We are here at the Amsterdam Stock Exchange, the oldest stock market in the world. One of the key traditional functions of stock markets is capital allocation. By channeling capital to the most productive companies, stock markets have contributed to economic prosperity around the world. The reason for being here today is that I believe that stock markets can also play a key role in addressing perhaps the greatest challenge stemming from all that economic prosperity, climate change. Again, capital allocation may well take center stage. Sustainable investing has been the dominant trend in the investment industry over the past decades, and it is only accelerating. According to some numbers, more than 30 trillion US dollars of global assets under management are at least in part invested using sustainability criteria. Such criteria are often referred to as environmental, social, and governance, or ESG criteria, signifying that it is not only about climate. So more and more investors allocate capital away from poor ESG companies towards strong ESG companies. Now why would you engage in sustainable investing in the first place? The first key motive is ethical. For example, some investors just do not want to be associated with tobacco. Second, investors also often quote financial reasons helping the financial return on their portfolios or mitigating the risk. Third, investors increasingly want to have impact, actually changing the behavior of companies to become more sustainable. In this video, I will reflect on the financial and impact motives for sustainable investing. A lot of study suggests that sustainable investors will also be richer investors because sustainability goes hand in hand with higher stock returns. I'm skeptical about this viewpoint and its evidence. I will argue that of the financial reasons not improving return, but reducing risk is the most compelling argument for sustainable a investing. A prominent line of reasoning is that more sustainable companies are better managed and thus have greater profitability, and thus have higher stock returns. Indeed, perhaps sustainable companies tend to be better managed, but arguing that sustainable corporate behavior is associated with greater profitability across the board seems simplistic. For example, sustainable choices such as less pollution often simply cost money. Even if it were that simple, one would expect that the stock market after more than 20 years of research on this topic, would by now understand the relation between sustainability and profits, and it will be priced in. Let me emphasize that I am not a strong believer in the efficient markets hypothesis, but I do think that markets have a tendency to learn over longer periods of time. If that is indeed the case, I see only one clear reason why in the short run, sustainable investing can yield higher returns, and that is a demand effect. As more and more investors flock into sustainable companies, their stock prices will be driven up, but that is a short run effect. In the long run, if anything, stock returns of more sustainable companies should be lower as investors are bidding up the stock prices and thus essentially accept a lower stock return going forward. This brings me to the impact motive for sustainable investing. Sustainable investing can impact corporate behavior through two broad checks. First, through capital allocation. If poor ESG accompanies have a harder time attracting capital, their cost of capital will increase, and hence these companies will decline as they will have fewer viable investment opportunities. Indeed, several key empirical studies confirm this. However, the corporate cost of equity capital and the expected stock returns for investors are two sides of the same coin. In other words, if we want to impact companies through capital allocation, investors will need to accept lower returns on sustainable companies going forward. The second impact channel is engagement. Actually talking to corporate executives and voting at shareholder meetings. This is a more direct but also a more costly way to generate impact. Current research is simply too scant to properly assess the cost and benefits of engagement as an investment strategy. In my view, from a financial perspective, the most compelling motive for a sustainable investing is the potential to reduce risk. After all, climate change will pose huge risks for companies around the world. Extreme weather events and changing climatic conditions generate significant physical risk, and the transition to a more sustainable economy gives rise to transition risk as regulation and technological change will lead to stranded assets. These risks could materialize over very long horizons and are very hard to anticipate, so it seems unlikely that financial markets currently price them incorrectly. That would suggest that investors could reduce risk without sacrificing return by investing in companies that are less exposed to such risks. In short, I doubt that sustainable investing will consistently be associated with higher stock returns going forward, but it may be an effective way to reduce long-term risks. For capital allocation to impact companies, investors will actually have to accept a lower return. Hence, more research is needed to assess the appeal of engagement in terms of return, risk, and impact.
