Article 15.7.2021

The death of responsible investing – why externalities redefine traditional investing

‘Today’s externalities are tomorrow’s risks that then become day-after-tomorrow’s losses’  - Pavan Sukhdev, President of WWF International   

One of the defining characteristics of today’s markets is the growth of responsible investing. Awareness of externalities, that contribute to socio-environmental harm, has increased. However, the popularity of ‘responsible investing’ has evolved into a double-edged sword. The issue is not the activity the term describes. It is the separation that persist between ‘responsible investing’ and ‘traditional investing’. In the future, a rational economic actor should holistically account for the net-value of their activities.  

A rational man – the stereotype of a traditional investor

The idealization of a rational man has long traditions in Western cultures. The current framework of rationality, self-regard and outcome orientation is still prevalent when assessing the behaviors of economic actors.  

 A ‘traditional investor’ who agrees to the idea of market-based-thinking has a straight-forward view of value. One example of a market-based consideration is Friedman doctrine, where the only responsibility an investee, i.e. a company, has is to its shareholders. Markets have accepted agents, who are motivated by self-regarding opportunistic pursue of financial gains, as the image of ‘rational men’.  

 However, as Gintis (2000) reports, economic actors are rarely self-regarding, out-come oriented rational agents. In environment-controlled studies, e.g. Jager et al. (2000), actors exhibited human decision-making biases like power of habits and reliance to social norms. As humans, all of us operate from self-perceived status quo, which is affected by the framing of our reality. Thus, our context of reality affects the perceived rationality of the decision-making.  

Externality – a tomorrow’s risk or return 

 Externality is defined as a social or an environmental outcome from activity that affects an unrelated third-party. For example, a business with high GHG emissions causes significant negative environmental externality for rest of the society. A failure in efficiency occurs when externalities are not internalized but left for the unrelated parties to account for the costs or benefits.  

 Traditional market-based valuation models are not capable to estimate risks or returns of socio-environmental externalities. Lack of information leads the models being unaware of the actual expected risk-return profile of a potential investment. Unaccounted externalities can offer momentary cost-reductions that skew the real value of business activities.  

Sounds great for the business? Think again. 

Every actor in the market should be aware that there are no free lunches. At some point, externalities are bound to be internalized. For an unaware investor the costs of internalization can come as a rude awakening. 

Externalities can also be positive. The unaccountability of positive effect is also an issue. The unknown true value of activity with positive externalities leads the activity to be less preferable as it should be. Although challenging, in an ideal world, it would be preferable that net externalities are accounted for. That would form a foundation of socio-environmental net-impact of an activity. 

Paradigm shift and a modern understanding of value 

Responsible investing was born out of the need to align investor’s values with their investment decisions. These values originally had religious or altruistic motivations. As the understanding of markets’ role in human-exacerbated environmental crisis and escalation of social injustices developed, so did the motivations behind responsible investing.  

Years of work by academics and practitioners have proved the materiality of social and environmental issues. Economic activities affect the environment and society. Also, nature, climate and society have significant effects on the markets. This dynamic is called double-materiality. 

 For responsible investors financial materiality of the externalities is an important part of investment process. Meta study of 2 200 empirical studies on financial effects of ESG (environment, social, governance) criteria by Friede et al. (2015) found large part of studies showing positive ESG-CFP (corporate financial performance) relation. Responsible investing has moved on from its thematic origins into a proven investment strategy that is expected to generate market-rate and above long-term risk-adjusted returns. 

The paradoxical need for ‘responsible investing’ to die 

Responsible investing is an investment strategy that strives for mitigating potential risks and identifying opportunities for added-value creation. Investors get good risk-adjusted returns, socio-environmental issues of economic activities get priced in, everyone’s happy. ‘Why would we look for the death of ‘responsible investing’, you might wonder. 

The issue is not the activity the term describes. It is the existing itch for categorizing ‘traditional’ and ‘responsible’ investing into two separate boxes. The prevailing separation functions as an unconditional gatekeeper for conservative individuals, who want to stick to traditional safe strategies, enables green washing of products and services, and stigmatizes both ‘traditional’ and ‘responsible’ investors.  

Both the hype and skepticism around the term ‘responsible investing’ causes the term to be emotionally charged. The turmoil was necessary for the topic to get recognition, but the market for considering externalities has already moved on to a more mature state. At this point acknowledging the double-materiality of environmental and social concerns should be a ‘traditional’ part of pursuing desired risk-adjusted returns.  

Therefore, it is time for the markets to start planning funeral for the term ‘responsible investing’ and normalize praxis that holistically account for the net-value of economic activities.     

Judit Lindstedt 
Junior Analyst, Responsible Investments, Ilmarinen 
M.Sc. Finance student at Hanken School of Economics 

Judit studies the double-materiality of Ilmarinen’s investments this summer. The consideration of both social and environmental impacts as part of financial valuation ensures profitable and secure investment of assets. 

Sources:

Gintis H. (2000), Beyond Homo Economicus: evidence from experimental economics. Special Issue the Human Actor in Ecological-Economic Models, Vol 35, Issue 3, pp. 311-322

Jager W., Janssen M.A., De Vries H.J.M., De Greef J., Vlek C.A.J. (2000), Behaviour in commons dilemmas: Homo economicus and Homo psychologicus in an ecological-economic model. Special Issue the Human Actor in Ecological-Economic Models, Vol 35, Issue 3, pp. 357-379

Friede G., Busch T., Bassen A. (2015), ESG and financial performance: aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment, Vol 5, Issue 4, pp. 210-233