Despite the growing popularity of environmental, social and governance- (ESG-) based investing, new research shows that it has not been any easier for “green” firms to raise equity or debt capital when compared to “brown” firms.
As evidence of the increased interest in sustainable investing, more than 3,000 asset managers and owners – representing $103.4 trillion in assets under management – have subscribed to the Principles for Responsible Investment, a global initiative that aims to create a more sustainable global financial system. The six principles for responsible investment are:
- We will incorporate ESG issues into investment analysis and decision-making processes.
- We will be active owners and incorporate ESG issues into our ownership policies and practices.
- We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- We will promote acceptance and implementation of the Principles within the investment industry.
- We will work together to enhance our effectiveness in implementing the Principles.
- We will each report on our activities and progress towards implementing the Principles.
While there has been a substantial body of research on sustainable investing’s impact on returns, there has been no research on its impact on the ability of firms to raise capital. David Blitz, Laurens Swinkels and Jan Anton van Zanten contribute to the sustainable investing literature with their December 2020 paper, “Does Sustainable Investing Deprive Unsustainable Firms from Fresh Capital?” They began by noting that an objective of sustainable investing is to support sustainable companies and hurt unsustainable firms, thereby giving the latter an incentive to improve their corporate behavior: “It may sound obvious that divestment negatively affects the target firm, but this mechanism is actually not so clear-cut. The issue here is that divesting comes down to selling one’s position in a stock or bond to another investor, who ends up holding the position instead. Thus, divestment is merely a transfer of ownership from one investor to another, which has no direct impact on the firm. However, divestment may hurt firms indirectly, by increasing their cost of capital. As a result, new projects will have a lower net present value, making it less attractive for a firm to expand its business operations. Divestment on a sufficiently large scale may even come down to a boycott that effectively blocks a firm’s access to capital markets, thereby severely limiting its funding opportunities and hence future growth.”
To evaluate the impact of sustainable investing on the ability of firms to raise capital, they chose to study the primary market (new stock and bond issuance); the secondary market doesn’t reflect the raising of new capital, only the exchange of ownership of existing shares. Their hypothesis was: “If sustainable investing is effective at significantly increasing the cost of capital of unsustainable firms, or even blocking their access to capital markets entirely, then one would expect to see this reflected in capital flows in the primary market.” Thus, they examined whether fresh capital is flowing more toward sustainable than toward unsustainable firms.
Their study covered the period 2010 through 2019 and all stocks in the MSCI All Country World Index. To assess which companies raised fresh capital, they classified a firm as an equity issuer if its number of shares outstanding increased by at least 10% over the year. Similarly, they classified a firm as a debt issuer if the book value of its debt increased by at least 10% over the year. The typical number of equity issuers was between 100 and 150 per annum, while the typical number of debt issuers was in the 200 to 300 range. They excluded IPOs (because there can be many reasons for a firm to go public other than raising money for new business activities, such as enhancing firm visibility and publicity, motivating management and employees, exploiting mispricing, tax avoidance in some jurisdictions and cashing in by owners of the private firm) and debt refinancing (because it doesn’t raise new capital). They used a broad range of metrics from multiple providers to capture the various styles of sustainable investing because the correlation between the scores of different providers is low. Following is a summary of their findings:
- There is no evidence that fresh capital is flowing more toward sustainable than toward unsustainable firms, as the sustainability profile, as well as the carbon footprint of equity issuers, was similar to that of the broad universe, and the sustainability scores of debt issuers was lower than the average scores of the universe.
- Unsustainable firms appear to have no problem obtaining funding in public markets.
- Their results were stable over time – they did not observe that sustainable firms had started to dominate issuance in recent years nor since the signing of the Paris climate agreement in 2015.
Their findings led Blitz, Swinkels and van Zanten to conclude: “Our results suggest that sustainable investing has not been able to deprive unsustainable firms from fresh capital. However, they do not disprove that sustainable investing may have prevented such firms from raising even more capital, nor that further mainstreaming of sustainable investing may lead to more noticeable impact on capital flows.”
While the authors found no evidence that sustainable investors were able to prevent “unsustainable firms” from raising capital, economic theory, supported by a significant body of research (for example, here and here) suggests that if a large enough proportion of investors chooses to favor companies with high sustainability ratings and avoid those with low sustainability ratings (“sin” businesses), the favored company’s share prices will be elevated and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets. The result is that the favored companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P/E) ratio; and the flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). The sin companies will have a higher cost of capital because they will trade at a lower P/E ratio; and the flip side of a company’s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies.
On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the “cost” of expressing their values.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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Despite the growing popularity of environmental, social and governance- (ESG-) based investing, new research shows that it has not been any easier for “green” firms to raise equity or debt capital when compared to “brown” firms.