Introduction

What exactly are sustainable investments? How effective are they in driving positive change? How is the world of sustainable finance evolving?

To find out the answers to these questions (and more), illuminem sat down with Florian Heeb, postdoctoral associate at MIT Sloan and illuminem Thought Leader. Join us as we delve into the depths of sustainable finance and gain invaluable insights into its ongoing transformation.

illuminem: Florian, can you please introduce yourself and tell us a bit about your work?

Heeb: Sure, I'm Florian Heeb, currently a postdoctoral associate at MIT Sloan, specifically at the Sustainability Initiative and the Aggregate Confusion Project. My background is in environmental science, and I have studied topics such as climate, water pollution, and more. After completing my studies at ETH Zurich, I worked in climate consulting. Later, I joined South Pole Group, which is the leading provider of voluntary carbon offsets, and worked in the management of the company. My role there involved building a team that helps companies achieve their Net Zero targets and many other exciting things.

However, I realized that, while management is interesting, what really fascinates me are the topics of climate change and sustainability. I saw many of my friends working on pressing questions related to sustainability and developing deep topic-specific knowledge, while I mainly focused on running a growing business unit. I wanted to take a step back and dive back into these urgent questions, so I decided to pursue a PhD at the University of Zurich on sustainable investing. Specifically, I focused on the impact of sustainable investing and how the enormous demand for green financial products can translate into real-world change.

illuminem: What's your biggest hope and fear about climate change?

Heeb: We will increasingly encounter the consequences of climate change in our daily lives. Existing climate change models may even underestimate the severity of what is to come. The complexity of numerous difficult-to-model factors, including tipping points, makes our future uncertain, and unexpected challenges will arise. Accordingly, there is a pressing need for action. In fact, we should have taken action much earlier than we have, as time is of the essence.

Nevertheless, I am encouraged by recent developments. While the scientific community has known about climate change since the 1970s and 1980s, progress toward addressing the issue has been slow. However, in the past year, we have witnessed a significant uptick in policy initiatives and private sector action around the world. While there is still an enormous amount of work to be done, the fact that many governments and companies are now embracing net-zero targets is a positive sign. However, achieving these targets will not be easy. We need to switch to an extremely steep decline in emissions in the years ahead, while, in the past years, emissions have been still on the rise.

illuminem: How does sustainable investing differ from traditional investing?

Heeb: Sustainable investing is a broad field that encompasses many things. At its core, investors want to see some kind of return on their investment. Traditionally, investing has been about making money, but increasingly, investors have other priorities beyond just financial returns. I would categorize these other priorities into three different motivations.

First, there are values. Many investors want their investments to reflect their personal values. This has traditionally been the case with religious investors in the US who have screened their portfolios for things that are not compatible with their beliefs, such as gambling, alcohol, tobacco, and weapons. This is also why we call them "sin stocks". However, this perspective has broadened. For example, many people just don't want to be associated with fossil fuel companies, whether or not excluding those from their portfolios them has a positive climate impact. All investors have values, and many want investments that do not just deliver returns but also match their values.

The second motivation is performance. There is a more recent narrative that by considering so-called ESG factors (environmental, social, and governance), you may have better risk-adjusted returns on your portfolio. This is an important motivation for investors to consider sustainability factors not just from a moral perspective, but also from a purely financial perspective, which is an important part of sustainable investing.

Lastly, there is impact which is my core research topic. More and more investors want to go beyond just saying that they won't invest in companies they don't like. They actually want to make a contribution to solving specific challenges we face, such as climate change, poverty, biodiversity, equality, diversity, and many others, with their investments. This is different from values because it's not just about excluding certain companies or industries, it's about actively wanting to change something, e.g., fighting climate change through investment.

illuminem: Referring to your article on investor impact, can sustainable investment save the world?

Heeb: When I began researching sustainable investing, I was struck by two things. Firstly, the industry was rapidly growing, even seven years ago. Given my background in environmental assessment and LCA (Life Cycle Assessment), I assumed that, given the growth of the industry, the impact of sustainable investment products would be well understood. But to my surprise, I discovered that this was not the case. Very few investors had any idea of their real-world impact. With colleagues at the University of Zurich and Hamburg, I embarked on a research project to assess what we knew about the actual impact of sustainable investing. We wanted to understand the extent of the change these investments potentially caused, based on existing scientific evidence. Our project mapped out the entire landscape of sustainable investing, leading to the question, "Can sustainable investing save the world?" 

