The Promise and Pitfalls of Investing for Change

Navigating the line between opportunity and uncertainty in the ESG boom

April 19, 2022

| by Alexander Gelfand Dave Gilson
Illustration of various cuttings of a map, pieced together to form a larger map that shows a road curving along it. Illustration by Tyler Comrie

Illustration by Tyler Comrie

When Engine No. 1 succeeded in seating three new directors on ExxonMobil’s board in June 2021, the move was widely hailed as a David versus Goliath moment. And rightly so: The hedge fund, which launched in late 2020 with $250 million in assets, owned a mere 0.02 percent of the energy giant’s shares.

Is Impact Possible Without Trade-Offs?

Frontiers of Social Innovation, a new book edited by Stanford GSB professor of political economy Neil Malhotra, explores a range of topics facing philanthropists, social entrepreneurs, and investors who seek “effective solutions to challenging and systemic social and environmental issues.” A major focus is the incentives and obstacles surrounding impact investing and ESG-driven investing.

Read an excerpt

Engine No. 1 had waged a proxy campaign that savaged the company for its lackluster financial performance and lack of a clear path to a low-carbon future, ultimately gaining the support of ExxonMobil’s largest shareholders, including Vanguard and BlackRock. Since the election of its new directors, the company has declared its intention to achieve net-zero greenhouse gas emissions by 2050. By February 2022, its stock price had soared by more than 90% — roughly doubling competitors’ gains at a time when oil prices were booming.

For Engine No. 1’s managing director at the time, Michael O’Leary, MBA ’19, the ExxonMobil coup was proof of concept for the firm’s approach to impact investing, which combines targeted investments with old-fashioned shareholder activism. Its goal is to reap financial rewards while advancing environmental, social, and governance (ESG) aims. “That was a test case,” says O’Leary, now a strategic advisor at the firm. “It was not easy. But we were able to show that if you have the right set of ideas, the right strategy, and the right partners, you can create real change.”

The market for investments that consider ESG criteria and seek ESG-related impacts is exploding. Estimates of its size vary widely. In 2020, the Global Impact Investment Network pegged the total market for impact investment at $715 billion, while the World Bank’s International Finance Corporation reckoned it was worth $2.3 trillion. The Global Sustainable Investment Alliance has tallied more than $25 trillion in assets under management using an “ESG integration approach” — a 143% increase since 2016. Whatever the figures may be, there’s no doubt that vast sums of money are now chasing financial rewards alongside returns such as reducing carbon emissions, strengthening worker protections, and diversifying boardrooms.

ESG “put a name on something that I think has always been there,” says Jim Coulter, MBA ’86, the executive chairman and founding partner of TPG, a private equity firm based in San Francisco. Socially responsible investing is not new; a subset of investors has long sought to prioritize investments that somehow contribute to the well-being of the planet and its inhabitants. Yet in the past few years, there’s been a rapid shift to a “new ethos” the likes of which Coulter has seen only a few times over the course of his nearly four-decade career. “I think of it as the world of and,” he explains. “Businesses are going to be measured for what they do and how they do it. It’s not or. You’re going to be measured for both.”

If you have the right set of ideas, the right strategy, and the right partners, you can create real change.
Michael O’Leary, MBA ’19, Strategic Advisor & Former Managing Director at Engine No. 1

TPG got a head start, adopting an ESG performance policy in 2012 and signing on to the United Nations–backed Principles for Responsible Investment the following year. It launched an impact investing platform, The Rise Fund, in 2016. Coulter and Steve Ellis, MBA ’90, serve as two of the fund’s three co-managing partners. (The fund’s founders board includes Laurene Powell Jobs, MBA ’91; Jeff Skoll, MBA ’95; and Bono.)

“Any type of company has the ability to participate in ESG,” Coulter says. But for investors who want to go beyond putting their money into corporations that are trying to do better, there’s investing for impact — “the extra credit of ESG.” When The Rise Fund launched, Coulter recalls, “Impact investing was something we had to sell rather than something people were looking to buy.” Today, Rise is the world’s largest private equity impact fund, with $13 billion in assets and investments in 50 companies across six continents. At the end of 2020, it reported having delivered an estimated $3.3 billion worth of impact in areas including education, health, and decarbonization.

