Wharton School of the University of Pennsylvania issued the following announcement on Nov. 8.
Investors who espouse environmental, social and governance (ESG) principles will achieve little by selling their shares in ESG-unfriendly companies, according to a new research paper titled “The Impact of Impact Investing” by finance professors Jonathan B. Berk at Stanford University and Jules H. van Binsbergen at Wharton. Instead, investors could have more success if they buy those so-called “dirty” stocks and then engage with those companies’ managements to adopt ESG-friendly policies, the paper contended.
When ESG investors sell stock in ESG-unfriendly companies, they hope to drive down those stock prices and thus make it harder and more expensive for those companies to raise capital. But “the impact [of divestment] on the cost of capital is too small to meaningfully affect real investment decisions,” the paper stated. “To have impact, instead of divesting, socially conscious investors who want to have an impact should invest and exercise their rights of control to change corporate policy.”
According to van Binsbergen, socially conscious investors who divest from ESG-unfriendly companies often state they have two objectives. The first is “to feel good that they’re not investing in dirty companies,” he said. “That’s more like a placebo effect. If that makes them feel good, it may have some utility.” Second, ESG investors want their divestment to “change the way companies do business” and become more ESG-friendly, he added.
But divestment is an unwise strategy, van Binsbergen and Berk found in their study. Suppose that your divestment has a meaningful effect. In that case, investors end up poorer when they sell dirty stocks and buy “clean” stocks. “With that, you drive up the stock prices of clean companies and drive down those of dirty companies,” said van Binsbergen. “But that means going forward, clean companies will have lower returns. You’ll make less money by investing in green stocks, and you will make more money by investing in dirty stocks. Not only do you as a green investor get lower returns, but on top of that you are rewarding investors that do not care about being green with higher returns.”
“If you sell stocks in a dirty company, somebody else will buy them.”–Jules H. van Binsbergen
More importantly, from a quantitative point of view, the effect is not going to be large enough. That is, ESG-unfriendly companies are not penalized sufficiently if investors dump them and switch to clean companies, van Binsbergen continued. Drawing from his earlier point, he noted that lower returns for clean companies will imply a lower cost of capital for them compared to so-called dirty companies, but the main question is how much lower.
High Bar for Divestment to Be Effective
KNOWLEDGE@WHARTON HIGH SCHOOL
“Using the most optimistic estimates, we show that to effect a more than 1% change in the cost of capital, impact investors would need to make up more than 80% of all investable wealth,” the paper stated. “Given the low likelihood of achieving such a high participation rate, the results in this paper question the effectiveness of disinvestment.” Van Binsbergen explained that with the analogy of a loan where the interest rate for a dirty company is 1% higher than that for a clean company: “You need 85% of the market to be with you before you can achieve that 1% effect.”
In order to determine that change in the cost of capital, Berk and van Binsbergen studied the FTSE 4Good USA Index, which has 491 companies including Microsoft, Apple and Amazon and is part of a broader FTSE 4Good index that measures the performance of companies with strong ESG practices around the world.
For the study, the authors created a model with both clean and dirty stocks and weighted the impact of four drivers on the cost of capital. One was the equity risk premium, which is a measure of how much stocks outperform bonds. The second looked at the shares of clean and dirty companies in the composition of the U.S. economy. The third driver is the amount of capital controlled by green and non-green investors. The fourth driver was a measure of how substitutable green and dirty stocks are.
“We find in the data that the correlation between green and ‘dirty’ is so high that some investors are willing to hold more dirty stocks for almost no inducement,” van Binsbergen said. “Therefore, you don’t have to give them much of a higher return at all to get them to hold more of those dirty stocks.” With that high a correlation between green and dirty companies, “the whole effect [of ESG investing] just disappears; it just doesn’t do anything,” he added.
“The reason divestiture has so little impact is that stocks are highly substitutable, and socially costly stocks make up less than half of the economy,” the paper explained. “Even with the growth in the popularity of impact investing in the last 10 years, we find no detectable difference in the cost of capital between firms that are targeted for their social or environmental costs and firms that are not.”
The paper noted that the Vanguard FTSE Social Index Fund, which tracks the FTSE 4Good index, is the world’s largest social index fund. But that Vanguard fund manages only $12 billion in assets, which is a small fraction of the U.S. stock market capitalization of about $50 trillion, van Binsbergen noted.
Van Binsbergen pointed to other reasons why divestment doesn’t always help the ESG cause, and in some cases, it could worsen the situation. “If you sell stocks in a dirty company, somebody else will buy them,” he said. “That person clearly doesn’t care about the ESG aspect of it, making it less likely that investor pressure could force changes in the company. The question in that case is, have you done something good?”
“If you want to convince companies to do the right thing, then go to the shareholder meeting and vote through the proposals that are the right thing to do.”–Jules H. van Binsbergen
In an extreme scenario van Binsbergen visualized, divestment could drive down the price of a dirty stock to a level where “other investors who don’t care” about ESG principles could end up gaining full control. “Suppose you could get the price of a dirty stock to go to, say, a dollar,” he said. “The CEO of the company could then buy the whole company for that low stock price. You’re giving the person that cares the least about ESG the opportunity to buy the whole stream of profits almost for free.”
Why Engagement Is a Better Option
On the other hand, socially conscious funds could buy stock in ESG-unfriendly companies, and they would need far less than 50% shareholder participation to effect change, the paper pointed out.
Van Binsbergen explained how that works with an example of a company’s shareholder meeting where 51% of the votes are against a green initiative. If socially conscious investors control the remaining 49% that is in favor of the initiative, they would need a little over 1% more to clinch the vote.
“If you as a socially conscious investor make sure that you are on the margin, then with little investment you can swing the vote, and potentially make a large impact,” he said. “If you want to convince companies to do the right thing, then go to the shareholder meeting and vote through the proposals that are the right thing to do. Show up and make your point.”
Over the past year, a few activist and institutional investors have adopted Berk and van Binsbergen’s approach of engagement with companies they perceive as ESG-unfriendly.
- Earlier in October, BlackRock announced that beginning in 2022, it would enable select institutional clients to have a greater say in voting on their investments. It said that move is consistent with its policy of “engaging” with companies “in advocating for sound corporate governance and sustainable business models to support long-term financial returns.”
- In June 2021, activist hedge fund investor Engine No. 1 wrested three board seats at ExxonMobil with the support of the “Big Three” institutional investment firms BlackRock, Vanguard, and State Street. Engine No. 1 had launched a campaign that called for “repositioning ExxonMobil for long-term value creation.”
- In late October, Third Point LLC, an activist investment firm led by Daniel Loeb, called upon Royal Dutch Shell to split into two standalone companies, The Wall Street Journal reported. Third Point’s plan is for one firm to have Royal Dutch Shell’s legacy businesses, such as refining, that would provide steady cash flows, and another firm for its renewables and other units that require substantial investment.
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