The Dubious Financial Impact of Impact Investing

Impact investing seeks to achieve social good, but new research show that it has had a negligible effect on the cost of capital for so-called “brown” companies.

Impact investments are made to generate positive, measurable social and environmental impact alongside a financial return. The growing impact investment market provides capital to address the world’s most pressing challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare and education. Divestment (not investing in or selling stocks in companies that impose social and environmental costs) is one tool investors can employ to achieve this goal.

Jonathan Berk and Jules van Binsbergen contribute to the impact investing literature with their September 2021 paper, “The Impact of Impact Investing.” They began by noting: “When a socially conscious shareholder sells her stake to another shareholder, the new shareholder needs to be induced into buying shares in the company. This inducement comes in the form of a lower price. The lower price implies a higher cost of capital which affects the company’s future real investment strategy by lowering the number of positive net present value (NPV) investment opportunities, thus lowering the company’s growth rate. The opposite is true when a socially conscious shareholder chooses to buy. The extra demand for clean companies increases the price of those companies, lowering the cost of capital and thus increasing their growth rates. In the long term, socially desirable companies become a larger fraction of the economy at the expense of socially undesirable companies and the social and environmental costs on society are reduced. Therefore, for divestiture to have impact, it is essential that the divestment strategy results in a large enough change in the cost of capital to materially affect the firm’s investment opportunity set.”

With the theory in mind, the authors set out to evaluate the impact of divestiture initiatives by determining whether they have materially affected the cost of capital and, if not, whether they are likely to do so in the future. Using the largest socially conscious index fund, they estimated that the fund targeted companies that made up about 50% of the economy (and those stocks had a correlation of 0.97 to the market). They also estimated (using the fraction of mutual fund wealth invested in ESG mutual funds) that socially conscious wealth makes up about 2% of the total market capitalization. They then assumed a 6% equity risk premium. Based on these assumptions, they estimated that the effect of impact investors on a company’s cost of capital was only about 0.35 basis points. They added: “Given the uncertainty in the capital budgeting process, one third of a basis point cannot meaningfully impact firms’ investment strategies.”