Counterproductive Sustainable Investing: Is Brown the New Green?
This week, Kelly Shue, Professor of Finance at Yale School of Management, joins the podcast. Earlier this year, Professor Shue and her co-author, Professor Samuel M. Hartzmark, published “Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms.” Their research paper concludes that the sustainable investing practice of divesting high-emitting companies (referred to as “brown” firms) in favor of low-emitting companies (referred to as “green” firms) is counterproductive to reducing greenhouse gas emissions.
Here are some of the questions that Peter and Jackie ask Professor Shue: Why did you conclude that the sustainable investing practice of divesting away from high-carbon companies towards low-carbon ones is counterproductive? What are some examples of “brown” and “green” companies? What are the shortcomings of measuring the percentage GHG emission reduction of a company, as opposed to absolute reductions? Were you surprised to learn that oil, gas, and energy-producing firms are key innovators in the United States’ green patent landscape? What are your thoughts on the anti-ESG movement, where some US states are asking their pension funds to divest ESG-orientated companies? Do you think institutional investors, who have made hard goals around reducing their financed emissions, should consider changing these goals? What are the shortcomings in using the company-level ESG ratings provided by firms such as Sustainalytics, MSCI, and Bloomberg to identify green companies?
Other content referenced in this podcast:
- Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms (2023)
- The ESG-Innovation Disconnect: Evidence from Green Patenting (2021)
- Yale Insights: Green Investing Could Push Polluters to Emit More Greenhouse Gases (2023)
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Episode 220 transcript.
Speaker 1:
The information and opinions presented in this ARC Energy Ideas podcast are provided for informational purposes only and are subject to the disclaimer link in the show notes.
Speaker 2:
This is the ARC Energy Ideas Podcast with Peter Tertzakian and Jackie Forrest exploring trends that influence the energy business.
Jackie Forrest:
Welcome to the ARC Energy Ideas podcast. I’m Jackie Forrest.
Peter Tertzakian:
And I’m Peter Tertzakian. Welcome back. Well, Jackie, we’re on the eve of yet another COP, COP28, which is going to be held at Expo City in Dubai later this week as we record here. And so the situation I think we can agree is as polarized as ever, and especially polarized because it is in an oil producing area of the world, Dubai. And so the contention around energy systems, green versus dirty is as stark as ever, and it’s also quite stark, as we know, in the world of finance.
Jackie Forrest:
It certainly is, and we’ve talked many times about ESG and the backlash that has occurred over the last few years, including more and more states in the US that are saying, “We’re not going to allow our pension funds to invest in funds that are pro-ESG.” But some of our issues with the ESG movement, I think in general, ESG makes a lot of sense, you want to understand the risks and mitigate them in any business and including the environmental, social and governance ones. But I think the reason there’s a backlash is a couple of areas. One is those rating agencies that put a score on companies, and I don’t think there’s a lot of consistency to how they do that. So that’s one issue we’ve talked about on the podcast. But another has been the divestment movement, and we haven’t been big fans of the divestment movement, so we were pretty interested when we read a paper earlier this year by Professor Kelly Shue and Professor Samuel Hartsmark titled Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms.
Peter Tertzakian:
Right. Well, just that first part of the title is intriguing enough to invite the author of the paper onto our podcast, Counterproductive Sustainable Investing. I think this is really a seminal academic study of how effective sustainable investing, which is sort of a nebulous term in itself, has been. And so well, who better to talk about it than Kelly Shue, professor of finance at the Yale University School of Management. Welcome, Kelly.
Kelly Shue:
Thank you. Thanks very much for inviting me.
Jackie Forrest:
Good. Well, professor Shue, why don’t you tell us about yourself and how you came to be a professor of finance at the Yale School of Management?
Kelly Shue:
Well, I have research interests in behavioral finance as well as corporate finance, and I’ve been teaching corporate finance to MBAs as well as law students at Yale for the past five years.
Jackie Forrest:
Okay, and then what motivated you to conduct your research on sustainable investing? Why did you decide to write a paper like the one that you did?
