The past several years have seen “green investing” rise to prominence. In 2020, environmental, social and governance (ESG) funds captured $51.1 billion of net new capital from investors, a fifth consecutive annual record. At the same time, companies are facing growing scrutiny of their environmental practices from institutional shareholders and activists. While these trends indicate progress toward sustainability at a time when concerns regarding climate change have never been greater, some have questioned the extent to which the growing focus on green investing truly benefits the environment.
A common theory of green investing goes as follows: if enough investors avoid companies that aren’t environmentally responsible, that will raise their cost of capital. Increasing capital costs will in turn force those companies to address their externalities responsibly or risk falling behind competitors as their ability to attract investment on desirable terms is diminished. As a result, companies will either embrace a long-term shift towards environmentally responsible practices or fade into obsolescence. In theory, then, investors can contribute to the positive environmental change they want to see by joining the green investing trend.
However, some suggest that this is not the complete picture. For example, Matt Levine, a Bloomberg opinion columnist, provides a counterargument that if increasing capital costs force companies to divest their polluting assets, those assets will likely be sold at a discount to the expected cash flows that could be generated from their continued operation. As a result, other businesses – ones that are less concerned with raising capital or the views of activist investors – are likely to purchase and continue operating those polluting, profit generating assets. In short, and as Levine aptly titled his article, Someone is Going to Drill the Oil. Unless all operators in a particular industry agree to act in an environmentally responsible manner, one organization’s steps toward green practices may simply result in polluting assets changing hands. In this situation, there is no net benefit to the environment.
An even bleaker view is offered by Tariq Fancy, BlackRock’s first global Chief Investment Officer for sustainable investing. He has referred to sustainable investing as a “dangerous placebo that harms the public interest”. A key problem is that no universal framework exists for measuring a company’s practices against established ESG metrics; often, sustainability initiatives are seen as including “anything ‘good’ for the world.”
The absence of a uniform approach to evaluating a company’s ESG performance opens the door for selective disclosure of ESG practices that, while laudable when viewed in isolation, may not be representative of the environmental impact of a business’s operations when viewed holistically. Such selective disclosure may result in companies being viewed as “green” while continuing to produce externalities that are not prominently reported. ESG funds and other investors intending to support environmentally responsible businesses therefore face a challenge in determining how to invest in a manner that truly benefits the environment. As ESG funds continue to raise record-setting capital, it may be inevitable that, unbeknownst to well-intending investors, some portion of that capital will ultimately fund operations that do harm to the environment.
Transparency with respect to the environmental impact of a business is therefore crucial to achieving sustainability, and in that regard, all is not bleak. For example, the Sustainable Finance Disclosure Regulation, which recently came into force in the EU, will require financial market participants (e.g., ESG funds) in the EU to disclose where they do – and do not – consider adverse impacts of their investment decisions on sustainability factors. The US Securities and Exchange Commission has established a task force to target misleading ESG claims and has indicated that it is working to establish a comprehensive ESG disclosure framework. Similarly, the Canadian Securities Administrators have proposed a new National Instrument which would require most public companies to disclose climate related information consistent with recommendations made by the Task Force on Climate-related Financial Disclosures, thus creating a somewhat standardized reporting framework that would apply across Canada.
In short, governments are aware that obfuscation of environmental practices may pose a barrier to those who desire to promote environmental responsibility through their investing activities, and they’re taking action to create transparency. Such transparency is just one step in the direction of sustainability – for example, organizations that are less susceptible to pressure from investors may continue producing externalities where it is profitable to do so. However, by aiding investors in ensuring that capital intended to support green enterprise is actually doing so, regulatory efforts regarding transparent reporting are an essential step toward sustainability.