There is a growing consensus that the stakes are too high not to try to harness the power of profit to tackle urgent environmental and social issues. Yet as players such as TPG and Engine No. 1 articulate a vision for long-term investing in change, the landscape is still dotted with heated debates and potential pitfalls.

Like O’Leary, Coulter notes that doing well by doing good is not easy to get right. “This is hard,” he says. “It’s an attractive type of investing, but it’s a difficult type of investing because we’re adding a whole other level of complexity by holding ourselves to the highest standards for measuring and delivering impact. But being early means you have to build the tools and refine your approach as you go.”

Measuring Up

There are a gazillion ESG measures. If you don’t have good measures, how the hell do you build your investment portfolio?
David Larcker, The James Irvin Miller Professor of Accounting, Emeritus

David Larcker, a professor emeritus of accounting at Stanford GSB and director of the Corporate Governance Research Initiative, believes it is imperative to achieve ESG goals. But he has some questions about how that will happen. He has found that many investors and companies are unclear about what, precisely, they are trying to achieve by pursuing ESG goals, and as a result can’t honestly say whether they are succeeding. And that uncertainty is compounded by numerous flaws in how policies and impacts are measured and analyzed. “There’s a lot of bad assumptions, bad measures, and unsupported claims,” he says.

In a recent paper, Larcker exploded several “myths” surrounding ESG investing — starting with the idea that it has a widely accepted definition. What exactly constitutes an ESG activity isn’t cut-and-dried. If a U.S. bank invests billions in initiatives to advance racial equality and economic opportunity, for example, is it really pursuing ESG objectives — or is it simply taking credit for complying with federal regulations that require it to serve low-income communities? After Russia invaded Ukraine in February, a German defense industry group said that weapons makers should be recognized for their “positive contribution to ‘social sustainability’ under the ESG taxonomy.” Larcker questions why governance is part of the formula: Shouldn’t shareholders value good governance at all companies, regardless of their environmental and social priorities?

Measuring the effects of even the most well-meaning ESG effort is tricky. “You start peeling back the onion, and it becomes very complicated,” Larcker says.

While calculating the environmental impact of a company’s carbon-reduction program might seem relatively straightforward, it becomes considerably less so if one considers all the emissions generated along the enterprise’s supply chain. Putting a figure on the “S” is even more challenging: How, for example, do you quantify the impact of a socially responsible policy on the lives of workers in the developing world?

“Good luck measuring the impact of an investment on social or economic inequality,” says Amit Seru, a professor of finance at Stanford GSB and a senior fellow at the Hoover Institution. “The data are messy, crude, and measured with a lag.”

Infographic showing the relative size of ESG investing from different sources as progressively larger circles.

Sources: Global Impact Investment Network, International Finance Corporation, Forum for Sustainable and Responsible Investment, Global Sustainable Investment Alliance, Bloomberg Intelligence, United Nations Principles for Responsible Investment

Most publicly traded ESG funds construct their holdings by considering the universe of all stocks, excluding the most obviously “dirty” companies, and weighting whatever remains according to a rating system. This strategy descends from a tradition of socially responsible investing focused on avoiding “sin stocks” and morally questionable enterprises (think of the movement to divest from apartheid-era South Africa).

But ESG screening is more complicated than simply excluding firms from a particular industry: a company that promotes good governance or racial equity, for instance, may still have a huge carbon footprint. And without mandatory disclosure or commonly accepted metrics, it’s difficult to make apple-to-apple comparisons of firms’ track records. Corporations may cherry-pick the numbers they disclose, increasing the possibility of greenwashing or greenwishing — mistaking good intentions for meaningful impact.

There is little overlap among the various proprietary methodologies for rating public companies’ ESG performance. A company might get high marks on one scale but failing ones on another. O’Leary cites the example of a medical-device maker in Engine No. 1’s portfolio that, according to one rating provider, has lower E and S scores than the Altria Group, one of the world’s largest producers of tobacco products.

“There are a gazillion ESG measures, but who knows whether any of them are really relevant?” Larcker says. “Are they measuring what they claim to be measuring? And if you don’t have good measures, how the hell do you build your investment portfolio?”

Known Unknowns

The whole idea of win-win only works at scale if you have a bunch of mismanaged firms.
Amit Seru, The Steven and Roberta Denning Professor of Finance

Fuzzy numbers can complicate decisions about whether to invest in a company or encourage it to undertake a particular ESG initiative. “It’s hard to push them until we really have that data,” says Madeline Hawes, MBA ’17, a director at Engine No. 1. Her firm tries to make up for the lack of high-quality information through “the magical work of our data science team,” which employs imputation methods to fill in gaps in the data.

