INSIGHTS

 

 

When can sustainable investing be counterproductive? Listen to Jason Mitchell discuss with Professor Kelly Shue, Yale University School of Management, why brown firms—not green firms—will drive the greatest emissions savings, how the cost of capital can be a powerful lever for behaviour change, and why it’s vital that sustainable investors move more towards energy transition-type strategies.

Recording date: 22 August 2023

Kelly Shue

Kelly Shue serves as a Professor of Finance at the Yale University School of Management. Her academic interests lie at the intersection of behavioural economics and empirical corporate finance. Her research has explored the Peter Principle, compensation and promotions, gender and negotiations, the gambler’s fallacy, contrast effects and non-proportional thinking in asset pricing, and executive social networks. Her research has been featured in numerous news outlets including CNN, NPR, and the Wall Street Journal, and has been awarded the AQR Insight Award, the Wharton School-WRDS Award for Best Empirical Finance Paper, and the UBS Global Asset Management Award for Research in Investments. She serves as an associate editor at the Journal of Finance and Journal of Financial Economics, and previously served as an editor at the Review of Finance.

Her latest paper is Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms 

 

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

 

Jason Mitchell

I’m Jason Mitchell, head of Responsible Investment Research at Man Group. You’re listening to A Sustainable Future, a podcast about what we’re doing today to build a more sustainable world tomorrow. Welcome back to the podcast and I hope everyone is staying well. Every now and then, a piece of research unexpectedly shakes me out of my comfort zone.

That’s a good thing. It gets me thinking and talking about it to a lot of different people because I’ve said this before and I’ll say it again I am a sucker for a good, provocative research paper that challenges prevailing views around sustainable investing. It’s why this episode and the notion of the cost of capital as an incentive is so interesting to me.

In my mind, this paper accomplishes three things. First, it closes the loop in the long running discussion around the cost of capital as a channel of influence. In other words, divesting underweight or even shorting carbon intensive brand from simply make them more short termist and consequently dirty. Second, the paper exposes a really interesting paradox in sustainable investing. After all, how do you manage your tail risk exposure to carbon while also creating impact to the real economy through the cost of capital channel in order to reduce carbon emissions?

And last. This research paper is the kind of evidence that should encourage policymakers to accelerate the rollout of energy transition type investment strategies. Up to now, regulators for the most part, have generally overlooked the transition lever. All of this is to say that it’s great to have Professor Kelly Shue on the podcast to discuss the paper she coauthored with Samuel Hart’s mark titled Counterproductive Sustainable Investing The Impact of Elasticity of Brown and Green Firms.

We discussed why brown firms, not green firms, will drive the greatest emission savings. How the cost of capital can be a powerful lever for behavior change, and why it’s vital that sustainable investors move more towards energy transition type strategies. Kelly Shue serves as a professor of finance at the Yale University School of Management. Her academic interests lie at the intersection of behavioral economics and empirical corporate finance. Her research has explored the Peter Principle, compensation and promotions, gender and negotiations, The Gambler’s Fallacy, Contrast Effects and non proportional Thinking and asset Pricing and executive social Networks.

Her research has been featured in numerous news outlets and garnered many awards. She also serves as an associate editor at the Journal of Finance. Welcome to the podcast, Professor Kelly Shue.

Jason Mitchell

It’s great to have you here and thank you so much for taking the time for this.

Prof. Kelly Shue

Thank you for taking the time to talk with me.

Jason Mitchell

Professor Shu, you recently coauthored a paper that’s a lot of attention. The paper is titled Counter-Productive Sustainable Investing The Impact Elasticity of Brown and Green Firms. So can you start by lifting the text off the paper to summarize its thesis? And essentially, what’s the problem in sustainable investing that you’re describing?

Prof. Kelly Shue

Well, this paper is new joint research with Professor Samuel Hart, work at Boston College. And what we’ve noticed is what we characterized as a problem with the current way that sustainable investing is implemented by the bulk of investors. Now, sustainable investing can take on many forms. Our paper is really a critique of the dominant sustainable investing strategy, which represents the strategy that is associated with the bulk of the money that is currently devoted to sustainable investing.

