Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms

Key Takeaways

The dominant sustainable investing strategy, which involves investing in “green” companies and avoiding “brown” companies, may be counterproductive in reducing emissions.
Brown firms have a large and negative impact elasticity: they respond to increases in their cost of capital by increasing their emissions. In contrast, green firms have an impact elasticity of around zero: their emissions do not meaningfully change following a change in cost of capital.
A mistaken focus on percentage rather than absolute emissions changes results in green firms rewarded for economically trivial emissions reductions and a lack of incentives for brown firms to improve their environmental impact.

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Summary

Motivation: Sustainable finance has grown significantly in popularity over recent years. The dominant sustainable investing strategy behind this growth involves directing capital towards green firms and away from brown firms, with the goal of facilitating a green economic transition by influencing the firms’ costs of capital. However, the authors empirically show that this strategy may be counterproductive, as it makes brown firms more brown without making green firms more green.

Methodology: The authors introduce a new measure called impact elasticity, which quantifies how a firm’s emissions intensity responds to a change in its cost of capital. They examine the impact elasticities along with other pertinent financial and emissions data of U.S. public companies from 2002 to 2020. Scope 1 and 2 greenhouse gas emissions are sourced from the Trucost database and are scaled by revenue to adjust for firm size (emissions intensity). Firms are then sorted into quintiles based on their emissions intensity, with the lowest representing brown firms and the highest representing green firms. With this data, the authors examine 1) the level and variability of firm emissions, 2) the impact elasticities of brown and green firms, and 3) the incentive effects of the dominant sustainable investing strategy.

Findings:

The average brown firm releases 261 times more emissions per unit of revenue than the average green firm. Additionally, the annual variability of emissions intensity for a brown firm is equal to the average level of emissions from 35 green firms combined.
The impact elasticity of green firms is close to zero, whereas the impact elasticity of brown firms is large and negative. This means that brown firms substantially increase their emissions following an increase in their cost of capital, while green firms’ emissions remain largely unchanged.
Brown firms have different impact elasticities than green firms because they have the choice to invest in green projects, such as new pollution abatement technology, or brown projects, such as expanding existing high-emitting production. Green firms do not have such choice, as their projects all have relatively low emissions.
Since green projects have higher up-front costs and relatively more backloaded cash flows than brown projects, an increase in a brown firm’s cost of capital will make brown projects more attractive. Therefore, following an increase in their cost of capital, brown firms deprioritize the green transition and emissions reductions, contrary to the goals of sustainable investing.
Changes in environmental impact are often measured in the wrong units. Many green funds and ESG ratings mistakenly reward firms for a large percentage reduction of emissions rather than a large reduction in the level of emissions. For example, a green firm reducing its emissions by 100% is much less economically meaningful than a brown firm reducing its emissions by only 1% since the initial level of the brown firm’s emissions intensity is substantially higher than the green firm’s.
Rather than avoiding brown industries, as many do not have suitable alternatives, sustainable investors should instead direct capital towards these brown industries and reward the relatively green or transitioning brown companies within these industries.