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What green investing means for companies, shareholders, and society

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Date: 2021-06-11 16:55:34

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Narrator: During the coronavirus crash of the spring of 2020, global stock markets experienced one of the steepest drops in history. Worried investors turned to professional money managers to help them navigate these volatile markets, as is typical in times of uncertainty. It turns out that during this period, active funds did better the higher they ranked in sustainability ratings, and it was driven in large part by environmental sustainability, which is the E in ESG investing. It’s also known as green investing. This leads to some questions, among them, what made greener investments outperform? And when do they deliver better returns than the alternative? Chicago Booth’s Lubos Pastor and his coauthors have developed a model to explain what going green could mean for investors. 

Lubos Pastor: Well, we started with a natural assumption, that investors prefer holding shares of green firms—and by green firms, I mean firms that are widely considered as more socially responsible, whereas by brown firms, I mean firms that are widely considered as socially irresponsible. We started with a natural assumption that investors have a taste for holding green assets and a distaste for holding brown assets. That’s kind of the novel part. The financial part of our model is completely standard. So then we asked: If investors have these tastes for green assets, what happens in equilibrium? In other words, what happens when supply meets demand? 

Narrator: In the researchers’ model, if investors want to hold green assets they bid up the prices for those stocks. The green stocks will then be more expensive than brown stocks. So their risk-adjusted returns will be lower. However, the model also finds that investors who prefer green stocks are prepared to earn lower returns than non-ESG investors. And in fact, they’re willing to sacrifice more returns than they actually end up having to sacrifice. So they actually earn what the researchers call an investor surplus. 

And there are times when green stocks can do better than expected or even outperform brown stocks. This has to do with sudden climate shocks, events like a giant iceberg splitting from an Antarctic ice shelf. Something like that can generate news, which reaches consumers. They can feel more compelled to buy green products. They can also call their elected leaders to push them to pass environmental laws. Those laws are likely to benefit green companies and hurt brown ones. 

Lubos Pastor: So brown firms end up performing poorly in bad states of the world when the climate shock hits. In other words, brown firms are a bad hedge against climate shocks, whereas green firms are a great hedge against climate shocks, and that makes green firms safer, and that’s why investors are willing to pay more for green firms, and that’s why they’re willing to accept lower returns on green firms. And vice versa, brown firms are particularly risky because they’re gonna do poorly in bad times when a bad climate shock hits, and that makes them risky. That means investors demand higher expected returns on brown firms. 

Narrator: Another thing that can help green firms outperform brown firms is an unexpected change in consumer preferences for greener products. For example, a rise in demand for electric cars or fair trade coffee. Further, when investors are willing to pay more for green investments and accept a lower rate of return, green companies are able to invest more in their own operations. They have a lower cost of capital, whereas brown firms see a higher cost of capital and less flexibility to make new investments. And the researchers conclude that green investing is a net positive for society. 

Lubos Pastor: One channel through which the social impact happens is through the cost of capital: green firms invest more; brown firms invest less. The other channel is that managers are gonna make their firms greener, and the interesting thing is that they will do this even if they are not focused on ESG at all, even if they simply maximize their market values. OK, so Milton Friedman in 1970 famously wrote that the social responsibility of business is to take care of profits, right, and for managers to maximize the market value of their firm. We consider Friedman-like managers who simply maximize market value, and yet, we show that ESG investing has a positive social impact, why? Because when a manager makes her firm greener, she is making it more valuable, because remember, in our setting, investors are willing to pay more for green firms. So they will appreciate it when managers make their firm green. In other words, even without activism, even without shareholder engagement, you do get positive social impact out of ESG investing. Of course, shareholder engagement and activism can potentially lead to even more social impact, but the interesting thing is that you don’t need them for ESG investment to actually have positive social impact. 

Narrator: When more investors care about ESG, this boosts the price of greener stocks, which in turn encourages green companies to invest more in their operations and thereby draw more attention from other investors. 

Lubos Pastor: Yeah, I expect ESG investment to grow in importance for the simple reason that surveys indicate that it’s mostly the young who exhibit a preference for green investments. You know, the old people are intrigued, but the young people are particularly interested, and of course the young are gonna account for an increasingly important proportion of our economy, proportion of our wealth. They will inherit wealth. They will build some wealth themselves. So for that reason alone, I expect ESG investing to grow in importance. At the same time, I don’t think we should rely on ESG investing alone to solve our big social problems. I think the role of the government is essential here. For example, if you wanna save, save our planet, you know? If you wanna solve the climate-change problem, the most efficient solution by far is for the government to impose a carbon tax, OK? Yes, we can fiddle around the edges with ESG investing and maybe make a little bit of impact here and there, but it’s much more natural for the government to take the lead on these big externality problems. In addition, if you think about social issues, as opposed to environmental issues, in today’s polarized society, it makes a lot of sense for the government, a democratically elected government, to make decisions about, you know, what should be and what should not be done. It seems much more difficult or challenging for a private firm to decide, “Well, this is socially just, and that is not socially just.” So again, I hope ESG investing will continue making a positive contribution. I also hope that governments will do more. 

Original Source: https://review.chicagobooth.edu/finance/2021/video/what-green-investing-means-companies-shareholders-and-society