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Sustainable assets are currently en vogue. In Switzerland alone, they amount to around two trillion francs. A decade ago, this figure stood at a mere 41 billion – just one-fiftieth of the current volume. But even though around half of investments in Switzerland now flows into assets of this kind, we are still far away from carbon neutrality or a green circular economy.
Apparently, green investments don't have the impact that they're supposed to. One part of the problem lies in how sustainability criteria – known as ESG ratings – are assessed for companies. ESG stands for environment, social and governance, and companies are rated by how well they perform in these categories. The problem is that leading agencies come to different conclusions regarding which companies should be considered sustainable based on ESG factors. Auto manufacturer Tesla fell out of the sustainability index at the beginning of the year, for instance, and the issue with Tesla wasn't environmental – but rather problems with the company's governance. These kinds of decisions confuse investors who want to invest their money in eco-friendly projects and make it easy for companies to engage in greenwashing – the practice of firms touting unsubstantiated claims about their environmental footprint.
Another problem lies in expectations about what kind of impact eco-investments actually have. “It's great that sustainable assets have hit the mainstream, but many investors confuse a sustainable rating with environmental impact,” says economist Falko Paetzold, who serves as managing director of the Center for Sustainable Finance and Private Wealth (CSP) at UZH. The relationship is more complex, he says: buying shares in a sustainable company isn't the same as making a sustainable impact. In order to paint a clearer picture for investors, Paetzold teamed up with Florian Heeb and Julian Kölbel to write The Investor’s Guide to Impact, a guide to sustainable assets. Some of their recommendations were also included in the recently published Swiss Climate Scores, a set of criteria for sustainable financial investments put out by the Swiss federal government.
As Paetzold explains, the first thing to understand is the distinction between the impact of a company and the impact of an investor. If you go to the stock exchange and buy shares of a booming company that produces something like windmills or solar panels, you don't generate any additional impact as an investor, since the company doesn't receive any new capital from your purchase. This means that the investor impact in this case is basically zero or very low, as no additional solar panels or windmills are produced because of the investment. But the situation would be different for a hypothetical company in a developing country that has developed an energy-efficient method for desalinating seawater and is looking for investors. Here the investment makes an immediate impact – even though this kind of support carries risks for the funders, of course.
Aspiring sustainable investors should thus primarily consider what their investment in a company actually triggers and focus less on what the company is already doing. According to Paetzold, it makes environmental sense to invest in up-and-coming, high-impact companies operating in inefficient financial markets – of course also considering one's risk profile as an investor. His brochure names US company Impossible Food as an example in this category: for the past decade, they have been producing vegetarian alternatives to meat thanks to heavy investment from Bill Gates. Without these millions in support, the company would probably not make a profit today.
Another piece of advice from Paetzold seems counterintuitive at first – to also make investments in environmentally unfriendly “brown” companies, for instance in the cement or the palm oil industry. By engaging financially with “dirty” companies, it becomes possible to directly influence their business practices and to bring about improvements. Making investments of this kind can generate more impact than buying shares in established green companies that already have no problems earning money. Paetzold says that the critical factor is the ability of shareholders to influence the company via their voting rights, nudging it towards realistic reforms such as cleaner production processes or replacing problematic raw materials. If harmful emissions can be reduced in this way, investor impact can be several orders of magnitude greater than with a small eco-firm.
Paetzold also advised against excluding entire industries from one’s investment portfolio. “Just withdrawing your support from a coal company won't change the business,” he says. “It can even be counterproductive.” The issue is that when green investors jump ship, there's the risk that new, less climate-concerned investors will get on board. This can lead to companies disappearing into non-transparent markets or outsourcing their dirtiest units in order to look cleaner.
Coal extraction will continue for as long as it's profitable; in this case, the problem lies with the externalized costs of fossil fuels. Once carbon taxes reach a level where coal becomes unprofitable, only then will it stop being extracted. Paetzold emphasizes that this is more the role of the state, not so much the finance sector: Governments are the ones with the power to make environmental regulations and set correct price signals. At the same time, however, it is also helpful for powerful large investors to speak publicly about their divestments in coal companies and other raw materials producers. This puts social pressure on these companies to act in a more environmentally friendly way. For instance, in 2014 Stanford University excluded coal companies from their over 20 billion dollars in investments. While this step didn't initially destabilize these companies and their stock prices, the resulting discussions and media coverage prompted additional companies and big funds to pull out of the coal industry.
Sustainable investments that make an impact require a certain amount of specialist knowledge or good advising. Paetzold says that there is currently much to be desired on this front. A new study about what motivates sustainability-minded private investors sheds additional light on the topic. Do Investors Care About Impact?, published by Paetzold and three co-researchers, comes to the sobering conclusion that while many investors are willing to pay more for assets with an environmental impact, they don't take into account how high this impact actually is.
Instead, they are primarily concerned about the good feelings – the “warm glow” – that investments of this kind trigger. If good feelings alone are sufficient to sell sustainable products to investors, there is the risk that shrewd salespeople will push pseudo-green assets on them while actual sustainable impact gets ignored. Considering that the global market for sustainable assets runs into the trillions, this is not an encouraging prospect.
The sustainability experts at the CSP have put out guidelines with the aim of strengthening investors’ knowledge about the impact of sustainable investments. There are different types of people working in finance, says Paetzold: some are wholeheartedly dedicated to sustainability; others less so. “But their numbers are growing,” he adds. “We've reached a turning point.” Paetzold is optimistic about the future. “Sustainable investing can make the world a better place. We live under capitalism, and capital is the most effective tool we have for bringing about change.”
This article first appeared in the UZH Magazin 4/2022