Prof. Kelly Shue

The dominant strategy is really quite simple These sustainable investors, they divest away, so they exclude firms that are considered to be brown. So these are brown firms with negative environmental impact firms with high greenhouse gas emissions. Meanwhile, these sustainable investors tilt their portfolio or they overweight firms that are considered to be green. These are firms that have positive environmental impact, and very typically they are firms with very low greenhouse gas emissions.

Prof. Kelly Shue

Now, the thought through how this strategy could be effective is that it is going to lower the cost of capital for firms that are going to be green and allows them to do more of the good stuff that they do, which is good for the environment. And the idea is also that by avoiding or divesting away from brown firms that sustainable investors are going to raise their cost of capital, which is going to make it more difficult for these brown firms to raise money, possibly push them toward financial distress.

Prof. Kelly Shue

And somehow this will incentivize or motivate these brown firms also to lower their greenhouse gas emissions and improve their environmental impact. Well, we point out in our paper is that this cost of capital channel could actually have a counterproductive effect. First, if we lower the cost of capital for green firms. While these green firms tend to be services firms in the insurance, health care or financial sectors.

Prof. Kelly Shue

These are firms that have close to zero greenhouse gas emissions in the first place. And if we lower their cost of capital, these are the types of firms that can’t get meaningfully more green because they have close to zero emissions already in the first place. And they’re also in industries that tend not to do much green R&D because it’s outside of their business model.

Prof. Kelly Shue

Even more importantly, let’s suppose sustainable investors succeed in raising the cost of capital for brown firms. Well, if we raise the cost of capital for Brown firms, it means that these firms eventually become more short termist. They can’t raise financing in a cheap way. Their push toward financial distress. And there’s a long history of research in corporate finance that shows that as firms become more short termist, they tend to double down on existing modes of production, which is their way of generating cash.

Prof. Kelly Shue

They’re instead going to avoid investing in big new projects that cost a lot of front and will only payoff further down the line. Now consider a typical brown firm the way that it can generate cash right now is actually to double down on an existing brown production or to cut back on pollution abatement efforts. Once Brown firm is punished and push toward financial distress, it’s going to find any projects that are involve upgrading to new clean technology or changing the new green production is going to find those types of projects very unappealing.

Prof. Kelly Shue

Those types of projects, while it could be profitable in the long term, they just require a lot of upfront investment and they only pay off years down the line. And that all becomes less appealing to a firm that has become more short term, as is due to an increase in the cost of capital. So altogether, that’s what we mean by the dominant sustainable investing strategy is likely be counterproductive.

Prof. Kelly Shue

It does not make existing green firms meaningfully more green, and it pushes existing brown firms actually to become more short termist in their investment choices, which can lead them to actually pollute more.

Jason Mitchell

That’s a great sum up the paper defines sustainable investing as investment strategies that seek to improve firm impact on society. And I would add to penalize brown firms as well. But I’m wondering, to what degree is this more about managing ESG tail risks like portfolio exposure to carbon emissions without specific intention to create this socio environmental impact?

Prof. Kelly Shue

I would say that there are actually two possible investor motives, and certainly they could represent different groups of people. My research is specifically speaking to the set of investors with sustainable motives. So these are investors who wish, through their investment strategy to motivate firms to improve their environmental impact so they have an objective of beyond just pecuniary motives.

Prof. Kelly Shue

Now there’s a different group of investors who could be worried about carbon transition risk. So these are investors who may not seek to directly influence a firms impact on the environment, but they may still wish to tilt their portfolio away from brown firms and other firms that they believe will face higher regulatory risk. So an example of this is that if you are worried about transition risk, you might decide to underweight the oil and gas industry because you think this industry is going to be hit by a high carbon taxes in the future.

Prof. Kelly Shue

And further, you don’t think this is currently fully priced into the firm’s market value and therefore you believe that this set of firms is a bad investment and has high tail risk. In that case, you may be less willing to hold these firms unless they offer you a very high expected return on your investment. I will say, though, that our research has interesting implications even for this group of investors who just worry about carbon transition risk.