Coulter says “information availability” is more of a problem in the public market than the private market. Nonetheless, “we would like clear standards,” he says. “We remind people that it took 70 years for GAAP to develop and 50 years for Moody’s to come up with A/B ratings for bonds. But we can’t wait. We’ve got to get action.”

To that end, TPG launched its own research arm, Y Analytics. It’s designed to “take the guesswork out of our impact assessments by deliberately avoiding intuition-based definitions of impact in favor of peer-reviewed, research-based definitions,” Coulter explains. “And we assess the potential impact of our investments on a net basis, so we are taking into account the potential for both positive and negative outcomes.”

Seru worries that the scarcity of consistent, quality information could place a ceiling on how much the overall ESG market can expand. “There’s a big conundrum here,” he says. “Standardization is hard. And because standardization is hard, it’s going to create pockets of people who more or less agree on things. But they’re going to be very specialized pockets, and as a result, the market will not grow as much as people might think.”

There is also the question of how many truly attractive opportunities the market contains — and whether there are enough to make this type of investing work at scale. Larcker says there’s not enough evidence behind claims that focusing on ESG criteria inevitably leads to better returns. A 2021 meta-analysis of 1,400 studies performed by researchers at the Wharton School, NYU, and Johns Hopkins indicates that the financial performance of ESG investing has on average been indistinguishable from conventional investing.

A 2019 study of the municipal bond market that Larcker conducted with Edward Watts, PhD ’20, now at the Yale School of Management, found that investors were unwilling to pay a “greenium,” or sacrifice returns to invest in eco-friendly securities. On the flip side, Stanford GSB finance professor Jonathan B. Berk recently showed that divestment from companies that fail to meet ESG criteria has little impact on their financial performance or their cost of capital.

Sources: Morningstar, Financial Times, International Monetary Fund, PricewaterhouseCoopers, BlackRock, Global Sustainable Investment Alliance, KPMG

While Larcker and Seru acknowledge that there are situations where investors can make money while making the world a better place, they question just how many of them are sprinkled throughout the broader economy. “The whole idea of win-win only works at scale if you have a bunch of mismanaged firms,” Seru says. Well-governed firms, he explains, will already have undertaken all the projects that could potentially maximize shareholder value — including those with obvious environmental and social benefits.

By that logic, ExxonMobil would be the exception rather than the rule, at least in developed markets. Seru argues that Engine No. 1 was able to rally larger shareholders to its cause because the oil company was already seen as being so poorly managed that it was failing to maximize returns. A well-run company, however, would not have needed any outside nudging to pursue an ESG-friendly course that clearly served its bottom line.

Or, as Larcker puts it, “If there were returns to be had, the greedy capitalists would already have been doing it.”

Confusion and Opportunity

It’s hard to push them until we really have that data.
Madeline Hawes, MBA ’17, Director at Engine No. 1

The issues raised by researchers like Larcker and Seru are not news to the proponents of sustainable investing. Coulter has stressed that ESG depends on accountability, not promises. “We have 1,500 companies that have made net-zero pledges — and yet none of them can say how that’s going to happen,” he told Bloomberg last year. In 2020, O’Leary published a book, Accountable: The Rise of Citizen Capitalism, which echoes much of Larcker and Seru’s critique. He and his coauthor wrote an article last year for Harvard Business Review with the ominous title “An ESG Reckoning Is Coming.” “A movement meant to benefit the public good risks becoming a buzzword coopted to keep maximizing short-term profits,” they warned.

But O’Leary and Coulter are determined to overcome and even capitalize on the uncertainty in the current boom. “It’s like a three-sided coin: We have need, chaos, and opportunity,” Coulter says. “Any time you flip the coin, you’ve got to ask which side you’re on. The way you deal with the chaos is through knowledge. I think this really speaks to the need for specialized capital and dedicated impact investing efforts.”

“Good investing of any type requires that you can take a contrarian stance and place a bet on a company or a trend that is different from what the rest of the market thinks,” O’Leary says. “And that’s possible right now because there’s so much confusion over what ESG investing even means.”

