Here’s how we can be more precise about responsible investing

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Alex Edmans, Professor of Finance, London Business School

• In order for responsible investing to have meaning, we must be clear about its objectives.
• Some of its objectives are in harmony, others are in conflict – leading to trade-offs between them.
• The World Economic Forum’s Global Future Council on Responsible Investing has released a note proposing a definition of what responsible investing involves to focus the discussion.

Responsible investing (RI) is a rapidly growing area of investing, but this excitement and enthusiasm has been accompanied by a lack of clarity as to what RI involves. On the one hand, some definitions are too loose. In 2020, the US Sustainable Investment Forum reported that $1 in every $3 professionally managed in the US was invested in RI strategies – totalling $17.1 trillion – which was 25 times the level in 1995. However, in 2022, it revised its methodology to exclude investors who state that they practice RI, but do not describe any specific RI criteria. After this revision, these figures more than halved to $1 in every $8 ($8.4 trillion).

On the other hand, some definitions of RI are too rigid and fail to recognize that RI can be pursued with different objectives and in different ways. Blanket statements about whether RI “works” or “does not work” are meaningless without being clear about the type of RI they refer to – the criteria against which to assess whether it “works”. Responsible investing may be more successful at achieving some objectives than others, so it’s important to be precise about the form of RI, rather than treating it as a homogenous entity.

The World Economic Global Future Council on Responsible Investing has released a note, Responsible Investment: Definitions and Taxonomies, which proposes a definition and taxonomy of what RI involves, to provide clarity, concreteness and focus to discussions. A secondary purpose is to highlight the potential trade-offs between its different objectives. The note defines RI as follows:

Responsible investing is the incorporation of environmental and social factors to achieve one or more of the following objectives:

• Financial returns

• Societal impact

• Values alignment

There are five key elements to this definition.

1. Incorporation

Responsible investing needs to be meaningful. It sometimes involves taking different decisions that an investor would not have done otherwise if it were simply an “investor”, not a “responsible investor”; otherwise all investors could call themselves responsible. This is why we define RI as the “incorporation” of environmental and social factors, rather than (for example) the “consideration”. An investor might consider environmental and social factors, but view them as always secondary to financial factors. “Incorporation” implies that they will sometimes change investment decision-making.

2. Environmental and social

Responsible investing is sometimes referred to as environmental, social and governance (ESG) investing. However, virtually all investors will take governance into account in their investment decisions, as the effects of poor governance are almost always ultimately internalized by the company. A company that lacks board expertise, or where CEO pay is insufficiently tied to long-term performance, will likely underperform and destroy shareholder value.

In contrast, some environmental and social (ES) factors are externalities that primarily affect wider society. An energy company can emit greenhouse gases, harming agri-businesses that are unable to grow crops in a warmer climate, but may not bear the full environmental cost of their actions in the absence of a global carbon tax. A clothing company can save costs by using forced labour and not be prosecuted because laws are weak. A responsible investor will incorporate ES factors into investment decisions either because they are an investment objective in their own right, or because it believes they will ultimately be internalized and affect financial returns. However, a non-responsible investor will not.

External environmental and societal risks may ultimately end up affecting business value.

3. Financial returns

One reason why responsible investors incorporate ES factors into investment decisions is the belief that they will increase risk-adjusted financial returns. They may increase returns if, for example, customers are more likely to buy from companies with strong environmental records, or employees are more motivated and productive in a firm that invests in their well-being. They may reduce risk if, for example, energy companies that invest in clean energy are less vulnerable to a carbon tax, or companies that mitigate the negative impact of restructuring on their employees are less susceptible to strikes.

4. Societal impact

Another motive for responsible investing is to positively impact society – to create ES value. There are two ways this can be done. The first is stock selection. By investing in “green” stocks with a positive societal impact (such as clean energy), investors can – at least in theory – make it easier for them to raise funds, allowing them to expand and increase their positive impact. Conversely, by disinvesting from “brown” stocks with a negative societal impact (such as tobacco), investors make it harder for them to raise funds, hindering them from expanding and increasing their negative impact.

The second method is stewardship: By voting and actively engaging on ES issues, investors can increase a company’s positive impact or reduce its negative impact. Importantly, while stock selection involves investing in green companies and disinvesting from brown companies, stewardship might involve investing in brown companies and engaging with them to reduce their negative impact (such as encouraging a tobacco company to develop less harmful products).

In some cases, financial returns and societal impact will overlap. For example, if a company has strong ES performance that is not priced into the market, buying such a company will create both financial returns and societal impact. Engaging with a company to improve its ES performance will have positive societal impact and also enhance financial returns if these ES factors are material to the company’s business, i.e. will ultimately be internalized.

However, in other cases, they will not. If ES performance is already priced in (or overly priced in), buying green companies will not enhance financial returns but will have societal impact. Engaging on ES factors that are pure externalities (i.e. will not eventually be internalized) will not enhance financial returns, but will have societal impact.

5. Values alignment

An additional motivation for responsible investing is to invest in companies that reflect the investor’s (or its clients’) values. This is undertaken purely through stock selection, by buying companies that align with the investor’s values and avoiding companies that do not. Note that different responsible investors will have different values; one may believe that an alcohol company contradicts its values, but another may not.

Values alignment will overlap with financial returns if companies that align with the investor’s values are underpriced, but conflict if they are overpriced. Values alignment will overlap with societal impact if investing in aligned companies reduces their cost of capital and allows them to expand, but sometimes conflict. An investor may achieve societal impact by buying tobacco companies and engaging with them to develop less harmful products, but owning such firms may contradict with some investors’ values. An investor may achieve societal impact by buying fossil fuel companies and reducing their cost of capital to help them transition into clean energy, but holding fossil fuel companies may conflict with some investors’ values.

As responsible investing continues to gain momentum, it is important to be precise about what it involves and what it seeks to achieve. The paper published by the Global Future Council on Responsible Investing aims to provide clarity about its objectives, the potential trade-offs between them, and the different ways in which it may be practiced.