Prof. Kelly Shue

What we argue is that if this group of investors who worry about carbon transition risk, if they start pricing in their concerns, effectively what that means is they also choose to divest away or underweight brown companies, which is going to raise the cost of capital for these brown companies, which ironically, that is going to make these firms actually more short termism and possibly pollute more, thereby further increasing actually their carbon transition risk and their risk of being hit by high taxes in the future.

Jason Mitchell

I guess to that end, how do you think about investors that are looking to capitalize on risk premiums? I guess much like insurers impose higher premiums and banks obviously higher lending rates to manage these climate risks. There’s obviously this line of thinking that markets will eventually experience a call it a minsky like moment where extreme weather and climate related losses reach this tipping point such that policymakers have to react through either a carbon tax or creating some kind of carbon market, which instantly represses the market, particularly companies with high carbon intensive operations.

Prof. Kelly Shue

I think investor concern about carbon transition risk seems to be a very reasonable concern. There certainly could be a minsky moment where extreme weather and climate related losses reach a tipping point, as you say, leading to a lot of regulation and an increase in the carbon tax which negatively impact these firms. So, you know, it could be quite rational and reasonable of investors to say we believe that these the set of firms that are exposed to that risk should today have a very low market value because they might face this risk in the future.

Prof. Kelly Shue

So we’re going to demand a high expected return for affording this set of firms. Where my research fits in is Wilder’s concern is could be perfectly rational. The pricing of this risk leads these firms actually to have a higher cost of capital than they would otherwise, which in turn could make these firms actually more short termist, which ironically increases their carbon transition risk even further because it pushes them to pollute more.

Jason Mitchell

Yeah, I want to dig into this point a little bit more. It’s generally recognized that investors have two main channels of influence. The first channel is obviously the cost of capital. The second channel is engagement, which has the potential to create corporate behavior change. But what’s your paper imply for that cost of capital, channel of influence? My read is that the cost of capital channel works.

Jason Mitchell

You know, essentially on a one way call it uni directional basis as an incentive. In other words, the only thing that creates positive impact in terms of emissions reductions is when the cost of capital acts is kind of a carrot and not as a stick, which would end up penalizing brown firms.

Prof. Kelly Shue

I think the cost of capital channel could have a valuable incentive or a carrot approach if implemented correctly. What I’m showing you in my research is that this incentive channel is currently very weak in the way that sustainable investing has been implemented. For the most part. Now, you know, there’s nothing wrong theoretically, with an incentive channel that goes like the following Consider a firm that is currently very brown.

Prof. Kelly Shue

So let’s think of a a high polluting agriculture firm. Okay. That brown firm, they see that other firms that are improving their environmental impact get access to a lower cost of capital from sustainable investors. So this means that the Brown Agriculture firm has an incentive to change its mode of production, to become greener in the future in order to access a lower cost of capital.

Prof. Kelly Shue

That would be the carrot. So again, there’s nothing wrong with this theoretical channel. I think it could actually be quite promising. But what we’ve seen in the data is that this carrot is currently very, very weak and it’s because sustainable portfolios currently, for the most part and again, there are many exceptions, but for the most part they just overweight firms that are already green.

Prof. Kelly Shue

They underweight firms that are brown. And further, they reward through increased weights, firms that have improved their environmental impact only on a large percentage basis. So the typical brown firm starts at about 261 times the level of greenhouse gas emissions as a similarly sized green firm. So let’s take a typical green firm, which might only emit, let’s say, ten tonnes of carbon per million dollars of revenue.

Prof. Kelly Shue

This is a firm that essentially, if you are willing to do some rounding, has zero emissions. It would be pretty cheap for this firm to actually reduce its carbon emissions by 50% over a few years. And this 50% reduction might seem very large on a percentage basis, but it’s actually pretty economically meaningless because the firm had such low emissions in the first place.