If you are building real companies that are solving real problems, there’s no reason that you can’t get real returns.
Jim Coulter, MBA ’86, Executive Chairman & Founding Partner of TPG

Coulter is adamant that investing for impact can — must — be a win-win. From the outset, The Rise Fund was intended to be “absolutely, unapologetically, non-concessionary.” “An impact deal doesn’t know it’s an impact deal from a financial point of view,” he says. If competitive performance is viewed as a tradeoff for positive impact, he argues, impact investing can’t scale. That defeats its purpose, which is to generate the capital necessary to spur large-scale change. “If you are building real companies that are solving real problems, there’s no reason that you can’t get real returns. And you create a more sustainable company,” Coulter says. “If you ask people to take below-market returns, there isn’t enough below-market capital out there to solve the problems we have to address.”

Coulter thinks there’s much more untapped demand, not just from ESG-curious investors but a new generation of entrepreneurs seeking “impact capital.” “I think there’s an opportunity for this market to grow — substantially,” he says. He has said that he believes the “climate revolution” will mimic the explosion of the digital economy: Many people 30 years ago knew tech would be big, but they still underestimated just how big it would get.

So far, institutional investors have driven much of the growth in ESG investing. Engine No. 1 hopes to bring its approach to active ownership to the masses with a recently launched exchange-traded fund called Engine No. 1 Transform 500 ETF (ticker symbol VOTE). Composed of the 500 largest companies in the U.S. public equity markets, it is by exposure virtually identical to any S&P 500 fund. The difference lies in how it plans to wield its shares.

The asset managers who run many ESG funds often vote their shares in ways that run counter to the values of impact investors. “There are climate-focused funds that have voted against 90 percent of climate-related proposals,” says O’Leary, who came up with the idea for VOTE while sitting on the second floor of Bass Library at Stanford GSB. “Every additional dollar in the [VOTE] fund makes us one dollar stronger in our voting and our advocacy work.”

It remains to be seen how many investors can muster the level of ambition and expertise required by Engine No. 1 and TPG’s respective strategies. Whatever happens next should provide an excellent test of Larcker’s and Seru’s questions about the potential size of the sustainable investment market.

Larcker looks forward to seeing how it all pans out. And he is willing to concede that when it comes to investing for change, the perfect should not be the enemy of the good. “At some point,” he says, “there’s a leap of faith where it’s like, ‘Let’s go for it and see.’”

Is Impact Possible Without Trade-Offs?

Book cover of Frontiers in Social Innovation with arches, triangles and lines.

Frontiers of Social Innovation, a new book edited by Stanford GSB professor of political economy Neil Malhotra, explores a range of topics facing philanthropists, social entrepreneurs, and investors who seek “effective solutions to challenging and systemic social and environmental issues.” Its nearly 20 contributors include academics, practitioners, and leaders who teach courses as part of Stanford GSB’s Certificate in Social Innovation and Public Management.

In their chapters, Malhotra and Bernadette Clavier, the executive director of the Center for Social Innovation, question whether the current wave of sustainable investors recognizes the challenge of realizing both meaningful impact and competitive returns.

NEIL MALHOTRA: Traditionally, investing has focused on maximizing risk-adjusted returns. Impact investing posits a third factor in the objective function in addition to risk and return: impact. Note that this conflicts with “win-win” conceptions of impact investing that assume away tradeoffs (i.e., “The best way to maximize longterm profits is to take into account social performance.”). If you believe in this world of no trade-offs, then there is no difference between investing and impact investing. The only value of the concept of impact investing is that we need to consider scenarios where we gain impact at the expense of risk-adjusted return.

BERNADETTE CLAVIER: As demonstrated by the success of the ESG investing space, capital owners are attracted by more-ethical ways of continuing to make money at similar rates. In other words, the popular approach is to “do no wrong” as opposed to proactively making a positive impact.

However, market-rate returns are precisely not the point of the social enterprise. The point is to create social value; it is hoped without losing money and possibly while producing a little bit of financial return. We don’t have a social ventures supply issue. Rather, we have a demand issue for the social enterprise value proposition, the vast majority of which is subcommercial. The “doing well while doing no harm” opportunity is quite large, but the “doing well by doing good” proposition is overhyped.

Reprinted by permission of Harvard Business Review Press. Excerpted from Frontiers in Social Innovation, edited by Neil Malhotra. © 2022 Harvard Business School Publishing Corporation. All rights reserved.

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