All the risks of financial sustainability

The Dalai Lama calls it “selfish altruism,” economic studies usually refer to it as “impure altruism” or “warm glow”: these are some of the descriptors for the attitude of people who opt to donate, consume, or invest sustainably.  They are motivated by the desire to do good, but more importantly the personal gratification they get from their good deeds.

Understanding why people do what they do is useful for many reasons. Today this is particularly true for regulators and big institutional investors, among others, who are taking action to funnel savings and investments into sustainable projects. In fact, sustainable finance is one of the mantras recent years, but the path to implementation is a torturous one, with regard to both supplying ESG-branded investment tools, and the demand among savers for greater sustainability. But while people are saying they want to go green, or to invest responsibly in general, they don’t “walk the talk.”  Empirical studies on responsible consumption have documented this tendency for some time, as has more recent research on ESG investments.  To cite one example, a 2021 Consob survey on the behaviors of Italian investors shows that 70% of families in this country are interested in investing sustainably, but only 10% actually hold such investments.

Behavioral economics addresses this phenomenon, which is known as the intention-action gap, and suggests ways for the financial industry and regulators to overcome the more common underlying cognitive factors. One concrete example is eco-labels, which we’ll soon find on financial products, just like we already see on our household appliances. So the road to transparency and cognitive simplification will lead to greater investor engagement in advancing sustainability, and these measures are currently the focus of extensive effort in the industry and in financial regulations.

As far as this last point is concerned, in Europe the Sustainable Finance Disclosure Regulation (SFDR) took effect in 2021 requiring institutional investors to disclose how they choose their investments, and color-coding products based on sustainability levels (gray, light green, and dark green).  Other governments around the world are also moving in the same direction, concentrating mainly on the path to transparency. This seems to reaffirm the conviction in the financial industry that appropriate, modulated information transparency is the solution for dealing with the behavior bias of investors. But while transparency is important, but it’s never a silver bullet. In fact, this kind of context is where the risk of overestimating transparency is even more acute, because the warm glow effect jeopardizes the effectiveness of strategies that center on clear and comprehensible information alone. To give an example, it would be logical to assume that if my priority is positive climate action, and I know that Investment A helps cut CO₂   by 10m³ and Option B by 100m³, I’ll choose B. But several experimental studies show that this is not what happens when investors choose sustainability based on an inclination toward impure altruism.  In other words, if I choose to invest in a green product primarily for my personal wellbeing, I won’t spend much time contemplating the various shades of green.

This kind of behavior complicates the situation and potentially makes the problem of greenwashing an even more dramatic one. In this context, reforming MIFID 2 takes on greater urgency. This directive, slated to take effect in August 2022, compels financial intermediaries to collect information from their customers on their sustainability preferences, so as to propose products that meet their needs when offering investment services.  Although this initiative envisages widespread attention among investors to sustainability issues, there are concrete risks: failure to funnel capital into more sustainable projects, for instance, or the emergence of new threats to investor protection arising from the commercialization of “green” products that come with a higher price tag and lower yield-risk performance.

The most satisfactory solutions for contending with these risks involve acting on both the demand for and supply of sustainable investments. For the former, “nudging” in various forms could be effective, which would influence behavior by leveraging social norms that convey the message that what counts is not simply opting for sustainable generally, but specifically how sustainable. As for the latter, regulating and classifying sustainable investments can have an impact if such measures aren’t limited solely to transparency, but go further, to comprehend the behavior of intermediaries, institutional investors and - last but not least - issuing companies, making everyone more accountable for their actions and choices. In other words, conditions must prevail that prevent institutions, and not just investors, from running the risk of warm glow.

So impact can be generated by financial intermediaries that decide a priori to concentrate on marketing dark green financial products, and from enterprises that embed more and more challenging sustainability goals into their materiality matrix. Sadly, today there are still far too many companies that successfully issue green bonds to finance specific, elaborate environmental projects, but without radically overhauling their corporate purpose with an eye to sustainability, and without being penalized in any way for their unvirtuous choices financed through other funding sources. Yet truth be told, more and more institutions are trying to move in the right direction. A few worth mentioning include BlackRock, the biggest international asset manager in the world, and Norway’s sovereign fund, another top global investor. Both were forerunners in adopting rigorous ESG criteria in their investment strategies, which led them to sharply reduce their participation in less-than-virtuous on the sustainability front.

So all good? Well, not all. Penalizing by exclusion is the most common approach and the easiest to implement, but stakeholder capitalism in a broader sense means going even further, taking additional steps, such as directly pressuring boards of directors. By doing so, investors can demonstrate that their goals are going beyond maximizing profits, and extend to encompass the wellbeing of society as a whole.