Kelly Shue:
Well, a big part of my teaching is actually on basic corporate finance to MBA students, and there we spend a lot of time discussing how firms behave when they become financially distressed, when they’re more worried about bankruptcy or worried about their short-term survival. And when firms are in that mode of thinking, in other words, when they have difficulty accessing finance or outside funds at a reasonable cost, then they effectively become more short-termist, and they are unwilling to invest in certain projects that while it may pay off in the long run, because they’re strapped for cash right now, they’re unwilling to make those types of long-term investments.
So teaching my students about bankruptcy behavior by firms led me to really consider whether sustainable investing could actually be counterproductive. Because one of the stated goals of many sustainable investors is that they want to punish high polluting firms by raising their cost of capital and basically pushing them a little bit closer to bankruptcy and making it more difficult for them to access outside capital. So I’m thinking, “Well, when firms get closer to bankruptcy, if anything, they’re less willing to invest in anything that pays off in the long-term but is expensive upfront.” And that’s going to include a lot of these green transition or green technology investments.
For your typical high emitting firm to transition toward being more sustainable, more environmentally friendly, usually that involves a big upfront capital investment toward a new production method. The way that technology is progressing, this type of transition could actually be quite profitable in the long run, but it’s not something that bankrupt firms or firms that are worried about cash right now, that’s not a strategy they’re going to be drawn to.
Peter Tertzakian:
Yeah, this is fascinating and I’m so glad you’ve published this study because so often we hear the line, these firms, particularly the incumbents in the energy space, should follow the science and the science of climate change, or they should follow the science and technology and implement solutions. But really the science is behavioral science and your study area, behavioral finance, is so important because behavioral science studies how people make decisions at a boardroom table. And as you say, if they’re pushed against the wall or they have a big stick hanging over their head, they’re not inclined to behave in the way that one would expect, which is really what you’re studying. So what are the conclusions of the study?
Kelly Shue:
We have a number of critiques about the way that sustainable investing and ESG have been implemented. So let me be clear that I am very concerned about climate change and I broadly very much support the ESG and sustainable investing movement. What I’m concerned about is the way that it has been implemented by many, but not all funds to date. A lot of that strategy focuses on punishing one group of firms which are current high emitters, and I’ve already described how that could be counterproductive because it makes these firms unable to raise outside financing and therefore unable to engage in these transition projects that involve buying new equipment, which is necessary for them to move on to cleaner production.
The second way in which we believe that sustainable investing as currently implemented may be counterproductive, is that many of these investment portfolios focus on rewarding a set of firms that have no room to further improve. If you look at the types of, let’s say, green firms that we show in our data are overweighted in the portfolios of sustainable investors, it’s a set of services firms in the industries of legal services, financial services, insurance and healthcare that really cannot pollute by the very nature of their business.
Peter Tertzakian:
Problem number one is the definition of what is a green or clean energy business. And you’re saying that service firms like legal firms are being lumped in with green firms because they’re just a bunch of people in an office that don’t emit anything?
Kelly Shue:
Exactly. I think maybe you want to reward firms that are actively innovating in the green energy or the green technology space, or in firms that are reducing their emissions, even if they’re still high emitters. But the set of firms that are actually overweighted, so they represent the bulk of these sustainable portfolios, is a set of services firms that don’t pollute by the nature of their business. I mean, these firms are green in the sense that they don’t pollute, but they’re not green in any meaningful sense, right? Because they’re not helping other businesses transition toward a more sustainable future.
Peter Tertzakian:
I just want to continue this, it’s so fascinating. It’s sort of like let’s divest of say a concrete plant and invest in a legal firm. So therefore the portfolio allocation of capital is now greener, but an actual fact, the concrete plant cost of capital goes up, so they can’t implement what they need to implement to reduce their emissions.
Kelly Shue:
Yeah, exactly. And I think many of these fund managers are doing this type of stock selection for two reasons. First, there are these divestment campaigns saying that they should not invest in various sin firms that own fossil fuels or just have high emissions. And they’re also judged by their portfolio level of financed emissions, which is total emissions within their portfolio relative to the market cap of that portfolio. How do you get financed emissions to look as low as possible? Well, you load up on a set of firms that don’t pollute by the nature of their business. A legal services firm would have less pollution than your greenest possible agriculture or energy firm, and it’s because a legal services firm doesn’t pollute.