Prof. Kelly Shue

You compare that to, say, a manufacturing firm, which by most metrics is considered to be brown. That manufacturing firm may reduce its emissions by only 10% over the same time period, but that 10% reduction is actually far more meaningful in terms of improving its environmental impact. But because that’s not the unit that is recognized by most sustainable investors, sustainable investors do not reward that brown firm with an increased portfolio weight.

Prof. Kelly Shue

So because of this focus on percentage reductions in emissions rather than level reductions in emissions, I would say that this incentive channeled through a basically improvement in your cost of capital. That incentive channel is not working for Brown for.

Jason Mitchell

I’m thinking laterally here, but talk about what your paper means for hedge funds for a second. Does it cut both ways for longs and shorts? There’s this emerging discussion about the role of short selling in sustainable finance. The rationale tends to focus primarily on impacting the cost of capital, but just as long only sustainable investors who underweight or divest of brown firms produce these counterproductive outcomes that you point out.

Jason Mitchell

Does that mean that short selling also makes these firms more short termist and ultimately dirtier?

Prof. Kelly Shue

Yes, I agree. So simply divesting brown firms from your portfolio will increase their cost of capital, but in an even faster way to raise the cost of capital for brown firms is to short them. So short selling brown firms is going to hasten the increase in their cost of capital, which is going to make them more short term.

Prof. Kelly Shue

So I would say shorting brown firms is likely to be counterproductive for sustainable investors who have a motive or a goal of improving these firms. Impact on the environment. Shorting Brown firms is not necessarily counter-productive. If your only goal was to hedge carbon transition risk because you know that is an effective way to hedge your carbon transition risk by shorting the set of firms with the greatest exposure to carbon transition risk.

Prof. Kelly Shue

But again, I would point to an unfortunate side effect of the shorting. Then, even if you had no particular motive for the environment, is this could actually end up harming the environment.

Jason Mitchell

The paper points to regulation and carbon pricing is promising alternatives to the dominant sustainable investing problem that you point out. But as I’m sure you’re aware and increasingly common response from both academics and practitioners is that it’s the government’s role to address climate change principally through regulation. And so if that’s true, apart from the role that transition type funds can play, what in your mind really is the utility of mainstream sustainable investing?

Prof. Kelly Shue

I believe many sustainable investors understand that if a government had full control of carbon pricing, that carbon pricing could be set up in a way that forces all firms to fully internalize their carbon externalities on society. So carbon pricing alone could in theory, solve these problems. But to the credit of many sustainable investors, I think they’re just trying to be practical.

Prof. Kelly Shue

They understand that the government is operating under a lot of constraints and therefore they believe that. Let’s suppose you can engage in a small amount of carbon pricing, but not to a sufficient degree that there is room for sustainable investing to further encourage firms to transition toward becoming more agree.

Jason Mitchell

On this point. Do you think that sustainable finance, regulation and the risk of greenwashing could be partly responsible for counter-productive practices in sustainable finance? For instance, Europe has defined expectations for what sustainable investing should look like. This includes the EU green taxonomy and even a do no significant harm test, which reinforces the idea that a sustainable investing strategy should carry less carbon risk exposure relative to its benchmark, not significantly more as a transition strategy.

Prof. Kelly Shue

Would I agree that the problem of greenwashing is quite significant? One thing that I find quite troublesome is the extreme emphasis on divesting away from companies with either high carbon reserves or divesting away from companies that refuse to make a net zero pledge. I think these two criteria are a bit too rigid on the first one. There are companies with high carbon reserves that if they’re being punished by in public markets, what they’ll do is they can divest those assets to another firm that is private.

Prof. Kelly Shue

Those high carbon reserve assets will go on polluting. It just won’t be in the sphere of public markets anymore. So I’m not sure that really solves the problem. The second issue is that even if our goal is to be globally net zero by some date, that pledge does not necessarily apply well at an individual company level. You know, some companies may be transitioning toward lower emissions, but by nature of their industry or technology, they’re going to transition at a slower rate than other companies.

