The E-axes Forum on Climate Change, Macroeconomics, and Finance

The pace of change: how can private market investors generate the fastest social and environmental impact?

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Jans Starmans

Stockholm School of Economics

Michael Barnett
Arizona State University
Diego Känzig
Northwestern University
Alissa M. Kleinnijenhuis
Cornell University
Ishita Sen
Harvard University

Over the past decade, socially responsible investing has seen a significant increase. In 2020, professionally managed assets worth about $15 trillion in the United States considered environmental, social, and governance (ESG) factors. This is an increase from less than $2 trillion in 2010 (US SIF 2020). However, despite this substantial increase in socially responsible investing, there is little agreement on the best way for socially responsible investors to have  impact. This issue is particularly crucial in light of climate change since scientists warn of potentially catastrophic consequences if greenhouse gas emissions are not reduced quickly.

In our paper titled “The Pace of Change: Socially Responsible Investing in Private Markets,” we explore how socially responsible investors can have impact in a timely manner. We develop a theoretical model where investors can acquire a privately held firm. We analyze the decision of the current owner of a dirty firm to turn it green and how the presence of socially responsible investors in the financial market affects this decision. In this scenario, the quickest way for a firm to become green is if its current owner reforms it immediately. If the firm remains dirty under the current owner, a socially responsible investor may be able to acquire the firm in the future and then turn it green. However, finding a socially responsible investor who is willing to acquire and reform the firm takes time in relatively illiquid private markets. Our model allows us to study how quickly different investment strategies can lead to a reduction in firms’ negative externalities in the context of private markets.

Should socially responsible investors acquire dirty firms and then reform them?

We highlight that such an investment strategy of acquiring and reforming dirty firms can generate high acquisition prices for dirty firms. Socially responsible investors value the impact they can generate by obtaining control of dirty firms to reform them. However, we show that this investment strategy can backfire and cause delays in turning some firms green. If the current owners can sell a dirty firm, but not a green firm, at a high price to socially responsible investors in the future, they have a greater incentive to keep their firm dirty. Even if the current owner of a firm would have turned it green in the absence of socially responsible investors, the presence of these investors may lead to strategic delay in reforming the firm.

Should investors acquire firms that are already green?

We show that if a current firm owner can sell a green firm to investors at a premium in the future, this can incentivize them to reform their firm immediately. The premium at which they expect to sell a green firm increases the value of owning a green firm. This investment strategy incentivizes current owners to turn their firms green themselves, which is the quickest way to reform a firm in the environment we consider. It, therefore, leads to firm reform in a timely manner. To implement such an investment strategy, socially responsible investors need to be able to commit to buying green firms at a premium. This implies that socially responsible investors must be willing to accept a lower financial return when acquiring green firms. In practice, such a strategy can be implemented through an investment mandate that is explicitly “below market rate” and engages in positive screening such as investing in firms that already have high ESG standards.

How should we define and measure impact in financial markets?

We show that only focusing on impact post-investment can lead to delays in the improvement of firm production processes. The best and quickest way for socially responsible investors to have impact is to commit to acquiring firms that are already green at a premium. This investment strategy incentivizes current owners to make their firms green before they are acquired by socially responsible investors. Most of the measurable improvement in the firm will, therefore, happen before the investment rather than after. Our results imply that focusing on post-transaction measures when determining impact only provides a partial picture of the impact socially responsible investors can generate. It is essential to consider how socially responsible investors affect market prices for green and dirty firms since market prices, in turn, affect the incentives of current owners to reform their firms.

The above Policy Brief was based on a webinar presentation by the author as part of the Young Scholars Webinar Series on Climate Finance and Economics. You can subscribe to our newsletter to receive information about upcoming Young Scholars webinars, publications, and/or submit your research for consideration for an upcoming webinar.

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