Jackie Forrest:
I know you looked at a whole series of companies that were in the major public market stock indexes. Can you just give us some examples of how many were what you consider, what you called, brown, which were the ones that were high emitting, and the green ones? And just some names so that people can get a sense of the types of companies in each of those categories and how big they are.
Kelly Shue:
To get enough statistical power, we’ve looked at about 3,000 publicly traded companies over the past two decades to look at how their emissions have reacted as their access to financing has either improved or gotten more difficult. The way that we categorize brown and green firms is pretty arbitrary, but it mimics how sustainable investors have also categorized them. So within each year, we look at the 20% of firms with the greatest emissions per unit of revenue, those we categorize as brown. The 20% of firms with the lowest emissions per unit of revenue we’re categorizing as green. So the brown firms tend to come from-
Kelly Shue:
Rising as green. The brown firms tend to come from the energy, manufacturing, transportation, and agriculture sectors. As I mentioned before, the green firms tend to come from services sectors such as insurance, financial services, healthcare, etc. So if we consider a typical brown firm that might be Martin Marietta Materials, which is a building materials manufacturer, it emits about 1000 tons per million of revenue. A typical green firm might be travelers insurance. It emits only one ton per million dollars of revenue. So for two firms that are approximately the same size, both in the S&P 500 index, the concrete manufacturing firm produces 1000 times as much emissions as the insurance firm.
But this also tells you that to the extent that one firm can improve its impact for the environment, it’s actually the current high polluters because they have a lot more room to improve. If you are already at essentially zero emissions, it’s very difficult for this insurance firm to further improve. It’s also very unlikely to do any type of R&D or innovation in the green space because that’s outside of its scope, which is insurance.
Jackie Forrest:
One of the quotes from your paper that I really liked was you had, “A 100% reduction in the emissions by a green firm is far less economically meaningful than is similarly sized brown firm reducing its emissions by a mere 1%.” So staying invested in a brown firm and asking them to reduce their emissions by 1% has a bigger impact to the climate than divesting into the green firms. And I just think that’s such a powerful thing. It seems obvious to me, but it really highlights how counterproductive some of these divestment movements are.
Kelly Shue:
Yeah, and I think, unfortunately, what we’ve also shown in our data is we’ve looked at rankings of firms that are considered to be climate leaders, so these are lists that encourage you to invest in these firms if you’re a sustainable investor, and these lists are ranking firms by their percentage improvements in emissions rather than their real reductions. It’s actually not surprising is that the biggest percentage, improvers are a set of firms that started out at close to zero emissions in the first place. So looking at percentage reductions in emissions is absolutely the wrong unit to focus on when you have these scale differences between brown and green firms of basically a thousand to one.
Peter Tertzakian:
There’s also sort of this double whammy effect I want to ask you about, which is that if a fund sells the shares of a brown firm, then the group that buys those shares, the new investor, may not be ESG conscious at all. All they want is just to reap the dividends and the benefits and not spend any money on decarbonization. So it’s sort of like not only is there all this, I don’t want to call it fake math, but deceiving math going on with percentages and also going from manufacturing companies from services companies, but this other dynamic of non-ESG conscious investors, of which I would argue there are many, coming into brown firms and basically exerting a completely negative influence counter to what the ESG movement wants.
Kelly Shue:
Yeah, exactly. I think there are two forces that are working in tandem. The first, and that’s the focus of our study, is just historically when we look at the data, when high-polluting firms are doing well and getting easy access to public investor money, they’re actually naturally reducing their emissions. They have the financing to buy this expensive green equipment up front that pays off in the future. Meanwhile, if they’re distressed, they’re having difficulty raising money from public investors, they actually increase their emissions, because by cutting back on abatement efforts, that’s actually how they get cash right now.
There’s a second important effect, which is what you’re mentioning is that, ideally, for any potentially polluting asset, you want that asset to be owned by an investor who cares about the environment, to the extent that the environmentally responsible investors divest away. Well, the asset doesn’t disappear, somebody else owns it, and it could fall into the hands of a private investor who has actually far weaker concerns for the environment.
