Do Investors Care About Impact?

Julian F. Kölbel is Assistant Professor of Sustainable Finance at the University of St. Gallen. This post is based on a recent paper, forthcoming in the Review of Financial Studies, by Professor Kölbel; Florian Heeb, Postdoctoral Associate at the MIT Sloan School of Management; Falko Paetzold, Assistant Professor for Social Finance at EBS University; and Stefan Zeisberger, Associate Professor of Fintech – Experimental Finance at the University of Zurich. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto TallaritaHow Much Do Investors Care about Social Responsibility? (discussed on the Forum here) by Scott Hirst, Kobi Kastiel, and Tamar Kricheli-Katz; and Does Enlightened Shareholder Value add Value (discussed on the Forum here) by Lucian Bebchuk, Kobi Kastiel, Roberto Tallarita. 

Do investors care about impact? Yes, in the same way, they care about pandas.

Sustainable investing is discussed as a potentially powerful mechanism to address negative externalities by appealing to investors’ prosocial preferences. The sustained growth in sustainable investing funds suggests that prosocial preferences are prevalent among individual investors. By expressing these preferences in their investment decisions, investors might shape the economy and society.

However, a crucial question remains: Do individual investors genuinely care about the impact of their investments, or are they driven by the warm glow associated with choosing a “green” option? The answer to that question is decisive for whether and how the sustainable investing industry has an impact. We provide this answer in our paper «Do Investors Care About Impact?”, recently published in the Review of Financial Studies.

A priori, one might expect two alternative behaviors. The standard view is that investors derive utility from the positive impact of investments and thus pay more for an investment with more impact. This view is embedded in many theoretical models of sustainable investing. However, research on charitable giving suggests that individuals can be surprisingly indifferent to the magnitude of their impact. For example, prior research in psychology has shown that people donate about the same amount to save one or four panda bears. People care a lot about pandas, no doubt. But it is more the emotions about pandas, not the number of pandas, that drive decisions. Our paper finds that investors care about impact as people care about pandas.

The core element of our paper is a framed field experiment with 219 experienced investors, next to robustness checks with many more. We measure their willingness to pay (WTP) for investments with varying amounts of impact. If you participated in the experiment, we might assign you to the low-impact group. There, we give you a choice between two funds, one fund where your investment will save 0.5 tons of CO2 and another financially equivalent fund with zero impact. We charge a one-off investment fee, which is identical for both options. We also explain that saving 0.5 tons of CO2 is equivalent to planting three trees or avoiding 1500km of air travel. You choose which fund you prefer. Next, we keep raising the fee for your preferred fund until you decline so that we know how strongly you want it.

We find that 93% of investors prefer the impact fund when fees are equal. If this makes you wonder who these investors were, they were Dutch retail investors with extensive investment experience. And those investors are willing to pay a substantial amount in fees to be able to invest in the impact fund. Thus, investors care about impact in the sense that they are willing to pay a meaningful amount to get from zero impact to some impact.

Let’s say we assign your friend to the high-impact treatment. There, we offer a fund that saves 5 tons of CO2 next to the fund with zero impact. In other words, we offer your friend an option with 10x more impact. Again, we measure her willingness to pay fees for this fund. We are interested in whether your friend is willing to pay higher fees than you. Statistically, the answer is no. The willingness to pay for the high-impact and low-impact groups is almost identical. Thus, we find that investors pay for impact but do not pay more for more impact.

We corroborate this finding in several ways. First, we check whether investors are sensitive to information about investment returns rather than impact. We find that their willingness to pay is exactly proportional to differences in past performance of funds. Second, we repeat the experiment with a group of dedicated impact investors. Even these impact investors do not differentiate between high-impact and low-impact funds. Third, we repeat the experiment with 2800 online participants and vary the nitty gritty details of the experimental procedure. The result is always the same. Fourth, we allow investors to compare the two funds. Here, they pay a little bit more for the high-impact fund, but by and large, they still ignore the underlying information. And finally, we document that the willingness to pay for the impact fund correlates with the positive emotion that individuals experience. In other words, the better it feels, the more people pay.

Based on these results, we conclude that people care about the impact of investments in the same way they care about pandas: driven by emotion rather than calculation. Thus we suggest viewing the average prosocial investor as a “warm glow” optimizer who optimizes the good feeling of making “the right” choice rather than a consequentialist who optimizes the impact of her investments. Ultimately, this suggests that positive emotions derived from choosing sustainable options are an essential driver of the trend for sustainable investment products we observe.

Is this a problem? Yes, but not an unsolvable one. There is a risk that widespread prosocial preferences result in negligible outcomes, which we call the “light green equilibrium.” Suppose investors’ WTP for sustainable investments scales with emotional warm glow rather than with impact. In that case, financial institutions are incentivized to create products that offer warm glow rather than impact. Furthermore, financial institutions may offer their products in such a way that a sustainable product with little impact stands out as the most impactful option available. The most damaging aspect is that providers have no incentive to offer high-impact products. In the light-green equilibrium, investors get their warm glow, financial institutions get their profits, and societal issues remain unchanged.

A promising solution to this problem is labels. Labels can square the circle, connecting investors’ emotions with a robust and quantitative assessment of the product’s impact. Of course, designing a good label is not trivial and opens another set of questions. But given how investors behave, labels are probably necessary to avoid a light-green equilibrium. Labels give a simple cue to the investor, and they set incentives for providers to offer meaningful products.

Labels already exist in the market which have a strong influence. It has been shown, for example, that the Morningstar Globe Ratings drives flows towards mutual funds. Globe ratings are pretty effective because they offer investors a ranking that is easy to understand. In Europe, there are several ratings, such as the FNG Label, which offers one to three stars. The European Union has – somewhat inadvertently – created a quasi-labeling scheme by introducing the distinction between Article 6, 8, and 9 funds. Prosocial investors seem to have a strong preference for Article 9 funds. This preference is consistent with our findings, where investors consistently opt for the best option in the choice set. However, important questions remain: Do funds receiving five globes, or three stars, deliver an impact that lives up to the level of positive emotions that investors associate with these products? Does the impact of Article 9 funds live up to the ambitions for transformation the EU has set out to trigger?

One essential point to remember is that there are different motivations for choosing sustainable investment products. In our paper, we have focused on the motivation to have impact. But there is also the motivation to own securities aligned with personal values. And there is the motivation to enhance financial performance by considering ESG information. Impact, value-alignment, and enhancing performance are not different degrees of the same sustainability preference. They are entirely distinct motivations and combining them into one product risks underdelivering on all three. Thus ideally, there would be separate labels for each dimension or one label that rates funds within these three categories separately.

Regulators should note that any classification of sustainable investment products will strongly influence the market. Investors’ demand for these products will respond to the classification, and providers will seek to comply with the classification. A good scheme will solve an important problem. Getting it wrong might make things worse.

To sum up, investors care about impact, but they evaluate impact by feeling, not by calculation. This behavior can be exploited, with the result that prosocial ambitions go to waste. The solution is well-designed labels. To help you remember, we propose the panda bear law: If only products that actually help pandas are allowed to display pandas, we’ll have more pandas.

The complete paper is available for download here.

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