Imagine you’re an investor focused on sustainability, and you read about two companies. Martin Marietta, which supplies heavy building materials, emitted about 1,000 tons of carbon per million dollars of revenue in 2021, while insurance company Traveler’s prides itself on its low emissions—just 1 ton per million dollars of revenue. Which would get your investment?
Most sustainable investment funds today would back Traveler’s and avoid Martin Marietta—and that’s a problem, according to Kelly Shue of Yale SOM and Samuel Hartzmark of the Carroll School of Management at Boston College. In a new paper, Shue and Hartzmark argue that the most widely used approach to sustainable investment is actively pushing heavily polluting firms toward greater greenhouse gas emissions.
Most sustainable investing today involves building a portfolio of low-emissions “green” firms like Traveler’s, while excluding so-called “brown” firms like Martin Marietta. The underlying goal is to lower the cost of financing for green firms and raise it for brown firms. With enough time and money, the thinking goes, this strategy will incentivize all firms, green and brown, to improve their environmental impact.
But that’s not what happens in practice, Shue explains. “When you punish brown firms, they become more short-termist,” she says. Ultimately, “they pollute more when they’re punished.” On the other hand, rewarding firms that are already green does little to improve their environmental impact. Most of the green firms favored by sustainable investors tend to be in the insurance, health care, and financial services industries. According to Shue, “green firms start with close-to-zero emissions by the nature of their business, and they are very unlikely candidates to develop new green technologies.”
She and Hartzmark reached this conclusion by studying emissions data from over three thousand large companies from 2002 to 2020. They divided firms into five different segments based on greenhouse gas emissions (adjusting for revenue, because larger companies generally emit more than smaller ones). Then, using historical data, they analyzed how the highest- and lowest-emitting groups responded to changes in their cost of capital—like those the sustainable investing movement seeks to bring about.
“What we find is that when green firms experience a change in their cost of capital, their emissions don’t change substantially,” Shue says. Brown firms, by contrast, significantly increase emissions following an increase to their cost of capital. Rather than incentivizing improvements, starving brown firms of cheap money leads them to double down on existing methods of production, because continuing with old high-pollution production is how brown firms earn cash quickly to avoid bankruptcy. Punishing brown firms with expensive financing pushes them away from investments in new green technology that could reduce emissions.
If a brown firm changes in emissions in either direction by just 1%, that is way more meaningful than a typical green firm changing its emissions by 100%.
And even a modest percentage increase in emissions from an already heavily polluting brown firm has a significant environmental impact. Shue and Hartzmark discovered that the average brown firm has 261 times the emissions of the average green firm. So for green firms, even a major percentage increase or reduction in emissions has negligible environmental impact. Meanwhile, “if a brown firm changes in emissions in either direction by just 1%,” Shue says, “that is way more meaningful than a typical green firm changing its emissions by 100%.” In the case of Traveler’s and Martin Marietta, the numbers are even more extreme: a 100% reduction by Traveler’s would be equivalent to a 0.1% reduction from Martin Marietta.
Focusing too much on percentage reduction in emissions and too little on absolute emissions is a broader problem with sustainable investing, Shue argues. Brown firms that make small, hard-won percentage reductions are generally “still considered toxic assets that cannot be included in the portfolios of sustainable investment funds. And that is offering entirely the wrong incentives,” Shue says. “Instead, it motivates firms that are currently green to engage in trivial or greenwashing attempts to make themselves look even more green.”
That doesn’t mean the larger goals of sustainable investing aren’t worthwhile. “To be concerned about climate change is very valid—this is the major risk we’re facing,” Shue says. However, she sees other, more direct means of driving change. For example, instead of divesting from brown firms, investors could try to influence them by gaining board seats and shifting corporate strategy in a more environmentally friendly direction. Investors could also put money directly into companies developing new green technologies, such as carbon dioxide removal.
With this research, Shue hopes to offer a counterweight to media coverage that tends to focus on the laudable goals of sustainable investing, rather than its concrete outcomes. The current discussion highlights the incentives offered to green firms without realizing that brown firms have much greater scope to change their environmental impact. As Shue explains, “What we haven’t considered is, when you punish brown firms, you make them more brown.”