Our research yielded two important points. Firstly, evidence of the impact of sustainable investing is still limited in many aspects. We lack clear measures to determine the impact of investment projects, and we don't have any systemic academic results that prove the efficacy of these products. While we do have some evidence that shareholder engagement can work in specific circumstances, its overall impact is uncertain. Additionally, capital allocation to small and young companies in markets with high friction can have a meaningful impact, but its impact on larger companies remains unclear. ESG integration, where investors screen against certain practices, can theoretically trigger change if enough investors turn against those practices. However, there is limited empirical evidence supporting this mechanism. 

Overall, we conclude that sustainable investing can have a meaningful impact if it's done in the right way, but quantifying this impact is difficult. Research on these topics is growing, but the impact of sustainable investing, as it's practiced, is likely limited. Most sustainable investment products do not have a clear theory of change or even evidence to back any impact claims.

illuminem: We are observing a boom in sustainable investments. Do you see this trend evolving in the future and what are your predictions for sustainable finance? Do you think it will continue to grow, or will we see a decline in interest?

Heeb: This is actually the second question that puzzled me. Upon realizing that there is limited knowledge about the impact of sustainable investments, we were left wondering why investors continue to invest in them despite this. In our article, "Do investors care about impact?", we discovered that investors are willing to pay a substantial premium for products that offer some level of impact. But they do not pay more for more impact.  We conclude that the level of impact a product offers is not really important as long as investors have the perception of doing “something good”. Even when presented with a green investment that has ten times more impact compared to another green investment, investors were willing to pay similar amounts for both, as long as it feels good to pick a green investment.

Our experiments with both retail and dedicated impact investors led us to conclude that the demand for sustainable investments is largely emotional. While investing is generally thought of as a rational activity, sustainable investment appeals to investors' emotions in a different way. This emotional appeal is not necessarily a bad thing, but it means that investors may not always connect their demand for sustainable investments with the real-world impact of products. Instead, we may see a "light green equilibrium," where investors want products that look and feel green, and asset managers are happy to provide such products at the lowest possible cost, without any meaningful impact. This raises the issue of greenwashing, where products are marketed as sustainable without actually having a significant impact. 

In sum, with the huge demand for sustainable investments, there is a huge potential to use this demand to solve urgent problems. However, this will not happen automatically - investors need guidance to connect their emotional, rather unspecific demand for doing good with real-world impact. This is a significant challenge for the coming years.

illuminem: You said that we cannot count on bottom-up initiatives from investors. If we combine grassroots motivation and top-down regulation — assuming it's possible — do you think we can make it work? 

Heeb: Some people think our results show that impact investing is just a feel-good and fuzzy concept. However, I think its potential to cause change is very real and that impact is, ultimately, what many investors want to see. To enable investors to make good decisions, I believe we need to clearly show the impact potential of sustainable products side-by-side with other options. For that we need to find ways standardized ways how to assess the impact of investments, be it qualitatively or quantitatively.

As we discussed earlier, we don't have all the data yet to reliably quantify the impact of individual products. But we do know that some things can work and some don't. I think regulators can play an important role here by pushing asset managers and banks to provide investors with the information they need to make decisions that align with their underlying desire to help solve problems.

Recently, the Federal Council of Switzerland proposed guidelines to avoid "greenwashing." The guidelines recommend that advisors ask clients whether they want to invest in products that have a real impact or just those that align with their values or use ESG factors to optimize profits. I believe that if investors are asked this clear question, many will choose to invest in products that have a real impact. This will consequently create a demand for products that can credibly demonstrate such an impact. 

I don't think we have all the answers yet about how to define and measure impact, but if there is a clear demand for real-world impact I believe in the innovation power of free markets to come up with solutions that really match this demand. If banks and asset managers are required to ask clients if they want to have an impact, they will need to deliver on this demand. I believe this will lead to healthy competition among investment managers to demonstrate the impact of their products.

Ultimately, I think we need more evidence to answer many of the questions around the impact of sustainable investing. However, I believe that by asking investors what they actually want and providing regulation that requires investment products to align with those preferences, we can channel more money to places where it's most likely to trigger positive change.

illuminem: You say you’re a lifelong learner. What is a recent development or finding in the field of sustainable investing that you find particularly exciting or impactful?

Heeb: That's a good question. Right now, what interests me a lot is the connection between the recent regulatory initiatives hitting the market on the EU level and in different countries. I am a bit skeptical about the European approach of the SFDR, especially when it comes to the big discussion around differentiating between Article Six, Eight, and Nine products. In practice, these articles have often been described as “gray”, “light green”, or “dark green” options. 

