Samuel Hartzmark, Boston College, Carroll School of Management, and Kelly Shue, Yale School of Management; National Bureau of Economic Research



Many of the most popular sustainable investment strategies involve building a portfolio of low-emission ‘green’ firms while underweighting or excluding high-emission so-called ‘brown’ firms. A key goal of many sustainable investors and asset managers is to lower the cost of financing for green firms and raise it for brown firms. With enough time and money, the thinking goes, this strategy will incentivise all firms, green and brown, to improve their environmental impact.

Our research shows that the dominant sustainable investing strategy may actually be counterproductive.

Rather than incentivising heavy polluters to cut back, such an approach may cause them to pollute more. When brown firms are punished with a higher cost of capital and pushed toward bankruptcy, they become short-termist, and are incentivized to pollute more to generate immediate cash. On the other hand, rewarding firms that are already green does little to improve their environmental impact. Most of the green firms favored by sustainable investors tend to be in the insurance, health care, and financial service industries. These firms start with close-to-zero emissions by the nature of their business. They have little room to further reduce emissions and are unlikely candidates to develop new green technologies.

How did we study ‘green’ and ‘brown’ firms?

We reached this conclusion by studying emissions data from over 3,000 large companies from 2002 to 2020. We divided firms into five segments based on greenhouse gas emissions (adjusting for revenue, because larger companies generally emit more than smaller ones). Then, using historical data, we analysed how the highest and lowest-emitting groups responded to changes in their cost of capital – and did they respond in the way that the sustainable investing movement seeks to bring about?

We found that when green firms experienced a change in their cost of capital, their emissions didn’t change substantially. Brown firms, by contrast, significantly increased emissions in response to an increase in their cost of capital. Rather than incentivising improvements, starving brown firms of cheap money led them to double down on existing methods of production, because continuing with high-pollution production is how brown firms earn cash quickly to avoid bankruptcy. This occurs because transitioning to cleaner production usually requires substantial up-front investment. Investments in these new green technologies could pay off in the long run, but they tend to be unattractive to any firm that is worried about generating cash in the short term.

Increasing costs of capital for brown firms is counterproductive

Even a modest percentage increase in emissions from a heavily polluting brown firm has a significant environmental impact. We show that the average brown firm has 261 times the emissions of the average green firm. So for green firms, even a large percentage reduction in emissions has negligible environmental impact. Meanwhile, if a brown firm changes in emissions in either direction by just 1%, that is significantly more meaningful than a typical green firm changing its emissions by 100%.

In this way, we show that sustainable investors focus too much on percentage reduction in emissions and too little on absolute emissions. Brown firms that make small, hard-won percentage reductions are generally still considered toxic assets that are excluded from sustainable investment fund portfolios. That offers the wrong incentives, in that it motivates firms that are already green to engage in trivial or greenwashing attempts to make themselves look even more green.

We also find that even the lowest-emitting firms within brown industries are shunned by sustainable investors. Sustainable investors, on average, overweight services industries, and underweight even the relatively green firms within manufacturing, energy, agriculture, and transportation industries. This further weakens incentives for firms in highly polluting industries to improve their environmental impact.

Let’s include those who make an effort

Our conclusions are not meant as a negative assessment of all possible sustainable investment strategies. Rather, they highlight potential problems with some of the most popular sustainable investment strategies to date. These strategies go by a variety of names, such as divestment, exclusion, negative screening, and certain forms of ESG integration. Collectively, they lead to an underweighting of brown firms and overweighting of green firms without fine industry adjustments. They also offer weak incentives for brown firms to improve.

Our analysis suggests that transition-oriented strategies and engagement are more likely to be effective because they target financial incentives at the brown firms with the greatest environmental impact.