Obstacles to Sustainable Finance and the Covid19 Crisis

Rodrigo Zeidana, NYU Shanghai, Shanghai, People’s Republic of China; Fundação Dom Cabral, Belo Horizonte, Brazil

Received 29 May 2020
Accepted 12 June 2020

Rarely are the incentives of portfolio managers aligned with those of companies’ stakeholders. In this article, I use access to the founder of Wright Capital, a wealth management company that has U$600
million under management, to explore the dynamics of sustainable finance and impact investment amidst the covid19 crisis. Pointedly, Wright Capital is a consumer of financial products related to the sustainability domain. As such, it encounters many of the supply-side obstacles that have been observed by researchers; chiefly among it, few specialized funds, the prevalence of green washing, and difficulties in disentangling ESG scores from other companies’ characteristics (larger companies tend to provide more detailed information on their environmental and social initiatives).

This perspective article is a case study regarding the obstacles that practitioners face when trying to improve the environmental and social performance of their portfolios without abandoning financial returns. The article does not deal directly with the impact of covid19 on financial markets but explores some of the issues that limit the efficiency of sustainable finance. Pointedly, covid19 may limit the dissemination of ESG-related funds but may increase incentives for the creation of financial products that fully incorporate
environmental and social outcomes. Some of the insights from the interview process corroborate previous works. Our main contribution is to critically evaluate the main barriers for sustainable finance to thrive.

Wright Capital’s business model incorporates a focus on impact investing and sustainable finance. Their institutional material includes citations on Ashwin Kumar et al. (2016) and Friede, Busch, and Bassen (2015). For their clients, at least 1% of their portfolio must  be allocated in narrowly defined impact investments through a dedicated fund (FIC FIM Wright Social Impact) that charges no management fees. Assets are allocated to investments related to one or more of the 10 selected Sustainable Development Goals (SDGs) (Figure 1). The firm is a consumer of sustainable finance products because it does not
invest their clients’ wealth directly. It buys shares in specialized funds in Brazil and abroad. As such, if a particular investment is related to quality education, one of the SDGs in the Social Capital fund, Wright Capital’s role is to ensure that the invested funds meet impact investing criteria.

At first, Wright Capital’s social impact strategy mostly involved convincing their clients to increase the share of their wealth devoted to impact investment. Recently, the firm has added lobbying for changes in financial regulations. Partly, this change in strategy has been motivated by academic research. Dyck et al. (2019) highlight the importance of institutional investors as promoters of change. The company aims at influencing decisionmakers by actively participating in associations that drive regulatory change. Their goal
is to accelerate the dynamic processes related to sustainable finance and impact investment.

One of the main barriers for companies to move away from business-as-usual is organizational inertia. Change can be forced upon companies or may result from pressures from competitors and consumers. These are the major categories of intervention for increasing the breadth and depth of sustainable investments: market mechanisms, regulation, and ideological changes. Table 1 summarizes costs and benefits of each type of intervention.

The interview with one of Wright Capital’s founders has been conducted on 25 May 2020. There are three salient points (Zeidan, Van Holt, and Whelan 2020), one each related to the supply-side, demand-side and the regulatory framework of financial markets, both in Brazil, where the firm is located, and globally, as a significant share of their clients’ wealth is invested outside of Brazil. Points 1–4 below are the main salient
points from the interview.

(1) The limits of Environmental Social and Governance (ESG) factors. Most corporations today publish sustainability reports in which ESG factors are disclosed. However, the quality of the information published by companies varies significantly, and investors cannot easily distinguish between value-creating sustainable initiatives and green-washing. There are numerous ESG-related funds, but there is no consistent evidence that screening companies for ESG factors generates long-term financial returns in excess of risk factors. At most, we can state that it is possible to build portfolios that, when screening for ESG factors, do not perform worse than most traditional-built portfolios (Alessandrini and Jondeau 2020). Funds who screen for ESG factors still rely on ‘intuition that the laggard’s cash flows are riskier and therefore demand a higher cost of capital and thus be valued using a high discount rate’ (Davis and Lescott 2019, 49). ESG factors have one limitation: they present only risks, and not opportunities (Zeidan, Boechat, and Fleury 2015). As such, sustainability-initiatives that are value enhancing are not captured in regular environmental funds. There are clear practical difficulties about allocating funds to high-performing ESG screened companies for consumer of financial products. Without dealing with such issues, it will be hard for sustainable finance to thrive.

(2) Shareholder pressure
On the demand-side, ‘companies will go as far as shareholders will take them, and no further’, according to the founder of Wright Capital. Of course, some market-pressure should lead to greenwashing (Marquis, Toffel, and Zhou 2016). Yet pressure from shareholders, especially for large corporations without consolidated ownership groups, should limit value-neutral initiatives. Managers cannot keep hiding from shareholders if the signal is clear for companies to improve environmental and social outcomes.

(3) Institutional investors
Scale matters. Institutional investors are key stakeholders in the sustainable finance domain. Among all types of shareholders, institutional investors could accelerate environmental and social improvements the most. Dyck et al. (2019) show that institutional investors from certain countries with a strong community belief in environmental and social issues (E&S) transplant their social norms regarding E&S issues around the world. Nevertheless, such processes take time. Improving the regulatory framework (Table 1) may
speed up the process. Regardless, without institutional investors pressuring companies, small wealth management companies should continue to struggle to find competitive ESG dedicated funds.

(4) Covid 19 and sustainable finance.
‘Money talks’. Amidst a global crisis, the search for financial returns (or minimizing financial losses) takes precedence among all else, in financial markets. There are reasons to expect that, at first, impact investing and sustainable finance should be negatively affected by the covid19 Institutional complexity fosters organizational inertia (Luo, Wang, and Zhang 2017), which increases the probability of greenwashing. In addition, Stieglitz, Knudsen, and Becker (2016) show how, in dynamic environments, the best-performing
organizations are generally more inert than less successful organizations.

Nevertheless, there is some silver lining regarding the evolution of sustainable finance: resiliency. Companies that survive will not come through unchanged and will seek ways to prepare for the next crisis. Environmental and social factors should become more important for companies and investors as the global economy recovers. Nevertheless, the dynamic evolution of ESG or other ways to measure non-financial outcomes by companies will continue to rely on shareholder pressure, new regulations and behavioral changes. Small boutique companies, from a systemic point of view, are more relevant as promoters
of regulatory and behavioral changes, than as allocators of financial resources.

(5) Final remarks
One can’t manage what can’t be measured. While ESG factors have allowed companies to disclose important information on environmental and social sources of risks, there are limits to its usefulness. There is little standardization in disclosure, and no major evidence that portfolios that screen for ESG factors outperform traditional portfolios. Nevertheless, business-as-usual has become less valuable amidst a global pandemic, and resilient companies should turn more valuable as the global economy recovers. As the regulatory pendulum swings again, this time to allow more lending for distressed companies, financial regulators can include disclosure rules on environmental and social outcomes as conditions for access to credit.

Disclosure statement
No potential conflict of interest was reported by the author(s).

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