Prof. Kelly Shue

So are demanding that all companies pledge to be net zero by, let’s say, 20, 30 or 2050 seems rather unrealistic. And it could force companies into a quarter in which they kind of exaggerate their goals, even if it’s highly improbable that they’ll actually reach those goals.

Jason Mitchell

I want to go back to the short termism point for for just a second. How does your paper demonstrate that a higher cost of capital drives greater short termism, which translates into higher emissions and dirtier production? And I’m specifically thinking about this in the context of how it contributes to the long running 30 year academic debate of short termism versus long termism.

Jason Mitchell

Popular opinion obviously supports the idea that short termism is bad and long termism is good. But Mark Rowe at Harvard Law School, who by the way, is a former podcast guest, points out that the data for this is actually quite mixed, that firms can easily be long termist and produce negative externalities. The notable example is DuPont, which ended up expelling ozone, damaging CFCs into the atmosphere for over 40 years.

Prof. Kelly Shue

Well, there’s a simple equivalence between the cost of capital and a firm’s discount rate. The cost of capital is really a measure of how much firms value cash right now versus cash in the future. So I think it’s intuitive that $1,000,000 is less valuable one year from now than having the same million dollars today. We would all rather have the same amount of cash today, and the cost of capital or the discount rate is a measure of how much more valuable it is to have cash right now versus a year in the future.

Prof. Kelly Shue

So if we raise that cost of capital for any firm, then it will tend to value cash today much more than cash in the future. And that’s why we argue and we also show in the data that raising the cost of capital for brown firms is going to cause the Brown firm to prefer any investment project that delivers short term cash flows over a similar project that delivers long term cash will.

Prof. Kelly Shue

The reason why this matters for greenhouse gas emissions is continuing with current production, which is tends to be high. Polluting is the predominant way that brown firms generate cash right now, whereas shifting toward green production, shifting toward new production methods, while those could actually be highly profitable strategies in the long run, they result in delayed cash flows and upfront costs, which all becomes less attractive as the firm has a higher cost of capital or equivalently has a higher valuation for cash today relative to cash tomorrow.

Jason Mitchell

How do brown firms differentiate between sustainable investors and, let’s say, general institutional investors? And I’m thinking about this in the context of market efficiency. I mean, if sustainable investors are driving up the cost of capital for brown firms, why wouldn’t that mean other general institutional investors step in as incremental shareholders given the higher expected return potential?

Prof. Kelly Shue

Yeah, I think this is a very interesting question. So there’s there’s this question of whether sustainable investors will ever impact the cost of capital for brown firms at all, because as soon as they divest away from a brown firm, maybe some other investor who doesn’t share the same environmental concerns can then buy up the Brown firm and essentially negate these flows.

Prof. Kelly Shue

I think there are two reasons why there wouldn’t be fully offsetting flows. So the first is other institutional investors, even if they don’t term themselves or think of themselves as sustainable investors, it could still be very bad optics for them to overweight brown firms relative to their market cap, which is what is needed to be done in order to offset what is being done by a large group of sustainable investors.

Prof. Kelly Shue

The second reason why I think there may not be large amounts of offsetting flows is that this group of institutional investors, even if their objective is not to improve firms environmental impacts, they are still very concerned about carbon transition risk. So they could be under weighting brown firms for that reason, which is they think that these brown firms are going to be hit by high carbon taxes in the future.

Prof. Kelly Shue

And again, their motives are different, but the impact is going to be the same because just not holding brown firms raises real cost of capital, leading them to be more short term.

Jason Mitchell

For emissions and firm performance. Is the relationship stronger when you think about market volatility? We’ve generally had a majority of bull markets over the last 10 to 20 years and emissions reductions has been a big and I guess it’s a fairly easy win at the start, at least for firms. So to what degree is this simply a natural call, a cop movement?

Prof. Kelly Shue

It is a pretty natural code movement for firms to become more green when they’re doing well. I think that’s in large part because many of these green transition projects for firms, they’re actually positive NPV. They just require upfront investment. So when a firm has low cost of capital, which tends to happen during boom times, they seem to naturally switch toward greener production, resulting in lower emissions.

