Professor Martin Oehmke of the LSE Department of Finance discusses a new approach to socially-responsible finance, based on his award-winning work 'A Theory of Socially Responsible Investment', co-authored with Marcus Opp.
Socially responsible or sustainable investment has been one of the biggest trends in finance over the last decade. More and more investors put their savings into funds that meet certain sustainability or ESG ratings. This all sounds very nice, but a key question is whether this actually makes a difference, for example, with respect to the amount of carbon that is emitted by corporations.
divestment or screening are not particularly effective at changing company behaviour
The traditional approach by which socially responsible investors have tried to make a difference is divestment or environmental screening. What this means is that a large fund or, say, a university endowment threatens to sell their holdings in a particular company (divestment) or to not invest at all (environmental screening). However, the evidence shows is that divestment or screening are not particularly effective at changing company behaviour. And the reason is intuitive: as one investor - say the university endowment - sells, another investor who cares less about carbon emissions steps in. In the extreme case, this new investor seamlessly replaces the capital that socially responsible investors withdraw, and divestment has no effect.
investment, rather than divestment
In my research, I have focused on investment, rather than divestment, as a means to change firm behavior. The idea is that by providing attractive financing terms to firms that adopt sustainable practices, socially responsible investors can actually change firm behaviour. And our research shows that this will work, under certain conditions.
The key condition that we highlight for socially responsible funds to affect firm behavior is that in their investment decisions they follow what we call a “broad mandate.” What we mean by that is that socially-responsible funds need to internalize, or care about, carbon emissions unconditionally – in other words, independent of whether these emissions are caused by a firm that they actually invest in. Thinking about their investments in this way means that they will internalize the benefits, in terms of a reduction in carbon emissions, that their investment makes relative to the counterfactual, in which they do not invest in that particular firm. This type of thinking makes them willing to provide funding at attractive terms if, in turn, firms commit to change their behaviour.
In contrast, if the sustainable fund only looks at emissions generated by companies they actually invest in, they will make no difference. Rather than investing in companies where they will make a difference, they will simply select companies that in all likelihood are sustainable anyway. And dirty companies would continue to be funded by purely profit-driven investors.
How much financial return are we willing to sacrifice to make the world a better place?
One of the important practical implications of our analysis is that, in order to change firm behavior, socially responsible investors need to be willing to accept lower financial returns than purely profit-driven investors.
Why? Well, because if socially responsible investors were to get the same return, then regular profit-driven investors would also be happy to invest. Therefore, in order to make a difference, socially responsible investors need to offer better terms.
This is an important finding, because the financial industry often claims otherwise, describing socially responsible investment as a win-win: doing good AND doing well. But, in our view, this would imply that socially responsible investors have no impact. Accepting a lower financial return is therefore key, and it is something that mutual funds or pension funds should be upfront about with their investors. How much financial return are we willing to sacrifice to make the world a better place?
Martin Oehmke is Professor of Finance at the London School of Economics and Political Science.
His paper, A Theory of Socially Responsible Investment, co-authored with Marcus Opp, won the European Finance Association Best Paper Prize in Responsible Finance.
This research received funding from the European Research Council (ERC) under the European Union’s Horizon 2020 research and innovation programme (grant agreement 715467).