approach for an investor concerned with environmental issues might seem to be to invest only in ecologically responsible companies with a low carbon footprint.

What are the intentions of the funds and investors?

It is important to recognize here that a presumed socially responsible investment fund is primarily concerned with raising money from its investors like any other investment fund. Such funds charge fees and make a profit. They are not, strictly speaking, in the business of lowering CO₂ emissions.

Whereas all investors care about the financial performance of their portfolios, some may also want to 'do the right thing' for the environment or society.

Individual investors also have their own concerns and motivations. Whereas all investors care about the financial performance of their portfolios, some may also want to 'do the right thing' for the environment or society. In particular, so-called value-alignment investors may be concerned with their money not being used by firms that have negative externalities. They may be less concerned with or simply unaware of the actual impact of their actions on reducing such externalities.

Can ESG investing drive down CO₂ emissions?

ESG investment funds investing only in green companies will attract value-alignment investors. These funds will continue to be invested only in green companies because that is what said investors want them to do. All parties are happy, but our research shows that their actions may have little or no impact on CO₂ emissions. 

Why? Green companies are already green, and putting more money into them will rarely make them greener. Therefore, the impact of investing in companies that, for example, are already emitting very little CO₂ is not particularly effective. Brown companies, on the other hand, will just be owned by other investors and will keep polluting as usual.

There can be exceptions to this effect. For example, one can imagine a case where the amount of money available to be invested in green sectors is larger than the total amount of money needed by those sectors, whereas the remainder of the capital in the economy is not enough to finance all brown sector companies. Thus, having invested in all the existing green companies, a sufficiently large fund would still have money left over to invest in the creation of new green companies. The green sectors will increase in size whereas fewer brown firms will be financed. Whereas this could reduce CO₂ emissions, it would have a perverse effect on financial returns. More green companies will be in competition, and their profitability will fall.

On the contrary, profitability grows for brown companies as their number falls. Thus, funds composed of green sector firms will offer poorer financial performance than those offered by more standard funds. As a consequence, only a small amount of capital would flow to ESG funds, which will not reach the critical size necessary to impact emissions. 

A less intuitive solution to boosting ESG investment impact

Surprisingly, we have shown that an alternative approach is to put money into brown companies. The key, however, is to do so with certain conditions attached, demanding that brown companies reduce their emissions to receive the funding. According to our research, this strategy is generally more effective at reducing CO₂ emissions than investing the same amount of money in companies that are already green. 

Investment capital, it turns out, is a powerful form of leverage for influencing and modifying the behavior of brown companies.

However, this approach has its own weaknesses. First, the ESG fund cannot attract capital from value-aligned investors by investing in brown companies. Second, there may be circumstances under which this approach is not feasible. For example, in a sector where available capital is abundant for investment, brown companies may find sufficient funding from investors who are not concerned about environmental performance. More responsible investors will have little or no direct leverage in such cases.

Extending leverage down the supply chain

One of our key findings involves the situation described above, where a polluting sector has plenty of cash. Here, brown companies that can easily get money without having to comply with environmental demands may nevertheless have companies among their customers operating in cash-constrained sectors. These industrial customers will need capital. Then, an ESG fund can have an impact by investing in such industrial customers, requiring them to commit to only having polluting sector suppliers’ firms who reduce their emissions. The brown companies are now compelled to go green, not because they need the investment cash, but because they will lose their customers if they do not.

Our research shows that conscientious investors can successfully pressure brown companies by targeting links in the supply chain that receive less investment.

A supply chain is made up of discreet links, each representing a company or companies in a separate sector or sub-sector. Our research shows that by targeting links in the chain that receive less investment, conscientious investors can successfully apply pressure on brown companies elsewhere in that chain from a distance.

Thus, investing in green sectors while requiring recipients of capital to select their brown suppliers among the least polluting ones might be the best way to attract value-aligned investors' capital, reduce emissions, and do this without sacrificing too much financial returns.

Takeaway: We consider the pecuniary and non-pecuniary performance of three investment strategies for socially responsible funds: exclusion, Scope 1 investing, and Scope 3 investing. 

Exclusion: Excluding polluting sectors from the fund’s portfolio has an impact only if the fund size is large enough. The impact is achieved with a low-footprint portfolio but comes at the cost of a substantial deterioration of the fund's financial performance.

Scope 1: Even a small fund can have an impact if the polluting sector is subject to capital market frictions by investing only in firms that commit to reducing their emissions. The impact comes with minimal deterioration of the fund's financial performance but is achieved with a high-footprint portfolio.  

Scope 3: By investing in clean sector firms that commit to only having polluting sector suppliers firms that reduce their emissions, even a small fund can have an impact if the clean sector is subject to capital market frictions. The impact is achieved with a low-footprint portfolio and comes with minimal deterioration of the fund's financial performance.
 

Both Scope 1 and Scope 3 strategies can have an impact with minimal deterioration in financial performance, but each has its pros and cons.

In summary, we propose that ESG funds should prioritize investing where competition for funding is high. By imposing restrictions on suppliers and customers, they can influence companies that are not directly financed with responsible capital.