The ESG-Innovation Disconnect: Evidence from Green Patenting

Lauren Cohen is the L.E. Simmons Professor in the Finance & Entrepreneurial Management Units at Harvard Business School; Umit G. Gurun is the Ashbel Smith Professor at the University of Texas at Dallas; and Quoc H. Nguyen is Assistant Professor of Finance at the DePaul University Driehaus College of Business. This post is based on their recent paperRelated research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here);  For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here); and Toward Fair and Sustainable Capitalism by Leo E. Strine, Jr (discussed on the Forum here).

No firm or sector of the global economy is untouched by innovation. In equilibrium, innovators will flock to (and innovation will occur where) the returns to innovative capital are the highest. In our paper, we document a strong empirical pattern in green patent production. Specifically, we find that oil, gas, and energy producing firms—firms with lower Environmental, Social, and Governance (ESG) scores, and who are often explicitly excluded from ESG funds’ investment universe—are key innovators in the United States’ green patent landscape. These energy producers produce more, and significantly higher quality, green innovation. Our findings raise important questions as to whether the current exclusions of many ESG-focused policies—along with the increasing incidence of explicit divestiture campaigns—are optimal, or whether reward-based incentives would lead to more efficient innovative outcomes.

As of 2019, sustainable investing represents more than 20 percent of the $46 trillion in the U.S. assets under management. Compared to 2015, sustainable and impact investing has increased by more than 40%. A large contributor to this growth has been the 2015 guidance issued by the Department of Labor which allowed fiduciaries to incorporate environmental, social, and governance (ESG) factors into their investment decision. Given this push, flows to ESG increased substantially. Norges Bank, as an illustration, decides on the exclusion of companies from the fund’s investment universe, or to place companies on an observation list. In 2020, out of 167 excluded companies, 76 % of them were either involved in production of coal-based energy, caused severe environmental damage, or emitted unacceptable amounts of green-house gasses.

The most straightforward motivation for ESG investing comes from a preference function that loads positively on the goals of a given ESG fund. An investor with these preferences might be willing to sacrifice an amount of risk-adjusted return in order to allow the fund to achieve those returns with aligned ESG focus; or alternatively, pay more for a fund that promises the same ex-ante risk-return dynamics while delivering aligned ESG investment.

However, a number of other views could motivate ESG investing. For instance, a micro-founded, belief-based view of ESG investing could exist irrespective of the investor’s actual preferences for ESG. If consumers value products that are ESG compliant, they might be willing to pay a premium for these, or firms might collect a monopolistic rent on production if it were a salient product differentiation attribute. Moreover, if talented workers preferred companies following ESG principles, it could also be a mechanism to attract higher quality factors of production (such as human capital) or pay less for these factors. In these ways, good ESG behavior might be a source of comparative advantage that—if the market didn’t fully impound—could result in favorable future return dynamics.

The clearest counterargument to these positive arguments is that the constrained portfolio maximization run by ESG-constrained fund managers is dominated by the unconstrained maximization run by other managers, resulting in likely underperformance in the risk-return space. The academic evidence on the realized performance of ESG-focused funds is decidedly mixed. Moreover, there is limited systematic evidence that firms receiving disproportional amounts of capital from ESG funds have outperformed in any measurable way. Given this, our understanding of whether ESG investment flows impact innovation which can help us solve environmental problems is incomplete.

We investigate who produces green patents, the most influential of these green patent producers, and whether the capital of investors who desire to allocate capital toward ESG objectives actually do end up investing in these producers. As a starting point, as ESG capital investment flows have been rising in the past decades, there has been a concurrent sharp increase in green innovation and patent production as we show in our paper.

We show that the much of this recent green patenting is not driven by highly rated ESG firms, firms that are commonly favored by ESG funds, but instead by firms that are explicitly excluded from ESG funds investment universe. We use two large datasets that capture the complete universe of patents from 2008 through 2017 in order to identify the universe of green patenting activity. Moreover, for much of our analysis on firm characteristics of patenting entities, we concentrate on publicly traded firms, due to there being rich, publicly available measures of firm characteristics, external activities, income, profitability, and patent holdings.

In addition, we present evidence that the energy sector has a large and growing percentage of their entirety of patenting activity dedicated to green research. The green patents of energy producing firms are significantly higher quality, in terms of being more highly cited. Energy producing firms are also significantly more likely to produce “blockbuster” green patents than other firms.

In total, we find consistent and robust markers that the quantity and quality of green patenting is higher for energy firms. Paradoxically, these firms are precisely those to which capital is often restricted by mandates and campaigns whose directive is to solve the important problems linked to green innovation.

Our analysis thus suggests there is a, perhaps surprisingly, negative relationship between the generators of innovation that can help us confront environmental challenges and where capital is being directed. That said, there is still work to be done as to whether capital allocation indeed follows the ESG scores, and to what extent this ESG score-motivated investment can be calibrated to achieve better capital allocation by the investors.

Stepping back, we believe investigation of these issues will provide critical insight into the shifting landscape of innovation, allowing us to capture and assess the full welfare impact of ESG capital on the economy. Moreover, our findings raise important questions as to whether the current exclusions of many ESG-focused policies—along with the increasing incidence of explicit divestiture campaigns—are optimal, or whether reward-based incentives would lead to more efficient innovative outcomes.

The complete paper is available here.

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One Comment

  1. Kyle Wagner Compton
    Posted Friday, November 20, 2020 at 11:11 am | Permalink

    The inquiry into green innovation seems interesting and useful to the efficacy of ESG investing, but there is at least some ambiguity in using patenting activity as a metric – in that a patent is a right to exclude, and the use of patents to block others’ ability to commercially deploy technology is a common business strategy. Non-use of patented technology by the patentee, use of patents to preclude others’ use, and use of patents to extract licensing fees from others who practice the technology covered by the patent by a patent owner that does not itself use the technology are all well established practices. So from a business strategy perspective, could energy companies that benefit financially from maximal demand for fossil fuels validly invest in R&D for purposes of precluding others’ deployment of technologies that could decrease demand for fossil fuel, rather than with the expectation of deploying such technology? Thinking in terms of economic incentives and risk, is it easier to pursue value through an existing capital-intensive business, or to build a new untested business that, if successful, would to some extent cannibalize the existing business? These questions suggest that utilization of green technology, rather than patenting, is more relevant to efficacy of ESG investing.

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