Investing for the Social Good

An Economic Innovation to better guide Technological Innovation

Through our series on Elon Musk (Part 1 here), we’ve discussed some shortcomings in how our finance system selects which innovations to support and develop. We’ve already discussed Sovereign Wealth Funds, and in this installment we will introduce the idea of Environmental, Social, and Governance based investing, or ESG investing.

ESG investing simply refers to investing in companies that improve the environment, have a positive social impact, or govern themselves more justly and equitably than the average corporation. Similar investing strategies abound, Socially Responsible Investing (SRI) has a more general focus on investing for the purpose of the social good writ large. SRI typically excludes companies that have tangible social harms, like firearms companies or oil and gas companies. Impact investing focuses on investments that will introduce some kind of tangibly positive outcome. For instance, after the COVID 19 downturn many impact investors purchased or invested in debt holding firms with the intention of easing debt burdens and reducing default rates to protect the economy.

While these terms refer to specific investment strategies that are not, by any means, synonymous, they all have the same overarching goal of using investment as a tool to steer markets in ways the investors feel are better. I will focus mostly on ESG investing because it offers the highest level of specificity about its investment criteria, but what I want to focus on is the more general idea that investing can be a tool for steering. As far as I can tell there are not yet any investment strategies with the specific goal of better steering technological development. But why couldn’t there be? And why couldn’t those strategies learn from ESG and others?

Moreover, ESG investing is not entirely separate from the goal of better technological development either. Surely more investment in green energy over fossil fuels will also lead to more desirable innovations as well. Won’t we be more likely to see more efficient solar panels before more efficient fracking if that's where the money is?

One of the key features of ESG investing compared to SRI or Impact investing is the use of a score system. Because it focuses on environmental, social, and governance factors, ESG funds usually assign scores which they use to grade different companies according to each factor.

This scoring system itself could have a variety of impacts. First, if the goal of ESG investing is to influence company behavior, executives have to know what kinds of behaviors investors want. To know what investors want, ESG funds need to adopt relatively uniform criteria. A uniform grading system is a good candidate for this effect.

A grading system also lowers the barrier to participation. Traditional investment firms could easily adopt ESG investing practices by simply simply offering pre-made portfolios that only include companies that meet an ESG grade threshold. A low information investor like myself, who currently just follows the advice to use an index fund, could just call up their investment bank and change to an ESG fund. Retirement accounts, like 401k’s, could also offer ESG versions fairly easily. In this way, such a scoring system opens the door for very broad adoption without the typical investor having to do much more than they already do.

Beyond just investments themselves, ESG grades could have broader economic and market impacts if they are consistent across companies and are broadly publicized. Companies with good ESG grades might have higher public support, better brand recognition, or higher consumer confidence. For some industries this could be extremely important. Homeowners shopping for rooftop solar are more likely to care about the environmental impacts of the solar companies they purchase from. If one company has a higher ESG score because they dispose of spent panels more cleanly, or because they don’t exploit third world workers for disposal, that might in turn lead to a sizeable preference for their products.

ESG grades could also be the basis for a variety of policy decisions. They could be tied to things like tax deduction eligibility. Or perhaps lower scoring companies might get more regulatory scrutiny. After all, even under administrations that *don’t* want to dismantle the federal regulatory apparatus, regulators have always been chronically understaffed. What better way to help regulators dealing with limited resources prioritize which companies to focus their efforts on!

But it isn’t just as easy as applying an ESG grading system and patting ourselves on the back. First, the data to create the grade has to be available. Perhaps the mere willingness to provide that information to whoever makes the score is a positive indication, but without near universal participation we lose many of the additional benefits on top of knowing which companies to invest in.

On top of that, the data has to be comparable between companies. Without standardization, companies might use their own methods for measuring environmental impact that is the most advantageous to them. Data centers that use a method that focuses on carbon emissions might move to deserts with lots of solar power but where their intensive water use is highly destructive. But if they focus instead on water sustainability then they might locate where their immense energy demands are met by coal power plants! Similarly, ESG investing strategies won’t necessarily be effective if companies can simply report numbers based on criteria that makes them look favorable compared to other companies.

However, any uniform measurement has the potential for perverse incentives. For example, in 2000 Gneezy and Rustichini published a study of Israeli daycares. When parents at these daycares were late to pick up their children, a teacher would have to stay late to watch the children in the meantime. To deter that behavior, these daycares introduced a fine for late pickups. But late pickups actually increased rather than decreased. The fine wasn’t actually a fine, it was a price. Introducing the fine changed parents’ view. Rather than see tardiness as a social faux pas, forcing a teacher to stay late, they began to see it as a service they could purchase. Those parents who could afford it thus were tardy more often, as the convenience of the flexibility outweighed the cost and they no longer saw it as the wrong thing to do.

Perverse incentives were also a common problem in command and control economies. If you mandated that your nail factories produce 1000 nails, they might make smaller, but useless nails. If you instead mandated them to produce 100kg of nails, they might make larger, and equally useless, nails. Standardizing the kinds of environmental, social, and governance factors we want to measure will require care to prevent companies from implementing changes that make things worse while making the measurements look better.

On the other hand, the goal might not be to influence behavior, but to simply ensure that money is available for more desirable innovations. In this case, it may not be necessary to standardize measurements across a limited number of criteria. Instead, a more general approach might be better, where perhaps investors get information on a larger variety of categories to help them select according to their values. The potential problem here is that barriers to entry are relatively high, so without some additional (likely state) intervention this isn’t likely to scale enough to change things much compared to traditional forms of investment e.g. VC.

Do ESG investments perform well?

