By Raman Uppal, Professor of Finance, EDHEC Business School
Debunking Skepticism: Challenging the Return Narrative
Skepticism about ESG investing often revolves around the notion that prioritizing sustainability inevitably comes at the expense of returns. Academic studies cast doubt, and investors, particularly in the U.S., have vehemently pushed back against ESG investing, citing concerns that ESG practices erode investment returns. But are these misgivings valid? The answer, as revealed through a meticulous examination of ESG investing, is a resounding no.
The heart of the skepticism lies in the assumption that redirecting capital from environmentally harmful "brown" firms to sustainable "green" ones will undoubtedly dilute returns for investors. Critics argue that the very act of spreading returns across these different sectors undermines the intended impact of ESG mandates, rendering them ineffective. This is because, as returns in the green sector decline and those in the brown sector rise, investors who are not constrained by ESG mandates, e.g., hedge funds, will shift capital from green to brown firms, thereby undoing the effect of ESG mandates.
Unraveling the Elasticity Enigma
Crucial to dismantling these arguments of critics of ESG investing is understanding the elasticity of demand for capital. The skeptic narrative presupposes a relatively inelastic demand for capital by firms, which implies that when investors shift capital from brown firms to green firms, the returns from investing in brown firms will increase while the returns from green firms will decline. However, the research my colleagues and I have conducted challenges this assumption.
By introducing the concept of elasticity and delving into the returns to scale, our findings point to a different reality. If firms' demand for capital is elastic, scaling up can occur without diminishing returns to investors. Specifically, in situations where there are constant returns to scale, firms can significantly expand without sacrificing returns. This critical nuance, often overlooked by skeptics, reshapes the narrative surrounding the impact of ESG mandates on investment returns.
Empirical Evidence: Constant Returns to Scale in the Green Sector
Empirical estimates from macroeconomic studies consistently suggest that returns to scale are close to constant, that is, demand for capital is very elastic. In the green sector, where ESG efforts are most concentrated, returns may even grow more than linearly with capital input due to network externalities and learning-by-doing. Contrary to skeptics, this scenario opens the door to the possibility that shifting capital to the green sector could potentially lead to higher returns for investors.
Our research underscores the empirical reality that when a fraction of investors is mandated to shift from brown to green firms, the cost of capital is minimally affected, even with substantial changes in capital demand. This is a pivotal revelation, ensuring that the positive impact of ESG-motivated mandates on capital allocation remains intact, undeterred by the actions of investors exempt from such mandates.
Strategic Implications for Actuarial Professionals: Guiding Clients Toward Informed Choices
For actuarial professionals navigating the complex landscape of Life Insurance, Pensions, and Investments, our research offers strategic insights. By understanding the flaws in the arguments offered by critics of ESG investing, professionals can guide clients toward ESG-conscious choices with confidence.
The core takeaways from our research redefine the narrative. Firstly, assessing the effectiveness of ESG mandates through the sole lens of their impact on the cost of capital is misleading. We find that the allocation of physical capital across green and brown sectors can significantly differ, even with minimal disparities in the cost of capital. Secondly, our research affirms that ESG-conscious investments need not result in lower returns. On the contrary, they can effectively advance ESG goals, demonstrating that positive environmental and social impacts can coexist with robust investment returns.
Conclusion: Steering Toward a Sustainable Financial Horizon
In conclusion, actuarial professionals hold the key to unlocking the potential of ESG investments. By debunking skeptical arguments and embracing the insights from our research, these professionals can usher in a new era where sustainability and returns not only coexist but complement each other. The actuarial marketplace stands at the forefront of a sustainable financial future, where informed choices not only align with ESG goals but also contribute to long-term financial prosperity.
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