A Realist’s Guide to Investing for Good

“How would you suggest that I invest my savings of ten thousand dollars to have a positive social and environmental impact?”
 

The question came from a PhD student this time, but we get it a lot. Many people want their money to work for them—to preserve their financial security and to improve the world. In fact, almost 85 percent of individual investors say they are interested in sustainable investing and more than three quarters believe they can use their investments to influence the extent of climate change. In response, asset managers have created and rebranded trillions of dollars of funds as ESG (environment, social, and governance) funds targeting socially minded investors. So, it should be easy to recommend many worthy qualifying investments. Right?

Not so fast. When we researched the issue, we found relatively few options to recommend. We came across investments that might help an investor feel better, but few were likely to deliver positive social or environmental impact. As a result, we ended up concluding that the best dual-purpose investments are often closer to home. Our findings may extend beyond individual investors to smaller organizations and endowments that are deciding where and how to invest.

What’s Your Goal?

We are not investment advisors, but we know that a good first step in choosing investments is to determine one’s goal. Before developing a plan, most advisors will ask clients to think about their risk preferences, timelines, return expectations, and go-forward financial needs. The same holds if you are thinking about responsible investing, albeit with two additional questions. With respect to impact, is your goal to feel better, or do you want to make a tangible difference? And, when it comes to investment returns, are you willing to concede some income to obtain impact, or do you want the same returns (or better) than other investments?

Feel better. Many people are troubled by the idea that their capital is invested in companies that are doing something harmful such as polluting, making dangerous products, or treating people badly. As a result, to feel better, these investors want to screen out problematic companies from their investment portfolio. To serve this constituency, asset managers have long offered “values” or “socially responsible” (SRI) funds that offer a “negative screen.” Early examples of such funds excluded the equities of companies with operations in South Africa or companies involved in production of nuclear weapons. More contemporary values funds might exclude the equities of companies selling controversial weapons, thermal coal, or tobacco.

The problem with such screens is that they are unlikely to do much good. Secondary market investments in the equities of companies do not provide the companies with new capital. At the same time, if one investor decides to withdraw money from a polluting firm, someone else’s capital will immediately flow to take its place. Nevertheless, some investors like to feel that “their money” is not supporting something bad. It’s just a feeling, but many socially responsible investors are more concerned with this sense of purity than they are in having authentic impact.

A recent field experiment assessed the extent to which investors are willing to sacrifice to feel good. Researchers presented investors with two different investments with equal returns where one generates positive externalities (as measured by reduced carbon emissions reductions) and the other does not. Though investors did prefer the more “sustainable” investment, their willingness to pay does not scale compensate with the impact of the investment. Said differently, according to the researchers, most investors are not willing “to pay significantly more for impact” and the desire for sustainability is “primarily driven by an emotional, rather than a calculative, valuation of impact.”

Deliver Impact. Investors in this group want their capital allocated to companies that materially improve social and environmental welfare. If you are an accredited investor of means, there is a growing list of private investment opportunities to deliver “additional” capital. To qualify as additional, an investment must deliver benefits that would not otherwise have occurred absent the investor’s involvement. For example, an investor might provide capital directly or via a venture or private equity fund to a startup or growing company to expand a product or service. While some of these investments may deliver lower returns, they can advance renewable energy systems, protect natural habitats, or build more affordable housing. Unfortunately, such private investment vehicles are not available to unaccredited individual investors like our PhD with only thousands of dollars to invest. Thus our befuddlement.

Returns. Investors want their capital to grow to support themselves and their families. The cohort of investors considering socially responsible funds must consider how much of this return they are willing to give up. After all, it is easier to have a positive impact if you are willing to take a lower return. This is because lowering return expectations allows for room to fund environmental or social welfare and money for good causes is always in short supply. The simplest way to make a difference with your investments is to divert some returns to things you care about: your children’s school, a homeless shelter, or an environmental group. Your money will be welcome and may make the difference between the success or failure of some programs. As a bonus, you may be able to see the results for yourself.

But if you are not willing to concede any returns from your “impact” investments, your options are limited. Essentially, you are asking for something for nothing—market returns plus social or environmental benefit. Traditionally, most experts in finance and economics thought this was an impossibility. Nonetheless, a cottage industry of academics has toiled away (sometimes in partnership with asset management firms) developing and testing theories such as creating shared value, circularity, and ESG investing. While compelling illustrations of such win-wins are oft-reported, there is no empirical evidence that these “something for nothing” theories persist at scale. Until there is, they remain indistinguishable from magic.