They do not seem distinguishable from the market as a whole. If we know why this is, we can overcome some of the barriers to performance. If better companies perform better, more companies will want to be better.

Barriers:

Scale:

Looking at investment strategies like ESG themselves, how could they actually impact markets and what innovations gain traction? There are two broad strategies for investing that focus on making a difference in two different ways. The first we’ll call value investing. The second we’ll call impact investing.

In values investing we invest only in companies that align with our values. In such an instance we select companies that have good ESG grades as the target of our investments.The goal of this strategy is to influence the market. But increasing investment in companies with good ESG grades, we hope to induce other firms to adopt policies and values that will increase their own ESG grades in order to attract more investors.

In impact investing, we invest in companies with *bad* ESG grades with the hope of using our power as shareholders to institute new policies. This strategy seeks to influence individual firms rather than whole markets, and focuses on firms where improvements are more promising. For example, investors might target a manufacturing company for greening, but the benefits and desirability of greening an oil and gas or mining company makes those sorts of firms less desirable for this strategy.

Furthermore, these investors can have different impacts by investing together or separately.

Let's take an example where the goal of investors is to lower carbon emissions. If value and impact investors are choosing between funds that mix together firms suitable to both investment strategies it has the potential for synergistic effects. Companies that are already lowering their carbon emissions get more investment which they can use to increase their market share. This reduces emissions up and down the supply chain. These low-carbon companies will purchase more from low carbon suppliers, and their low carbon products will have market advantages with buyers as their scale increases. So combining value and impact investing in this manner multiplies the influence of the investments, reducing emissions of even those companies that didn’t directly receive investments. The downside is that this also requires the scale of these investments to be large enough to change the shape of the market to advantage the companies being invested in. ESG investing will need to become a lot more popular to see this strategy work.

But what happens if value and impact investors invest separately? In a situation where each group invests in funds focused on their specific strategy, rather than mixed funds, we expect to see more of a two pronged approach. In this case, we expect the value investors to fund already low carbon sectors like green energy tech, thus expanding that sector. At the same time we expect impact investors to fund high carbon sectors and lower emissions there. While this would still take very large scales to change whole industries, this strategy does have the potential for smaller scale influence. Small groups of investors can target individual companies to still have a limited impact even in the event ESG investing doesn’t go mainstream.

We measure what we value, and we value what we measure. The final potential benefit of ESG investing is establishing new norms around how firms should behave and their roles in society. Klaus Schwab, the founder of the World Economic Forum, wrote “Stakeholder Capitalism” in 2021. In it, he argues that modern firms are too narrowly concerned with maximizing shareholder profits. By using examples of policies like employee board members in Germany, he demonstrates that may not only be possible, but desirable for firms to have other commitments which contribute to the social good. The underlying theme of the book is that the creation of social and ethical norms where firms feel a commitment to stakeholders writ large rather than merely their shareholders will result in policies and choices that are beneficial both socially and economically. Measuring and grading firms based on other values, like environmental, social, or governance based values, may help to normalize firms acting on these values rather than merely maximizing shareholder value.

Compared to SWFs, ESG investing is, admittedly, a fairly weak alternative. It still, for the most part, excludes from participation those who lack the wealth to invest. In the U.S. 61% of adults own stocks. And while this is, economically speaking, relatively good news, it still leaves 39% who would remain completely excluded from the process of technological development. Worse yet, as an indication of the more active role in investments ESG requires, only 21% of American adults own stock shares directly, and even fewer than that own mutual funds of exchange-traded funds (ETFs), the kinds of investments that are most relevant to ESG investing. Schemes that focus on scaling the influence of individual investors, therefore, seem a poor choice for democratizing the current investment based failures of technological development.

But reforming how we govern innovation isn’t a zero sum game. Trying one reform doesn’t automatically foreclose another, and there can be multiple reforms. Just because ESG investing has drawbacks and limitations doesn’t mean it also lacks advantages. And it has one huge advantage: it does not challenge the privileged position of business.

In 1982 Yale economist and political scientist Charles Lindblom published “The Market as Prison.” Through most of his career, Lindblohm had championed markets as a uniquely capable coordinating mechanism. But they weren’t without their faults. In “The Market as Prison, Lindblom demonstrated that it wasn’t through bribes or political donations that the wealthy got the policies they wanted, it was through their influence on the economy. In summary, he showed that politicians were too worried about the economic consequences of enacting policies that were too harsh on businesses and their owners. They might raise the minimum wage, but not too high for fear that it might result in layoffs. They might increase taxes on the wealthy, but not too much for fear that borrowing and investment might decrease and create an economic slump. You’ve likely heard these arguments before. And business owners don’t need to tell politicians to make them, politicians come to these conclusions on their own.

This is the basis for the privileged position of business. Even in a democracy where business interests don’t drown out other interests, they will still have disproportionate say because politicians are afraid to enact any policies that might be too harmful to them. As Lindblom said in his 1977 book Politics and Markets, “even in democracies, masses are persuaded to ask from elites only what elites wish to give them.”

I generally shy away from encouraging an overly restrictive focus on feasibility when thinking about policy interventions. Excluding options from even consideration just because they don’t seem likely to get the necessary support is far too obstructive of good thinking. But when it comes time to think strategically about what changes we can actually enact, feasibility must be a consideration. And the privileged position of business offers a substantial barrier to action precisely because it drastically reduces the realm of policy options which are feasible. We are unlikely to pass reforms if they offer nothing but downsides to business interests. This is why market based reforms have a tendency to be more politically successful than those than many progressives might otherwise prefer. And this is the advantage that ESG investing has: it as an almost entirely market based intervention.