The pace of change: how can investors generate the fastest environmental impact?

Jan. 12, 2023

Acquiring dirty firms to turn them green will create impact but buying companies that are already green—at a premium—may create impact more quickly, a new study shows.

Climate scientists say that unless greenhouse gas emissions are reduced quickly, the world faces potentially catastrophic consequences. Despite the surge in environmental, social and governance (ESG) investing, the current debate focuses on how investors can generate impact but not on how swiftly the impact can be achieved.

In a theoretical study, Swedish House of Finance’s Jan Starmans, Johns Hopkins University’s Deeksha Gupta and University of Hong Kong’s Alexandr Kopytov investigate for the first time how investors can generate positive environmental and social impact in a timely manner: should investors passively invest in “green” firms or actively target and reform “dirty” companies?

Should investors buy “dirty” firms to turn them green?

The authors study a financial market with regular financial investors who are strictly concerned with financial returns as well as socially responsible investors who value measurable social and environmental impact alongside financial returns.

In the case where there are no socially responsible investors, the study shows that the owners of “dirty” firms will turn their companies green only if their pro-social preferences are sufficiently strong. In this scenario, to create impact, it makes sense that investors should invest in firms that remain dirty to reform the production processes.

Starmans, Gupta and Kopytov’s study show however, that such an investment strategy can cause strategic delay in reform for some entrepreneurs.

If more investors buy dirty firms to turn them green, the higher demand may bump up acquisition prices for these companies. This incentivizes owners of unsustainable companies to keep them dirty until they find an investor, and this in turn delays the company’s reform. This is also true even if the owners of dirty firms would have turned it green themselves in the absence of the socially responsible investors, the study found.

When investors commit to not buying dirty firms

ESG investors can choose a “negative screening” of their portfolios by excluding companies that do not align with certain values and the study looked into how this strategy impacts the timeliness of company reform.

It found that owners of a dirty firm with some pro-social preferences will tend to reform the company themselves if investors commit to not investing in dirty firms. They will realize that there are no gains in keeping their company dirty, so they reform the firm immediately.

However, the study also suggests that such an investment mandate may derail the reformation of dirty firms that are owned by those with weak social preferences. In this scenario, unsustainable companies will remain dirty as there are no investors in the market who are willing to acquire dirty firms to turn them green.

Should investors buy firms that are already “green”?

Current research suggests that investing in companies that are already green is suboptimal as they already have environmentally friendly business models, and this is generally not considered to be “impact investing”.

However, the study shows that when investors choose to only invest in companies that are already green and pay a premium for such firms, the current owners of the firms are incentivized to reform the firm immediately, preventing any delays and generating impact quickly.

Such a strategy can be implemented, for example, through an investment mandate where investors commit to buying stakes in firms with already high ESG standards while accepting financial returns below the market rate; the study even suggests that the more concessions investors are willing to accept on the financial returns of their green investments, the more they can incentivize current owners to reform their firms.

Implications for impact investing

The “impact” of an investment is typically measured after the investment is made, so investors who employ positive screening (to include only green firms in their portfolio) or negative screening when choosing which firms to invest in without creating additional positive change post-investment are typically not considered “impact investors”.

The study, however, suggests that only focusing on impact post investment can in fact generate a delay in firm reform. It  found that the  quickest way for socially responsible investors to have impact is to commit to acquiring firms that are already green at a premium.

The measurable impact, at least where the pace of change is concerned, should therefore happen before the investment instead of after as focusing on results post-investment only provides a partial picture of the actual impact investors can generate.