Options for a Small Individual Investor

So, what is an individual investor who wants both market returns and real impact to do? Frustrated by the analysis we have presented, and continually asked for advice, we decided to delve deeper. We interviewed more than two dozen professionals with expertise in asset management, impact investment, asset allocation, and measurement. We asked them what they would recommend to a PhD student like the one who asked us how to invest for good. We made it clear that, for an answer to qualify, the investment had to be both accessible to an unaccredited investor and impactful. What follows is a review and assessment of the most prominent suggestions that we heard:

Public Equities

• ESG funds: Notwithstanding the acronym, public market ESG funds are not designed to deliver impact. ESG funds are built of the securities of companies deemed to be resilient to environmental, social, and governance changes (single materiality), not companies that are committed to advancing planetary welfare (double materiality). As a result, ESG funds are often weighted toward health care and technology companies. In addition, ESG funds are secondary market vehicles that provide no primary capital to companies. As a result, according to Catherine Howard, CEO of ShareAction, “people employed on the ESG beat… are still seeing a failure to allocate or steward investment capital in a way that contributes to the resolution of these multiplying [social and environmental] threats.”
  
   

Our judgment: Steer clear. ESG funds have higher fees, thereby dampening returns. And they do not meaningfully advance planetary welfare.

• Engagement funds: Public equity funds led by managers that use their clout to actively advocate for positive impact are another option. For decades, investment companies, such as Trillium Asset Management and Green Century Capital have directly engaged with management teams to champion more transparency and diversity and press for less environmental damage. A new study of over 7,400 engagements confirmed that material (key issues linked to performance) engagements on environmental issues have led to decreases in targeted companies’ carbon intensity.
  
   

The imminence and intensity of climate change has inspired more equity funds that promise to actively engage with corporate managers. A prominent example is “Engine No. 1” which used its investment in ExxonMobil to rally support from far bigger asset managers to replace three board members at ExxonMobil. Engine No. 1 then tried to use this perch to prod ExxonMobil to increase investment in renewable energy and disclose the company’s Scope 3 emissions.

Investing in this type of impact fund may engender positive social or environmental impact, but it will be hard to tell. Most engagement takes years and the process to deliver change is often opaque. Even when progress happens, it is ultimately hard to tell what motivated a corporation to change.

The story of Engine #1 at ExxonMobil is a case in point. Heralded as a breakthrough for demonstrating that “social good is also good for the bottom line,” Engine #1 leveraged its ExxonMobil success by creating two socially minded ETFs. Two years later, Engine #1 sold its asset management business and invested over 700 million dollars into Brazilian miner Vale, the company responsible for the 2019 Brumadinho dam disaster that killed 270 people. Meanwhile, ExxonMobil has yet to disclose its Scope 3 emissions and has doubled down on oil and gas, significantly increasing drilling in the Permian Basin and expanding offshore drilling in Guyana.

Our judgment: This is the best path to deliver impact via investment in public equities. That said, choosing the right fund manager is key.

• B-Corps IPOs: The B Corp movement has grown to now include over 6,000 companies. To gain accreditation as a B Corp, companies must demonstrate a high level of social and environmental performance, make a legal commitment to a corporate structure assuring accountability to all stakeholders, and exhibit transparency. Were an individual able to get an allocation of primary shares of a B Corp (or a traditional company directly engaged in decarbonization) that would qualify as a way to invest for impact. Unfortunately, there are fewer than 20 publicly traded US B Corps and access to their initial or secondary offerings is extremely limited. There is also no evidence that B Corps deliver outsized market returns.
  
   

Our judgment: Delivery of impact is plausible, but availability is extremely limited.

• Shareholder voting: Individuals can deliver a measure of influence by voting on shareholder proposals. Ownership of shares in a public company provides investors with the opportunity to vote on corporate shareholder proposals. Increasingly, individual investors are now able to use pass-through voting platforms instead of relying on their asset managers to vote proxies and management resolutions on their behalf.
  
  That said, the recent backlash against ESG investing has made winning shareholder votes to advance social and environmental welfare even more daunting. Though the number of ESG shareholder proposals is accelerating (up 65 percent this year as compared to the average of 2019 -2021), the passage rate of such proposals is declining precipitously. For example, the aforementioned effort to compel ExxonMobil to report on Scope 3 carbon emissions received 27 percent of shareholder’s votes last year and only 11 percent this year. At the same time, none of the 50 shareholder proposals on climate risk passed this past year.
  
  Two notes: Part of the reason why success rates with shareholder proposals are down is because many climate-related proposals were withdrawn after engagement funds reached agreement with companies. Also, it is important to note that even successful outcomes for shareholder proposals are non-binding.
  
