When socially responsible investing backfires

(Press-News.org) Socially responsible investors (SRIs) often see themselves as agents of social or environmental progress. They buy into polluting or “dirty” companies believing that their capital can nudge a business toward a cleaner path. Their intention is straightforward: to invest in the bad to make it good.

But a new study by finance professors at the University of Rochester, Johns Hopkins University, and the Stockholm School of Economics argues that this logic can backfire. Instead of accelerating environmental reforms, SRIs may unintentionally create incentives for firms to postpone them.

“It’s surprising at first,” agrees study coauthor Alexandr Kopytov, an assistant professor of finance at URochester’s Simon Business School, “but when you think about this from the correct angle, it makes sense.”

Waiting for the good guys The researchers model a scenario that companies may face in real life: Imagine you own a polluting but profitable factory. You could invest now to make it greener, or you could hold off, knowing that an SRI—someone who is explicitly looking for a company to improve—might come along later and pay a premium precisely because the company is “dirty.”

And that, according to Kopytov, is the crux of the problem. Well-intentioned investors “just do not want to invest in a green firm that already has achieved everything it can,” he says. “Instead, they really want to make an impact with their money.”

Managers at such polluting companies are aware of this motivation to do good.

“I might think, ‘Well, why would I invest in this project on my own? I can allocate my money somewhere else and wait until those socially responsible investors come along and give me their money because they care about making the world a greener place,’” Kopytov says.

That’s how green reforms get stalled. In other words, the very presence of investors seeking to do good can create an incentive for firms to delay doing good themselves.

Traditional investors may add further delays The effect is magnified by traditional investors who care predominantly about financial gains. Because SRIs will pay less if a company is already inclined to go green, a purely financially motivated owner becomes a tougher negotiator. If you’re a polluting firm, that’s valuable.

“Instead of selling directly to socially responsible investors at a relatively low price, I can actually sell it to a financial investor who then will sell it to socially responsible investors at a higher price,” Kopytov explains. This dynamic creates a resale chain that rewards waiting (to enact environmental change) rather than acting.

A possible fix The researchers examined how investment mandates might counteract this delay. Many funds already use policies that exclude polluters or reward cleaner firms. But exclusion alone isn’t enough.

A more effective approach, Kopytov says, is for SRIs to publicly commit to paying a premium for firms that have already cleaned up their act. “If they can commit to such a mandate,” he says, “managers would reform earlier in order to earn that premium.”

The key challenge here is credibility. If the reform has already been done, some investors may ask, why pay now? To overcome the temptation not to pay the premium, investment funds may need public, enforceable commitments that would penalize them if they broke the promise of paying a premium for already enacted green reforms. Signing binding principles of responsible investing, Kopytov says, would create a reputational cost for those SRIs who deviate from the agreed-upon premium rule.

Rethinking impact investing Ultimately, the study seeks to reframe what “impact investing” really means. Investors often measure progress after a deal is made but the authors argue that if mandates are structured correctly, all the measurable impact happens before the acquisition rather than afterward.

“It’s really important how you invest your money responsibly if you care that the money is making an impact—because that can slow down the speed at which firms are being reformed by their current owners,” Kopytov cautions.

In other words, good intentions may not be enough. Real change depends not just on desiring impact but on designing incentives that make acting sooner, not later, the best financial choice.

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