The other thing that we have seen happening is, right now, sustainable investors are rating firms according to their scope 1 and scope 2 emissions, which is direct emissions as well as emissions due to the energy that I purchase. But emissions due to stuff that I purchase further down my supply chain does not matter for my ESG or sustainability rating. So because of this is the standard by which we measure firms, a lot of public firms have an incentive to move pollution further down their supply chain. That pollution is still going to occur, but instead of it occurring within a public company in a developed country, it is now moving, possibly, to further down the supply chain to a developing country with weaker environmental standards. So it’s still happening, it’s just not happening within the ownership space of the public company.
Jackie Forrest:
A lot of institutional investors will tell you, well, those scope 3 emissions are so hard to measure. That’s why they’re not making goals around them. But it does create some unintended consequences. There’s another element to this too, Peter, that you mentioned in your paper, you actually referenced another paper, and for our listeners, we’ll be including links to Dr. Xu’s paper, but as well as this other paper. But this one talked about how these polluting companies actually make more green patents.
The paper found that oil, gas and energy producing firms with lower environmental, social, and governance scores who are often not part of the ESG funds, are actually key innovators in terms of creating new technologies to reduce emissions. Makes sense if you have them, you might invest some money and know how to reduce them.
We have this similar dynamic in Canada. We have the Canadian Resource Network, CRN, reported in 2019 that $1.4 billion a year was invested in clean technology in Canada, and 75% of that came from the oil and gas industry here in Canada. Professor Xu, does that surprise you that oil and gas companies and other higher emitting companies are best suited to develop new green solutions?
Kelly Shue:
After I saw that paper, I found the results very fascinating. I was surprised, but upon reflection, I realized I shouldn’t have been surprised, because what industry is most likely to come up with green energy patents? It’s not going to be a services industry. It’s more likely to be an existing energy player, both because you have to have expertise in energy in order to innovate in energy, and I think it’s also true that a lot of the most influential innovations are process innovations that tweak an existing process, and therefore it doesn’t make sense to view existing energy companies as completely unable or unwilling to transition toward greener production. If anything, they’re trying to innovate pretty hard in this space.
The other thing that I think people should be aware of is, again, because many of these high emissions companies are starting out with such extremely high levels of emissions, again, up to a thousand times higher than your typical same size green firm, these minor process innovations, maybe they’re not going to get completely to net-zero by 2030, but for them to reduce emissions by 1%, 2%, or 3% still has a far better environmental impact than some lower-emitting company reducing its emissions completely.
Jackie Forrest:
And they may be developing technologies that others can use while they’re pursuing that.
Peter Tertzakian:
The studies that you have done comes out of a university with an endowment office, like many in Western countries, where divestment is actively encouraged by students. How has your paper been received by the university community?
Kelly Shue:
I have presented this particular research paper to the Yale Investments Office, which is in charge of managing the Yale endowment. They were very receptive and very thoughtful. I do think that they are under pressure from various constituents with a variety of goals, but some of those goals are just complete divestment from certain fossil fuel and other sin firms.
One interesting insight that I heard from the Yale Investments Office, and also from a number of other institutional investors that I’ve talked to, is that the goal of transitioning firms toward being more environmentally friendly does not always align with the goal of minimizing climate transition risk. The first, which is if you want to help firms transition toward becoming more green, actually involves owning some of these high-emissions companies and incentivizing them or monitoring them so that they improve.
On the other hand, if your only goal is to minimize your personal portfolio’s exposure to potential carbon taxation or regulation in the future, then, yeah, it might make sense to underweight entire industries, potentially, that are high emitters because those industries you might believe are at the greatest risk of being under heavy regulatory burden in the future. It’s important to recognize those are two very different goals, and they imply very different investment strategies.
Jackie Forrest:
Right. Yeah. One isn’t trying to solve the climate issue, it’s trying to reduce your own risk.
Kelly Shue:
Exactly.
Jackie Forrest:
Come back to the students at Yale, because I know there’s been-
Jackie Forrest:
… risk.