Prof. Kelly Shue

On the other hand, when firms are pushed toward financial distress, so these are the opposite of boom times. That seems to be when they shy away from these green investments.

Jason Mitchell

How do you think about the cost of capital implications across different asset classes and financing mechanisms? In one of the messages from a paper I really like called The City Never Sleeps, but when will investment banks wake up to the climate crisis? The message is that the majority of global financing flows, at least in the oil and gas industry, are from debt issuance and bank loan finance, not equity issuance, which generally represents slightly around 10% of overall financing.

Jason Mitchell

This would seem to reinforce the point about more leveraged Brown firms becoming dirtier as a means to avoid bankruptcy. But doesn’t it also temper the effect of the cost of equity as a meaningful signal to corporates given the small equity issuance that we’re talking about?

Prof. Kelly Shue

Our research is not about sustainable equity investments in particular. Our argument could also apply to sustainable debt investing. Really the problem is when a strategy either debt or equity is targeted at the firm level and not industry adjusted. So you could have equity investments that exclude brown stocks and overweight green stocks. You could also have debt markets or banks that refuse to give any financing or demand a very high interest rate for any loans given to brown firms that are high polluting.

Prof. Kelly Shue

Both these types of strategies is going to raise the overall cost of capital. So both the cost of debt and the cost of equity for brown firms, which is going to lead them to be more short term, is what is more promising. Perhaps is project specific financing. So these are financing targeted at specific projects within a firm that help it transition in toward becoming more green projects.

Prof. Kelly Shue

Specific financing exists in equity markets, but there seems to be more movement and growth in debt markets, and I think that’s a very promising space. So these are all loans that could be given actually to a high polluting firm, but it’s designed to subsidize a particular project that’s going to help this firm improve its environmental impact.

Jason Mitchell

Super interesting. Is there any sectoral differentiation among Brown sectors when it comes to the cost of capital as an incentive? In other words, do some carbon intensive sectors like the steel industry respond differently to incentives versus other sectors like the oil and gas industry? In my mind, the oil and gas industry is, it seems like an interesting example to really hone on.

Jason Mitchell

And I can’t tell you to what degree it’s an outlier. The market seems to have rewarded the oil and gas sector with higher valuations and a lower cost of capital, in many cases, a ten year low following a super normal profit cycle over the last several years, but that only seemed to reinforce their, I would say, frankly, short termist approach in going to the International Energy Agency.

Jason Mitchell

They quote that the $1.5 trillion return to shareholders from the oil and gas companies in the form of dividends and buybacks from 2020 to 2022 could have fully covered the investment requirements in oil clean fuels in the net zero emissions pathway by 2050 scenario between 2023 and 2030. I guess what I’m asking is does the cost of capital signal work less well for industries who are arguably facing more existential pressures?

Prof. Kelly Shue

I mean, I think this is a very interesting question. In my research, we’ve looked at how firms across numerous high polluting industries have reacted to general cost of capital variation. Historically, And we haven’t found, you know, large differences in how they react. But it’s something that we want to look at more carefully because there are differences across these industries that could matter.

Prof. Kelly Shue

For example, they differ a lot in how strongly they’re regulated, and they also differ in kind of the natural flow of technology. For example, there’s research not my own, but research I find very interesting, showing that it’s actually the energy sector firms that hold the most highly cited green energy patents. So one interpretation of this is that energy sector firms, including many of the very traditional oil and gas firms, they just see a natural transition in technology that is favoring newer green technologies.

Prof. Kelly Shue

So actually, in good times, they’re preparing for this existential risk by investing R&D into technologies that could help them transition to a new mode of production. That is both more green and also more profitable in the long run.

Jason Mitchell

Your paper focuses on Scope one and scope two carbon emissions, which makes sense given the scarcity of accurate scope. Three Emissions data. I’m wondering, do you have any sense for how scope three emissions could influence the paper’s findings in the future? The CDP estimates that scope three emissions represents roughly around 75% of total emissions based on the European companies that report Scope three currently.

