The past few years have seen many actors in the financial system take sustainability into account in their decision-making. In this post, I paint a broad picture of the related efforts and how they interact with one another.
Let’s first start with discussing sustainable investing in equity markets, often summarized as Environment, Social, and Governance (ESG). The main idea is that investors should consider not only financial objectives but also other criteria, and it comes in two main forms:
The verdict on which strategy is more effective — or whether they are effective at all — is still unclear. Papers like Broccardo, Hart and Zingales (2021) or Edmans, Levit, and Schneemeier (2021) examine this issue theoretically, but the empirical research is quite scant.
One of the major issues in sustainable equity investing is identifying which firms are green and which firms are brown. The first layer of complication, which is often overlooked in the discussion regarding ESG, is determining what really matters for investor demand. Is it how much carbon emissions they are emitting today? Is it how much they are willing to curtail? Is it how good they are at reducing carbon emissions?
The second layer of complication, which has received relatively more attention is actually measuring these dimensions of firm operations. For example, Berg, Kolbel, and Rigobon (2022) show that the major ESG ratings lack internal consistency.
From an academic’s perspective, there is a final layer of complication, in which we do not have a good understanding of what investors pay attention to in deciding sustainable capital allocation decisions. Fortunately, with granular holdings data and recent progresses in demand estimation techniques, this complication is easier to address than the preceding two.
On the corporate financing side, there has been a recent development in green bonds. There are several slightly different structures, but the broad idea is that the firm is able to raise money more cheaply due its commitment to use the proceeds to finance sustainable projects or because its coupon structures are explicitly linked to sustainability targets.
The first question to ask is whether the commitment to sustainability embedded in these bonds enable cheaper financing. Generally, the answer seems to be yes.