Sustainable Finance in a Turbulent World

Socially responsible investment (SRI) is coming of age in a particularly volatile and turbulent time for global politics. While a huge number of investors have checked the ESG status of investment choices – be that in traditional investment funds or consumer choices in an app that offers a sliding scale of responsibility – there has been a slight retreat from this market, driven largely by US policy turning against ESG.

In the six years since starting my award-winning work with Marcus Opp, "A Theory of Socially Responsible Investment" (now published in the Review of Economic Studies), we have seen greater corporate scrutiny and more calls for evidence-based outcomes for socially responsible investment. Such calls have not only come from large corporate investors but from governments and authorities, with the UK and Europe notably looking to crack down on 'greenwashing'.

There has also been a significant political backlash against Net Zero, one of the concepts that underpins sustainable investment. A broad political agreement from the centre to the right is that 'this will cost too much money and too many jobs'. Environmental funds tend to look to the long term, and politicians know that when times are hard, voters look to the bottom line before long-term impacts.

Despite this, the overall investment picture remains buoyant, with no real-terms dip in funds and $3.16TN currently invested. While this looks positive, the key question remains as to whether such investments do or can make a real-world difference in the way that investors believe they can or should. In short, does putting your money into funds that finance green initiatives mean fewer carbon emissions from large corporations globally?

The way in which socially responsible investors have seen their influence playing out is largely in terms of divestment – withholding or withdrawing their funds from businesses that they see as damaging. Consumer pressure can press investors to carry out such actions, with universities being a common example of those subject to calls for divestment from students or activists.

The hope is that a business that is screened, avoided, boycotted, or divested from will note the lack of investment and change its ways, opting for green initiatives and reducing carbon output. However, this rarely occurs. When one investor sells, they merely create an opportunity for another – perhaps less ethically-minded – investor to simply replace those funds.

My research has shown that, in order to be effective, SRI funds and investors need to flip the script. "Less stick and more carrot" is the way to go, with more influence to be gained by offering favourable funding terms in exchange for environmental action or initiatives that bring about social change. The challenge for impact funds is that this increased effectiveness likely comes at a cost.

The influence that such investment terms offer comes with a financial sacrifice, whereby SRI funds are offering to make lower returns than traditional funds. This is the pay-off that makes changing their ways worthwhile for the businesses in question. Companies will only change behaviour if an SRI fund provides something not on offer from traditional profit-chasing investors. This translates into lower returns for socially responsible investors.

The influence that such investment terms offer comes with a financial sacrifice, whereby SRI funds are offering to make lower returns than traditional funds. This is the pay-off that makes changing their ways worthwhile for the businesses in question. Companies will only change behaviour if an SRI fund provides something not on offer from traditional profit-chasing investors. This translates into lower returns for socially responsible investors.

This strategy requires a solid commitment to the cause, internalising wider social benefits rather than focusing on financial returns. This raises important questions for investors. After all, which pension fund would be able to confidently turn to its investors and offer reduced returns in exchange for the knowledge that the percentage lost will help to cut carbon emissions over the next decade? There are certainly politically and socially motivated investors willing to take that hit, but those who can afford to and would be willing to do so are currently still small in number. New ways of looking at the problem will require new thinking.

The next challenge for SRI is to find ways to increase the number of such investors and, hence, their influence. This requires going beyond simplistic ESG mantras such as "doing well by doing good" and outdated approaches such as portfolio screening. This seems like an essential move in a political environment becoming, for now at least, hostile towards ESG.

In this challenging environment, LSE's Sustainable Finance and Impact Investing programme will bring together executives who have the will to engage with this difficult challenge head-on and embrace the trade-offs necessary for genuine impact. Doing so will be invaluable in reshaping how we measure the purpose and impact of capital, leading the move from good intentions to meaningful, measurable impact.