Article by Dr Marko Graenitz, Editor-in-Chief Alpha for Impact Magazine
The term "sustainability" originates from forestry, with the underlying principle dating back over 300 years: do not harvest more trees than can naturally regenerate. However, the concept becomes significantly more complex when applied to the capital market. In this context, the acronym "ESG" has gained prominence, representing ecological (environmental), social, and corporate governance factors. Nevertheless, in the public's perception, sustainability often focuses predominantly on environmental concerns. Interestingly, these sustainable investments have occasionally outperformed traditional ones due to substantial capital inflows. Yet, according to the study "Flow-Driven ESG Returns," this outperformance appears to be transient. Further analyses, such as those found in the Credit Suisse Global Investment Returns Yearbook, suggest that sustained outperformance is improbable. Capital market models also lend support to this notion.
Smaller investment universe should lead to underperformance
In a theoretical framework, to maximize portfolio returns while maintaining a given level of risk, it is imperative to broaden the investment universe rather than limit it. Excluding equities from the portfolio may yield the same results in the best-case scenario but is more likely to yield worse results. This becomes particularly relevant when the excluded stocks exhibit superior performance, as is often the case with so-called "sin stocks." Market arithmetic provides a theoretical explanation for this phenomenon: all stocks must have owners. If only a subset of market participants is willing to hold certain stocks, they can command higher returns as compensation. Consequently, sustainable investments might, over the long term, exhibit a slight underperformance depending on the extent of exclusions or divestments. Divestment, in this context, refers to the sale of existing positions in non-sustainable stocks.
However, divestments do offer a potential benefit: as the expected returns of "bad" stocks rise, the cost of capital used by companies to evaluate investment projects theoretically increases. This higher hurdle means that fewer projects should be deemed profitable and, consequently, fewer projects will be executed. This mechanism could be a lever for the positive change that sustainable investors aspire to achieve.
Nonetheless, the effectiveness of this adjustment is not as significant as often assumed. According to the authors of the study "The Impact of Impact Investing," divestments only marginally increase companies' cost of capital, by a few basis points. This marginal change is unlikely to impact corporate investment decisions. This is primarily due to the highly substitutable nature of equities. If one group of investors divests certain stocks, it takes only a small price shift to attract other investors to hold them. To effect a practical change of at least 1% in the cost of capital, more than 80% of total invested capital would need to be allocated to sustainable investments, according to the researchers. Therefore, divestments only exert a significant influence if the majority of investors participate. However, there's a substantial caveat: As the incentive for investing in "sin stocks" grows, given their expected higher returns, will the majority of investors voluntarily relinquish them?
Active engagement as solution?
An alternative approach to achieving change is through active engagement rather than divestment. By acquiring significant stakes in such companies, investors can leverage their voting rights to influence sustainability practices. The study suggests that a much smaller portion of investment capital would be required to achieve a comparable effect to divestments in this manner. Furthermore, non-sustainable companies may offer the greatest potential for improvements, especially if they focus on the most promising candidates in each sector. Over time, this approach could exert pressure on less sustainable companies within those sectors, fostering a signal effect.
Some experts argue against investing in "bad" companies, believing that meaningful change is unlikely when sustainability concerns fall on deaf ears. They propose a focus on "good" companies already on a sustainable trajectory, where resistance to further improvements is lower. However, it's crucial to note that active engagement only succeeds with a serious and persistent commitment. Thus far, results in this regard have been underwhelming, according to Prof. Dr. Dirk Soehnholz, Managing Director of Soehnholz ESG GmbH, who suggests that divestments achieve more than voting rights or engagement. Notably, one argument favouring divestments is their potential to apply pressure when strategies for active influence falter. Nonetheless, divestment advocates contend that merely excluding certain stocks is the simplest (and least effective) approach to sustainable investing. Superior alternatives, such as the Best-in-Class approach that focuses on industry leaders in sustainability, have long been available.
Throughout this discussion, it is essential to recognize that society still relies on many products from the non-sustainable sector. Avoiding stocks associated with these sectors does not address the underlying problem; it merely shifts profits. Additionally, it's vital to acknowledge that sustainability carries a cost. Frederike von Tucher, Team head of the ESG Investment Team at Flossbach von Storch, highlights that companies only contribute positively to the environment and society when they are profitable and possess adequate resources for research and development. Furthermore, substantial investments are required in developing countries, with Deirdre Cooper, Head of Sustainable Equity at Ninety One, estimating that 70% of the capital needed to achieve sustainability goals must be directed there. Clearly, economic factors of an existential nature must be considered.
So what to do?
In light of these considerations, the question arises: what should be done? Many discussions regarding the implementation of sustainability in financial markets seem to revolve in circles. Perhaps it is time to adopt a broader perspective. Mark Schieritz, a political and economic book author, recently argued in an article for "DIE ZEIT" that the free market, as we understand it, does not exist in practice. The state establishes the framework conditions for production and consumption, and incentives, regulations, and prohibitions have frequently proven effective. Thus, Schieritz suggests the introduction of clear incentives such as taxes and subsidies, as well as rules and bans, to gradually steer the economy towards sustainability. Although not a novel idea, it could be expanded upon. All stakeholders must receive unequivocal signals about the desired direction of development. The financial market can then assess opportunities and risks accordingly. Sustainable investments, in particular, would remain a choice for individual investors, avoiding the need for a complex, universally binding framework that leaves many questions unanswered. In Schieritz's words, "That is the strength of the market: It ensures that production and consumption adapt quite excellently to new framework conditions."