  Our judgment: This path can deliver impact, but it is often very hard to prevail with shareholder proposals and evidence of progress is limited.

Fixed Income
 

• “Green” and Sustainability Linked Bonds (SLB): Bonds dedicated to financing renewable energy, corporate investments in “brown to green” transformation and sustainability initiatives have proven popular and sound like a possible avenue to invest for impact. Issuance of green bonds has more than tripled from 2017 to 2021. Since their onset in 2019, a related instrument, sustainability linked bonds have surged as a source of financing. Most often, these vehicles enable companies to raise capital with interest rates tied to delivery of certain decarbonization or nature restoration targets. These securities have interest payments that are stepped up should issuers not deliver on ecological targets or decreases in rates should companies hit their goals.
  
   

That said, like public equity ESG funds, investments in secondary market green bond funds do not provide primary capital to issuers. In addition, the green bond market remains fraught with challenges including poor quality of reporting and transparency, and, according to the head of the International Accounting Standards Board, “rampant greenwashing.” Worse still, a recent examination of more than 100 SLBs found “the majority are tied to climate targets that are weak, irrelevant or even already achieved.”

Our judgment: These products sound attractive but are of variable quality and uncertain influence.

• Municipal Bonds: These tax-free bonds are issued by cities and states (among others) to fund general obligations and specific projects. For example, the Los Angeles Department of Water and Power recently issued bonds to finance capital improvements in its water system and the Massachusetts Housing Finance Agency issued bonds to expand access to affordable public housing. While investments in single municipal bond issuances are not diversified, they can provide primary capital to issuers and they are liquid and accessible in increments of $5,000 to individual investors. They can also be specifically aimed at discrete environmental or social outcomes.
  
   

Our judgment: A good solution that could fit in a portfolio, albeit with likely lower returns as compared to equities.

Our Suggestion: Personal Improvement

As you can see, our interviews did not deliver any obvious winners. How could they? Retail investors have no private information to help pick stocks or funds and their investments are typically in secondary market vehicles that are not “additional.” So, what can individual investors do if they seek to deliver both good returns and impact?

A good first step is to consider where you have special information and unique access. For most individual investors, the answer will be at home. Only you know about the insulation of your house, your heating system, your car problems, or the educational needs of your children. And your money is well positioned to make these investments. It alone will make the difference between positive change and business as usual.

If this idea seems disappointing because it is commonplace, think again. For the average US consumer, switching from a conventional heating and air conditioning system to a heat pump can have the same impact as cutting your car emissions in half. Thanks to subsidies from the Inflation Reduction Act (IRA), buying a heat pump pays back in two to five years generating double digit returns. Depending on the state in which one lives (due to the differences in the source of primary energy), buying an electric vehicle can also deliver consequential carbon reduction with a short payback. These investments will generate relatively certain returns and guarantee environmental impact.

Implications

So, here is what we would now advise our PhD student.

For small individuals seeking market returns and impact, it makes sense to forego oversold equity and bond funds and, instead, invest “close to home” in physical decarbonization. For remaining working capital, new commercial banks, including Forebright Bank and Walden Mutual Bank, offer competitive rates on individual deposits and originate loans to “green” solutions-based companies and food producers committed to regenerative practices. Another good option is Calvert Impact Capital’s Community Investment Notes. These notes fund affordable housing and green solutions and are available to retail investors in denominations as low as 20 dollars.

This recommendation has its limits. Not every individual investor owns a home or a car, and the returns on many of these investments depend on government subsidies, which could end at any time. Investments in physical decarbonization are also limited in scope. Once one’s heating system is replaced once, it need not be tended to again for a long time. Our recommendation is also dependent on geography. Adherence to our recommendation would, for example, do nothing to advance welfare in Africa where the transition to renewable energy lags progress in the developed world. Transformation of the global energy, agricultural, industrial, and built environments to clean systems requires four times last year’s record one trillion-dollar investment. Investing close to home will not supply anywhere near that amount of capital.

That is why it is vital to energize the capital markets to match the growing supply of transformative solutions with demand from individual investors seeking impact and returns. As a first step to make this happen, policymakers ought to restrict the overselling of ESG funds. Absent such regulation, asset managers will have little incentive to invent new products that deliver legitimate positive impact.

To that end, the SEC just adopted amendments to the “Names Rule” that limit the branding of ESG funds to ensure that fund names are not “materially deceptive or misleading.” Hopefully, this change will motivate asset managers to innovate and provide individual investors with credible paths to invest for impact. Given growing social and environmental challenges, matching individual investors with opportunities for impact is something we cannot afford to delay.