Kelly Shue:
Exactly.
Jackie Forrest:
Come back to the students at Yale, because I know there’s been a very strong divestment movement. Some of the pro-divestment people would have a view that we should just not put money into these brown firms because, eventually, they’re going to go out of business and that will stop them from polluting. There’s logic out there like that. What’s the flaw in that argument, from your perspective?
Kelly Shue:
In the short term, if we all pull our money out from these high-polluting firms, they’re going to become quite distressed and may actually end up polluting more in their fight to survive. So right now, they’re investing a lot in abatement efforts and transition technologies, and investments are going to pull back from all of that if we aggressively divest, potentially. The other thing to consider is, for better or worse, probably for worse, but it’s unavoidable, there’s a number of industries that are high emitting that produce output that we don’t have ready substitutes for. We need agriculture. We need energy. To some degree, we also need transportation. So it would be nice to preserve some of the output from these industries and perhaps help them keep on producing output that’s valuable for a well-functioning society while helping the improving set of firms within these industries grow.
Peter Tertzakian:
I would argue additionally that climate scientists and environmental movements and groups have their place and investment professionals have their place and function. And for people like climate think tanks and others to come forth and say, “Don’t invest in such and such brown company because you are going to lose money,” well, it’s a rather demeaning. Financial professionals are trained to assess risk and return and factor in all sorts of risks, including climate risks and others. So to me, it’s quite patronizing, and that’s the real flaw in that argument.
But I want to even expand that further, Dr. Xu, and talk about the binary nature of the divestment movement, in other words, divest, which means no investment, and then the other side is don’t do anything, which would be invest to your heart’s content. I don’t think you’re necessarily arguing that it’s black and white. There’s a question of, well, how big is the stick that we should be using to put some pressure on brown companies to innovate? Because, arguably, the other side of the argument might be, if there is no pressure whatsoever, they’ll just wantonly go off and pollute and not do any innovation to address the problem.
Kelly Shue:
Yeah. I would hope that sustainable investors provide stronger incentives, more meaningful incentives for high-polluting companies to improve. Right now, what we’ve found is there’s very much, as you say, a binary approach. It’s basically net zero or nothing. And there is a lot of economics research showing that, if the goalpost is too far for one to reach, then the incentive becomes very weak. So we have a company currently, various companies out there that have huge environmental impact. And the environmental investing community is basically saying, “Unless you get to net zero by 2030 or 2050,” which is extremely difficult for some of these firms to do, “then we’re not going to reward any other type of improvement if they’re more modest.” So if that’s the goalpost, it’s a bit too far for these companies to reach with their current available technology.
Peter Tertzakian:
You’ve used the word incentive a few times. So there’s, as they say, carrots, which are incentives, and sticks. You hear that a lot. So divestment is a big stick which affects and raises the cost of capital, whereas you’re actually saying what is really needed to get the brown firms to innovate are incentives and not even a small stick? Where do you sit on that?
Kelly Shue:
I would hope for the incentive channel to be dialed way up in future sustainable investing strategies. And I do see some progress there, but overall, if we look in the data at how sustainable investors have reacted to firms improving and lowering their emissions, what we see is they’ve primarily rewarded firms that have always been green, that have large percentage reductions in their emissions. And this is rewarding the wrong set of firms because, again, a 100% reduction in emissions by a services firm is still environmentally pretty much meaningless, whereas what we see is that, when high polluters reduce their emissions, and that could be measured in absolute or percentage units, the reaction by sustainable investors have been actually quite minimal. There’s almost no improvement in the extent to which sustainable investors are willing to invest in high-polluting companies that reduce their emissions.
And I think the problem is these firms are still on, basically, a binary divestment or don’t divest list. And by the nature of their level of emissions, which is still going to be high, they’re still on that divestment list. So right now, there’s no monetary incentive for these firms to improve.