If you ask environmentally motivated investors, I think it's obvious what they will want on this scale. However, if you really go to the complex details of the regulation I’m not sure if an Article 9 (“dark green”) product actually delivers what most investors expect. The SFDR text in Article 9 definitively does not talk about the real-world impact of investing products. So, there might be some regulatory failure in this regard. 

I find it intriguing to see how this could be changed. One way to do this could be by introducing a new “Article 10” that focuses on products that can credibly demonstrate a real-world impact. This could trigger a lot of innovation. Currently, there aren't many products that strike a balance between risk, return, and impact for retail investors. However, this could, for example, be achieved by designing products that invest mainly in liquid equities, but also take a small portion of their funds to invest in more risky but potentially more impactful assets like venture capital, private equity, or in emerging markets. Also, I think there is a lot of innovation potential in shareholder engagement. There are also some fascinating technological approaches that enable retail investors to directly vote for their shares and express their preferences on how companies should behave

illuminem: What are some common misconceptions about sustainable investing, and how would you dispel them (e.g. sustainable investing sacrifices financial returns, sustainable investing is only relevant to large investors with significant resources)?

Heeb: I think there are two questions to consider here. Firstly, does traditional sustainable ESG investing cost money, or can it be profitable to invest green? Secondly, what about specific impact investing with a dedication to impact?

Regarding the first question, the profitability of ESG investing has been extensively studied, with a majority of studies showing that sustainable investment products have outperformed slightly in the past, although there have been some negative findings as well. However, I think it's important to ask why this may be the case. From both a theoretical and common sense perspective, in order to create outperformance in the financial market, one needs to trade on information that the market has not priced in or does not expect, otherwise one cannot create outperformance. 

There are two different explanations for the past outperformace of sustainable investment products. First, an unexpected demand for green financial products and, second, an unexpected relevance of ESG risks and opportunities on the company level. While it is possible that ESG risks have been neglected in the past, I think that the huge and largely unanticipated demand by investors for green investments, driving up share prices of green firms, is the main driver behind the outperformance of sustainable investment products over the last 10 to 20 years.

If this is the case, the observed outperformace may not continue in the future. There will be a point where inflows into green products will flatten as the market reaches some level of saturation. Then it may become costly to hold green stocks that are overvalued from a purely financial perspective. If we follow asset pricing theory will see underperformance from this point onward. Therefore, as a sustainable investor, it is important to be aware that what we have seen in the past may not apply as a good indicator for the future.

Regarding the second question on impact investing, I believe that achieving impact may be associated with some costs, particularly if one wants to create real impact rather than just investing in stocks of large “green” firms. For example, investing in venture capital or emerging markets finance can be risky and may require leaving some money on the table. Often there is a reason why impactful young companies struggle to raise capital, and often it is because they try to resolve unpriced externalities and these are not as profitable as fully commercially motivated ventures. Additionally, shareholder engagement campaigns are expensive. However, our research indicates that investors are willing to pay for products with real impact, so if products really deliver on the impact front these costs may be acceptable. Nonetheless, as long as many funds claim to deliver impact at no cost, without any credible evidence, funds that deliver real impact at a cost may struggle to attract funding.

illuminem: Can you recommend any resources or organizations that can help individuals learn more about sustainable investing and get involved in this space?

Heeb: A useful resource that we have created is "The Investor's Guide to Impact." It contains our knowledge on the mechanisms of investors' impact presented in an accessible and easy-to-understand format. Also, what I find particularly valuable is the Impact Management Project, which has now moved to Impact Frontiers. If you are an institutional or professional investor looking to integrate impact considerations seriously into your investment decision-making process, I believe Impact Frontiers is the go-to source. They gather all the available evidence and knowledge and translate it into practical investment processes, templates, evaluation sheets, and operational procedures. They make the work of more academic and scientific researchers applicable to investment decision-making, and I find that amazing.

illuminem: What is your mission when you write for illuminem.com? What do you think is the value added?

Heeb: As a researcher, my primary responsibility is to do independent and rigorous academic research, and I feel fortunate to be able to work on a topic that is both exciting intellectually and very relevant outside of the ivory tower. However, I also recognize that simply publishing papers may not necessarily have a meaningful impact on practitioners and financial markets. Given the timeliness of the topic and the significant shift happening in the industry around ESG, I am motivated to make our insights, as well as those of other researchers, accessible to those working with investments and thinking about these issues.

I believe that platforms like this provide an excellent opportunity to disseminate insights and hopefully inspire individuals who work on these topics day in and day out. Ultimately, my goal is to bridge the gap between academic research and practical implementation, so that we can work together to create a positive impact in the world of investing.