Jason Mitchell

You know, I’d point to the oil and gas sector where it could represent as much as 95% of overall emissions. Likewise, even tech companies could see big emissions increases owing to their data center and downstream emissions exposure.

Prof. Kelly Shue

I think there are at least two reasons to not look at scope three emissions. But I’ll give you a third reason why we could want to look at scope three emissions. So the first is just one of reporting and noise reporting for scope one. And scope two is already far from perfect reporting of scope three by a firm.

Prof. Kelly Shue

So this is one firm having to estimate emissions by all of its suppliers, and that is going to be extremely noisy. I can imagine severe problems with greenwashing in these estimates. The other problem with using scope three is that the scope three emissions of one firm is going to be the scope one emissions of a different firm, and therefore it results in this quite severe double counting of emissions.

Prof. Kelly Shue

Those are the two stand arguments for possibly not using scope. Three When considering the composition of a sustainable investing portfolio, what you could do if you want to look at scope three is you consider only final goods producers and you exert pressure only on these final goods producers to lower their own emissions and also exert pressure on all of their suppliers to reduce their emissions.

Jason Mitchell

In what way do ESG ratings, apart from carbon intensity ratios, present their own problems in your mind? It’s interesting to see a recent paper by Dennis BAMS and Bram Van der Croft find that portfolio tilts, which are driven by inflated ESG ratings. They lead to information asymmetries, capital misallocation, and ultimately negate the aim of sustainable investing. But the problem is, in that process, these ESG tilts end up lowering firms cost of capital.

Prof. Kelly Shue

Yeah, the combination of environmental, social and governance goals into one single investment strategy is complicated. And I’m not sure makes sense. You know, I think it makes the strategy much more complicated and also allows more wiggle room for firms to manage their image without necessarily making meaningful improvements on any of these metrics. So I kind of agree with a recent cover story in The Economist magazine, where they argue that ESG should be boiled down to one single metric, which is e for emissions instead of even E for a broader set of environmental goals.

Prof. Kelly Shue

And the reality of this is, unfortunately, the threat of global climate change is the largest existential risk that we face. I wish that we could prioritize actually all of these goals because it would certainly be good to have improved governance, improved social impact of these firms, less discrimination by these firms against certainly certain disadvantaged groups. So I support all of these motives.

Prof. Kelly Shue

But in terms of priorities, it really seems like global climate change is the most pressing concern that we face.

Jason Mitchell

Some academic research has questioned the efficacy of Engage payments focused on carbon emissions reductions. There’s also, from my view, an interesting turn, at least in the U.K., among a part of the sustainable finance community in terms of divesting from heavy emitters, particularly the oil and gas industry. For instance, after five years of engagement, the church commissioners of England have decided to divest of oil and gas companies as another example.

Jason Mitchell

Ten of BP’s top shareholders are members of the Climate Action 100 plus Collaborative Engagement Initiative. But look, to be fair, that doesn’t seem to have helped BP walk back its 2030 climate targets. And so I guess my question is, is the Exxon engine number one campaign, in your mind, an outlier against a history of generally unsuccessful engagements in the sector, or is it something to is it a model to look forward to?

Prof. Kelly Shue

You know, I remain very hopeful about engagement strategies. So that’s investing in a brown firm, interacting with its board, trying to directly pressure that brown firm to transition toward more green. I’m hopeful of that strategy, as well as very targeted impact strategies that invest in particular green projects or subsidized green R&D. So I think those are all strategies that could have a major impact on helping the world become more green.

Prof. Kelly Shue

But I do sympathize with the general sense that these are not practical strategies for the bulk of sustainable investors. And the reason is there is now so much money in sustainable investing. Recent estimates by Bloomberg said 35 trillion as of 2020, so I’m guessing over 40 trillion by now committed to in some form to sustainable investing and ESG.

