Doing good before doing well – the future of investing?
Zheng (2023) finds that sustainable investments respond favourably to climate policies, and the underlying drivers are nonpecuniary social mandates of climate mitigation and adaptation rather than financial gain.
Wong Wei Chen
26 May 2023
In 2015, many nations worldwide entered into an international treaty known as the Paris Agreement, which required participants to substantially reduce greenhouse gas emissions, and eventually reach net zero by 2050. To date, 194 parties – comprising 193 states and the European Union – have joined the Paris Agreement.
Accordingly, sustainable investments, or mutual funds that integrate socially responsible investing and ESG into their investment process, have grown tremendously. The worldwide asset under management (AUM) targeting sustainable investments grew from US$11 million in 2001 to US$2 trillion in 2021, representing an 83% compound annual growth rate. In comparison, traditional AUM expanded by a relatively modest rate of 26% per annum, from US$0.23 trillion to US$24 trillion over the same period.
In her working paper “Climate Policy and Sustainable Investments around the World”, Zheng (2023) demonstrates how climate policies accelerate sustainable investing, and at the same time investigates the underlying mechanisms driving such investment behaviours.
The underlying logic
Why do sustainable investments respond positively to climate policies? The most obvious reason would be that both share complementary goals. To uphold their social mandates for climate mitigation and adaptation, sustainable investments seek out green assets. Climate policies, on the other hand, require the creation and deployment of such assets.
Additionally, climate policies trigger the market to reallocate resources to climate-friendly activities such as clean production and green innovation, while firms falling within the ambit of regulation will progressively require more green products and services. In this regard, climate policies play an important role in demand creation, which in turn raises the valuation of green assets and reduces their exposure to climate regulatory risks. As a result, sustainable investments holding these green assets may have higher financial returns or lower financial risks after the introduction of climate policies.
Empirical design
Using data from Emerging Portfolio Fund Research (EPFR), the World Bank and BP’s Statistical Review of World Energy 2021, Zheng’s study tracked weekly sustainable and traditional investments in 94 distinct economies over a sample period spanning 20 years, from July 2001 and December 2021.
With sustainable investments and traditional investments respectively classified into treatment and control groups, a staggered difference-in-differences (DID) approach was deployed to investigate the extent to which climate policies influenced sustainable investing behaviour.
Under the null hypothesis scenario (meaning that climate policies had no impact), the difference between sustainable investments and traditional investments would be expected to persist over time: any variation would be statistically insignificant and regarded as arising from random factors, usually absorbed into the error term of a multiple linear regression model. However, if climate policies had any impact, a DID analysis would detect a statistically significant change in the gap between the two types of investments.
The dependent variables in Zheng’s baseline regression model are the weekly growth rates of: (i) assets under management (AUM Growth); (ii) capital flows (Flow); and (iii) investment profits (Return). Assuming the absence of cash holdings, AUM Growth is further defined as the sum of Flow and Return i.e. AUM Growth = Flow + Return.
After filtering out and controlling for various fixed effects, the independent variables are socially responsible investments (SRI) and climate policy (CP), both of which are dummy variables that respectively take on a value of 1 for sustainable investments and after policy announcement, but are otherwise zero. Both SRI and CP are zero for traditional investments – which are treated as a function of fixed effects arising from the economy, the state of financial markets and asset classes (e.g. equity vs bonds) over time.
The model allows for comparison between sustainable and traditional investments in the same economy after the announcement of climate policy, relative to their preannouncement patterns.
Findings
Overall statistics computed from the entire sample of 94 economies over the whole sample period showed that AUM Growth for sustainable investments increased by 4% per year relative to traditional investments after policy announcement. This acceleration in growth meant that the gap between sustainable investments and their traditional counterparts had narrowed. Likewise, capital flows and investment returns for sustainable investments picked up pace following announcement. These general statistics provide preliminary evidence that the initiation of a climate policy augments the growth of sustainable investments.
With the deployment of DID methodology, post-announcement AUM Growth for sustainable investments was about 0.5% per week, which translated into approximately 30% per year. This figure is substantially larger than the 4% recorded in the general statistics, as the DID approach carefully controls for cross-sectional differences that were glossed over earlier.
Out of the 0.5% weekly increase in AUM Growth, Flow accounted for about 77%, while Return accounted for the balance 23%. Such a finding suggest that investment growth triggered by climate policies comes primarily from fresh capital injected into green assets.
Zheng next elaborated the regression model to account for policy implementation following announcement. Sustainable AUM Growth further increased by about 0.3% per week, raising the overall total to almost 0.6%, or 35% per year. This finding suggest that sustainable investments remained relatively conservative even after policy announcement, but expanded more aggressively after the actual enforcement of the climate policy.
Economic mechanisms
As climate policies impose a price on carbon emissions, companies holding brown assets are expected to face increasing operational costs. In contrast, firms operating with green assets will enjoy lower climate-regulatory risks and progressively higher returns over time as policies become more entrenched.
Are sustainable investments in it primarily for the money, or are they more concerned about their social mandates of climate mitigation and adaption? Under the first scenario, sustainable investments will be more responsive to climate policies associated with larger return improvements and risk reductions, whereas, in the latter scenario, funds will gravitate towards policies that are more focused on tackling climate change.
To analyse such behaviours, Zheng analysed polices that are above sample medians in terms of financial returns/risks reduction and climate mitigation and adaptation. In other words, this subset of policies in the overall sample offer better than average benefits, be it pecuniary or environmental.
Regression analysis found that the observed increase in capital flows in response to greater financial returns and lower climate-regulatory risks was statistically insignificant, and there was therefore insufficient evidence that climate policy attracts sustainable Flow through the pecuniary channel. This suggests that improved returns and reduced risks after the climate policy are outcomes, rather than reasons for sustainable investments to respond positively to climate policy. Intuitively, this finding makes sense – if financial gains were the main driver, funds would be better off pursuing traditional investments instead.
The hypothesis is corroborated by positive responses to policies that demonstrated higher-than-average (above sample median) reduction in carbon emissions, renewable energy generation and green technology innovation. Capital flows respectively increased by 0.1%, 0.07% and 0.09% per week after policy announcement, and were all statistically significant.
Policy implications
The study has found that sustainable investments respond favourably to climate policies, and additionally, that the underlying motivators are nonpecuniary considerations of climate mitigation and adaption.
This alleviates concerns over greenwashing – which would appear to be somewhat trivial, since funds pursuing financial gains are better off putting their money in traditional investments.
Going forward, the further tightening of carbon regulations and higher levels of commitment towards net zero by 2050 is expected to attract capital driven primarily by social mandates.
Zheng, Huanhuan is an assistant professor at the Lee Kuan Yew School of Public Policy, National University of Singapore.