Tilting is more constructive than divesting of ‘brown’ stocks, says Edmans

New research has concluded that investors would find tilting a much more constructive strategy as an alternative to blanket exclusion of irresponsible industries, which rarely leads to improved ESG performance, according to Alex Edmans, professor of finance at London Business School.

‘Socially Responsible Divestment’, a paper co-authored with Doron Levit of the University of Washington and Jan Schneemeier of Indiana University, disclosed that 1,500 institutions managing $40trn (€39trn) have publicly committed to divesting from fossil fuels and many clients evaluate asset managers according to their holdings of “brown” sectors.

“If a brown industry is excluded, there’s no incentive for a CEO of a brown company to become green – such as a fossil company investing in clean energy – since it will be excluded anyway. A tilting strategy, which tilts away from a sector but is willing to hold the best-in-class companies within that sector, provides these incentives,” Edmans said.

“However, clients and the media accuse asset managers who invest in some brown companies of greenwashing; they praise funds that refuse to touch brown industries as being true sustainable investors,” he said.

“Our research highlights the danger in such black-and-white assessments. To encourage companies to change, investors need to reward improved ESG performance, and blanket exclusion fails to do that,” Edmans added.

The trio has built a model capturing the optimal investment strategy of a responsible investor whose goal is to minimise the externalities emitted by a brown firm.

While exclusion – never investing in the brown firm – minimises the stock price and thus the amount of externality-enhancing investment that the firm can undertake, it provides no incentives for a brown firm to undertake a corrective action as it will be excluded regardless.

Tilting, the paper stated, provides incentives to take the action, at the cost of providing capital to a brown firm and allowing it to expand.

“The optimal strategy is for the investor to choose tilting if the action is effective at reducing externalities and comes at little cost to firm value,” the paper stated.

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