Prof. Kelly Shue

Now, the bulk of this money is money that used to be in diversified equities, and now they have more of a green or an ESG focus. So this is money that seeks to have a risk and return profile that is similar to a diversified equities portfolio. So these are not investors that would commit the same giant pot of money to a targeted impact or engagement strategy because those types of strategies are probably much higher risk and also would not mimic the broad market index.

Prof. Kelly Shue

So it would be difficult to transfer this giant pot of possibly $40 trillion into these more specialized engagement or impact strategies. I’ve also heard from fund managers that they are not set up. This is not part of their expertise to exercise engagement. So when they’re given funds to commit to a sustainable strategy, it’s not easy for them to just pivot toward direct engagement.

Prof. Kelly Shue

So in the absence of direct engagement, I think some other ways for sustainable investors to be more productive with their investment dollars is one to dial up the incentive channel. So instead of just rewarding firms that have had large percentage reductions in their emissions reward, even firms that are still high polluting but that have reduced their emissions in meaningful amounts as measured in levels.

Prof. Kelly Shue

The second thing that sustainable investors could do is that they could do a better job of adjusting by industry. So instead of divest ing away from all of agriculture and then overweighting insurance, even though these two industries are not at all substitutable, what sustainable investors could do is they still invest in agriculture because we know we need food, but invest in the greener firms within agriculture or invest in the firms in agriculture that are still high polluting but have meaningfully reduced their emissions over the past several years.

Prof. Kelly Shue

So those are ways, I think, to be effective as a sustainable investor without necessarily changing to an engagement only strategy.

Jason Mitchell

Thanks, Professor Shu, last question. How are you thinking about expanding the short termist cost of capital observation that the paper covers? Climate data has a clear advantage in history comparability and transparency relative to social and governance data. But is there a next best area in the space that you’re focused on?

Prof. Kelly Shue

It’s a difficult question because, you know, I will say I’m not sure one view is we actually should not care about the ESG equally. Instead, you know, while it would be good to improve on all three metrics, maybe we should just focus on the most pressing problem and target carbon emissions and greenhouse gas emissions. So that’s one view.

Prof. Kelly Shue

I think there’s another view, which is if we try to make progress on all fronts, you know, it’s not obvious that, let’s say social or governance investment would react in the same way as carbon emissions. The reason why we find that carbon emissions is so sensitive to the cost of capital is to pollute a lot. Right now is a way to generate cash right now.

Prof. Kelly Shue

And then switching to cleaner production. So lower carbon emitting production typically and via requires large upfront investment and delayed cash flows. So investments in green production in particular is going to be very sensitive to the cost of capital investment in, let’s say, social impact of a firm I’m not sure is going to be as sensitive to the cost of capital.

Prof. Kelly Shue

You can take an example, which is let’s suppose a firm decides to stop discriminating against its female employees. Well, that type of project is not necessarily extremely costly upfront and requires a huge capital investment. So it’s not obvious that improvements on the social dimension would stall if a firm had a higher cost of capital. You know, it’s possible.

Prof. Kelly Shue

I would say that in general, bankrupt firms or firms that are in financial distress tend not to think much about, you know, the S org. They’re just so focused on short term survival, but is probably the part of the firm that is most sensitive to the cost of capital.

Jason Mitchell

That’s great. So it’s been fascinating to discuss why brown firms, not green firms, will drive the greatest emission savings, how the cost of capital can be a powerful lever for behavior change, and why it’s vital that sustainable investors move more towards energy transition type strategies. So I’d really like to thank you for your time and insights today. I’m Jason Mitchell, head of Responsible Investment Research at Mann Group.

Jason Mitchell

Here today with Professor Kelly Shue at the Yale University School of Management. Many thanks for joining us on a sustainable future. And I hope you’ll join us on our next podcast episode. Thank you so much, Kelly. I really appreciate this.

Prof. Kelly Shue

Thank you.

Jason Mitchell

I’m Jason Mitchell. Thanks for joining us. Special thanks to our guests and, of course, everyone that helped produce this show. To check out more episodes of this podcast, please visit us at MANKOFF Forward Slash. All right, Dash podcast.

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