Jackie Forrest:
Now, we talk about these kind of binary strategies. There is some meeting in the middle. Your paper referenced that Engine Number One, an asset manager who successfully engaged with ExxonMobil to reduce its environmental impact, and just for those that aren’t following this in 2021, Engine Number One put forward a shareholder resolution to add new board members to Exxon. That did happen. And since that change, Exxon has started their low-carbon solutions business. Remember Matt Crocker, who came on our podcast in September, Peter, who talked to-
Peter Tertzakian:
Yeah, I remember.
Jackie Forrest:
… who’s leading that business, and a lot of people say it was because of that change in the board members that Exxon is spending something like $17 billion between 2022 and 2027, and that doesn’t even include this new lithium investment that they just made in the last month, announcement of that. So Professor Xu, do you think that type of example is causing ESG-focused investors to rethink divestment when they see a success story like that?
Kelly Shue:
Yes. I am seeing a lot of mention and discussion around this word engagement, which is the idea that you should own brown firms and actually try to engage with their management. Large funds are actively doing direct engagement. Smaller investment funds, there’s some progress in coordinating with each other so that they can make a concerted engagement effort. So I think there’s a lot of hope in the growth of these engagement-oriented strategies.
The other area that I believe is growing are these transition-oriented portfolios. So these are portfolios with sustainable objectives. However, they do a very detailed industry adjustment so that they’re not under-weighted in entire brown industries and over-weighted in services industries. Instead, they tend to actually invest in the industries that matter and direct their capital toward the set of firms within an industry that are improving. So this means that they have to be comfortable with an overall high emissions to market value for their portfolio because that’s automatically going to be high if you’re engaging with manufacturing and energy sector firms, for example, but they are trying to provide meaningful incentives to the set of firms that actually matter.
Jackie Forrest:
Now, what do you say to those investors that, and there’s many of those pension funds and big institutional investors, who’ve made very public statements around reducing their financed emissions, their scope one, two emissions? Do you think they should U-turn on those past commitments? What should they do if they’ve already made them?
Kelly Shue:
I actually hope that they do drastically change their divestment strategy and basically stop divesting. I think they can remain very committed to their environmental goals, so they can actually recommit or further commit to environmental goals with the idea that they’re going to be more productive in that space by changing their strategy.
Peter Tertzakian:
It reminds me of the Aesop fable, The Wind and the Sun, where the wind and the sun engage in a challenge to see who can take the coat off of a person who’s walking on the street. Of course, the wind is the metaphor for the stick and the sun is the metaphor for the incentive. And of course, the sun wins. And I think there’s some sort of a parallel here that there is a rethink that needs to happen. Now, the pendulum seems to swing completely the other way oftentimes with human behavior. It seems that 20 states in the United States have gone completely the other way, Jackie. So what are they doing?
Jackie Forrest:
Yeah. Something like 20 states, including Texas, Indiana, Florida, and many others, have asked their pension funds to divest from financial institutions that are pro-ESG. So if you’re using ESG to help make a business decision, they don’t want to invest in you, which, I have to say, I don’t know how many companies they can invest in since most of them have sustainability reports and say that they do use ESG in their decisions. I’m interested, professor Xu, in your thought-
Peter Tertzakian:
Yeah, what do you think?
Jackie Forrest:
… in this movement.
Kelly Shue:
I think it’s very unfortunate that concern for the environment is now split between left and right and ESG and anti-ESG. I am not a climate change expert. I am concerned about what I see as increasing risk that global climate change is going to occur, and that’s going to be a problem for everybody, left or right. It does seem that, to the extent that we want to actively combat this risk, it calls for …
Kelly Shue:
To actively combat this risk, it calls for not just a naive divestment strategy, but more of an engagement or transition oriented investment strategy. The other unfortunate trend that I see is that in reaction to the anti-ESG movement, the pro-ESG movement has reframed everything in terms of environmental risk, because by framing it as not as we want to improve the environment, but as we want to minimize climate transition risk, this puts it all back under the responsibility of the fund manager. Maybe you could say the fund manager should not have a direct environmental objective, but it is the job of the fund manager, any fund manager, to manage the fund’s risk and return profile.
Peter Tertzakian:
Right. And then the fund manager basically throws up their arms and says, “I don’t get any of this so my default is not to invest in anything to do with the green transition.” So what we’re observing is you basically, you get capital paralysis and misallocation, which is completely unhealthy for any sort of green energy transition.
