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Written by Raman Uppal, Professor of Finance, EDHEC Business School ESG
Investing has evolved into a financial juggernaut, drawing heightened attention from governments, corporations, and investors.
The numbers are staggering, with PricewaterhouseCoopers projecting ESG assets to surge from USD 18.4 tn in 2021 to USD 33.9 tn by 2026, constituting 21.5 percent of total global assets under management.
However, as ESG gains momentum, skepticism lingers, particularly regarding its impact on returns. In this article, we explore the intricacies of ESG investing and its nuanced effects on the financial landscape, providing insights tailored for discerning readers.
ESG Investments: A Pinnacle in Financial Decision-Making
As ESG-related assets ascend to represent a significant portion of global assets under management, the financial world witnesses a paradigm shift. However, this shift is not without its challenges. Academic studies and resistance from investors, including legal battles in the US (for instance, twenty-five US states have sued the Biden Administration to halt a Department of Labor rule that prioritizes ESG concepts in retirement fund regulations), pose questions about the efficacy of ESG investing.
Navigating Misgivings: The Cost of Capital Conundrum
Amidst the skepticism, a central question looms: Does ESG investing necessarily translate to lower returns? The answer lies in understanding the intricate dance between ESG strategies and the cost of capital. Strategies like “portfolio screens” and “portfolio mandates” redirect capital from environmentally harmful “brown” firms to sustainable “green” ones, aiming to usher in a more socially equitable economy. The contention arises from the assumption that increasing investment in green assets necessarily implies reduced returns.
However, the skepticism overlooks a critical consideration — the elasticity of demand for capital. Contrary to the skeptics’ narrative, the research conducted by my colleagues and I challenges the assumption that a substantial reallocation in capital from brown to green firms will lead to a significant return spread. We argue that if firms’ demand for capital is elastic, ESG mandates can indeed lead to substantial shifts in physical capital from brown to green firms without a substantial change in the returns from investing in brown and green firms.
Elasticity of Capital Demand: A Strategic Lens for Financial Advisers
For financial advisers, the key lies in grasping the elasticity of demand for capital. Recent research reveals that if demand for capital is elastic, that is, firms can change scale without much effect on returns, then ESG mandates can influence capital allocation without significantly impacting the cost of capital. This newfound understanding becomes a strategic lens for financial advisers grappling with concerns from investors.
Constant Returns to Scale: An Empirical Reassurance
This raises the empirical question of whether demand for capital is elastic or inelastic. Empirical estimates from several macroeconomic studies suggest that it is elastic, implying that firms can change scale without much effect on returns. In fact, in the green sector, returns may grow more than linearly with capital input because of network externalities and learning-by-doing. In this case, shifting capital to the green sector could even lead to higher returns for investors in the green sector.
Strategic Implications for Financial Advisers: Shaping Conversations
Armed with the knowledge that ESG mandates can substantially impact capital allocation without jeopardizing the cost of capital, financial advisers can reshape conversations with investors resistant to ESG activities. Rather than fixating on the cost of capital, advisers can underscore the substantial shifts in physical capital allocation. This strategic pivot in communication empowers financial advisers to reassure investors that returns need not be compromised.
Conclusion: Investing in a Sustainable Financial Future
As ESG investments continue to reshape the financial landscape, financial advisers stand at the forefront of guiding investors through these transformative times. Our research offers a strategic guide for readers, emphasizing that the impact of ESG mandates extends beyond the cost of capital. The core conclusion of our research is twofold. Firstly, assessing the efficacy of ESG mandates solely through the lens of their impact on the cost of capital is a limited perspective: substantial shifts in physical capital allocation across green and brown sectors can coexist with minimal differences in the cost of capital.
Secondly, ESG-conscious investors need not fear diminished returns when shifting investments from brown to green firms. As stewards of financial wisdom, advisers play a crucial role in fostering an understanding that ESG investments not only align with responsible values but can also be a catalyst for robust financial performance. By addressing the misconceptions surrounding ESG investing, our research allows advisers to instill confidence in clients, assuring them that embracing ESG-conscious investments aligns with both values and financial goals. Financial advisers can champion ESG investments with the understanding that positive environmental and social impact can coexist with financial prosperity.
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