Trucost Blog / 15 Mar 2018

ESG Meets Behavioral Finance – Part 2

In the second of a series of blogs, Trucost’s Global Head Financial Institutions Business explores how insights from behavioral economics could be used to revolutionize ESG investing.

Behavioral economics has had a transformational effect on the fortunes of millions of people saving for retirement through the introduction of auto-enrollment, default plans, and “save more tomorrow” schemes.

In a series of blogs, I explore how insights from behavioral economics could be used to revolutionize ESG investing and facilitate critical finance flows to a more sustainable economy. In part 1, I explored how we could harness the power of inertia to address the intent-action gap for sustainable investing. In part 2, I explore some of the behavioral biases we exhibit about green investing.

The Big Green Elephant in the Room: Why Do We Assume That “Green” Investing Means Sacrificing Returns?

In an era of information overload, competition for our attention causes us to take mental shortcuts leading to errors and biases. As behavioral economists have pointed out, investors are not immune, which could account for the disconnect between science and investor action on climate change. The World Economic Forum’s 2018 risk report highlights the failure of climate change mitigation and adaptation as one of the most impactful and probable issues facing the global economy and the Financial Stability Board asserts that climate is “the most significant” risk investors face. So why is it that in the 2017 CFA Society ESG survey only 50% of respondents admitted incorporating environmental issues into their investment process, and the main reason cited was immateriality?

The big green elephant in the room is the pervasive belief that investing in a way that considers climate requires financial sacrifice. While this can partially be explained by limited knowledge about climate impacts on asset valuations and how environmental issues can be integrated into portfolio construction, behavioral finance provides insights into additional factors at play. The “no free lunch” heuristic is at the root of our automatic response that “green” or sustainable finance requires a returns sacrifice. To lose weight, you must diet, to pass your CFA, you must sacrifice your social life; there is no reward without risk and “good” things (like “green” products) require sacrifice. Even when there is abundant evidence to the contrary, we are less likely to take it into account because of confirmation bias, which is the tendency to prioritize or interpret new information in a way that confirms our existing beliefs. Confirmation bias is stronger for more emotive and deeply entrenched beliefs, which could explain the slower adoption of sustainable finance in markets where issues like climate change are politically polarized, such as the U.S.

Listening to our reflective systems may lead us to a more logical judgement. We are entering an era of unprecedented population growth, placing huge pressure on the finite resource base for food, water, and energy. At the same time, more volatile weather and increasing pollution is depleting our “natural capital” base and governments globally are working to change the cost-benefit dynamics of polluting industries. Against this macroeconomic backdrop, it is logical that more resource-efficient companies and ones more responsive to changing consumer demand for greener products should do better.

Indeed, to make the case more powerfully, try reversing the argument—do we believe more resource-inefficient, polluting companies will outperform going forward? A meta-study by Oxford University seems to confirm the thesis. It found that in 90% of cases, environmentally efficient companies have lower costs of capital and superior stock market performance. This is reinforced by a Stanford University study demonstrating that carbon-efficient companies perform better on traditional financial metrics, such as higher ROI, cash flow, and coverage ratios. This data can feed into portfolio construction for both environmentally themed strategies and the greening of “mainstream” strategies. For example, the S&P 500 Carbon Efficient Index tilts rather than excludes companies and has outperformed the underlying index over the past  five-year period—as have versions that exclude fossil fuels, widely perceived to be the economic “losers” of a low-carbon transition. By addressing our cognitive biases, we can remove a key blocker to the flow of capital to a more sustainable economy.

Exhibit 1: A Free Lunch?

If you liked this blog, you might also enjoy the blog, “Can ‘Being Green’ Deliver Enhanced Returns?

You can also register to attend the Discover the ESG Advantage event on May 17, 2018, in London.

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