Kelly Shue:
I do think, yeah, there’s a disingenuous labeling of ESG objectives as purely risk management. Yeah, we do care about risk management, but I think a lot of investors out there just have direct environmental goals, and it’s okay to have those goals, but we should think concretely about, is this strategy aligned with those goals?
Jackie Forrest:
Right, yeah. Is it actually reducing emissions in the big picture?
Kelly Shue:
Exactly.
Jackie Forrest:
Well, the good news is I do think there’s more reflection by groups. I would tell you that in the groups we’ve talked to, I think there’s some softening of some of those hard stances. Also, you see groups like GFANZ publishing things on Scope 4 emissions, which we’ve talked about on the podcast, which is saying just by looking at Scope 1 and 2, you may be screening out companies that actually have a really positive impact. For example, a company making electric cars actually has fairly high Scope 1 and 2 if they’re producing their own batteries. But yet when those cars go on the road, they’re helping to reduce emissions in the big picture. So I think there’s more recognition by some of these frameworks that they need to be looking at the big picture. Yeah-
Peter Tertzakian:
Yeah, there’s recognition, but a lot of damage has been done, I think, with this very binary type of attitude towards approaching an optimization problem ultimately. In other words, how do you optimally allocate capital to a transition? And this is just really unhealthy. And I want to ask you Professor Xu about the rating agencies, firms like Sustainalytics, MCSI, Bloomberg, et cetera, who rate and score companies on their ESG behavior, which is now entrenched, it seems, and that entrenchment implicitly encourages, I believe, divestment and this misallocation behavior. What do you see in terms of these rating agencies?
Kelly Shue:
I do think naive rating systems can be quite problematic because ratings heavily reflect the level of emissions for a company without much of an industry adjustment, and they also reward companies who have had large percentage rather than meaningful level reductions in their emissions. There’s also just a broader problem with firm level ratings, which is that they’re at the firm level rather than at the project level. Ideally, we would have project specific financing, which would be to say that any firm, even if it is high emitting on average, if it were to invest in a specific project that is good for the environment, it should have subsidized financing or some incentive to engage in that specific project. But right now, because we label an entire firm as either good or bad or with a high or low rating, that firm now has an incentive essentially to split up.
Firms right now have no incentive to be part green and part brown because the green portion of that firm is going to get labeled as brown under this umbrella firm rating. So ideally, we move towards some of this more project specific financing, which we’ve seen done effectively in some of the green debt markets. There’s green project specific financing. Doesn’t matter what type of firm you are, if you can credibly show that your project is going to be good for the environment, you can get subsidized financing. But a lot of what’s been going on in the equity space is we view the firm as an indivisible unit, and we’re labeling it by its ownership of fossil fuel assets regardless of what any specific division does.
Jackie Forrest:
Right. And you’re seeing that in the oil and gas companies, especially the European ones that have put more and more money into clean energy investing. And then investors, it’s so polarized. You either want to be in oil and gas, or you want to be in green. You don’t want to be in a blended company, but we really need the blended companies if we’re going to achieve our goals of decarbonizing these high emitting industries. So Professor Xu, it’s been just fascinating hearing your perspectives. You put so much thought into this, and we’re going to continue to follow your great work, and thank you for this paper. I think when I first read it, I’m like, this always made sense to me, but it’s so great to have an academic study that really validates it.
Peter Tertzakian:
Yeah, validates the common sense of people’s behavior. The more you bring out a big stick, the less likely they are to cooperate with something. So yeah. Thanks for quantifying that in your paper. You’re going to post it, right, Jackie?
Jackie Forrest:
Yes. Yeah. I’ll have a link to the paper as well as the other paper on the green patenting that we talked about.
Peter Tertzakian:
Yeah. Yeah. Thank you so much, Dr. Xu.
Kelly Shue:
Thank you very much for having this discussion with me and for the opportunity to talk with your audience.
Jackie Forrest:
And thank you to our listeners. If you enjoyed this podcast, please rate us on the app that you listen to and tell someone else about us.
Speaker 1:
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