Ethical investing is great. It gives us, as investors, a sense of agency. We can help shape the world we want by choosing where our investment dollars go. If a company is doing things we believe are harmful, we don’t invest in it. If a company is doing things we believe are good, we direct our money there instead.
Collectively, if enough investors make that choice, capital should begin moving away from harmful businesses and toward better ones. The harmful companies either change their behaviour or gradually lose access to the capital they need.
At least, that is the theory. I’m always a sucker for “unintended consequences,” things we don’t expect to happen when a new government policy or private practice is put into place.
I recently came across a Freakonomics podcast that made me wonder what the unintended consequences of ethical investing might be. In this podcast, they interview the co-author of an academic paper: Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms (Hartzmark & Shue, 2023).
The researchers’ question is not whether sustainable investing has good intentions. It is whether the way we currently practise it actually creates the environmental outcomes we intend.
I want to make it clear that I consider myself an environmentalist. I also want to emphasise that it is perfectly legitimate to say, I do not want to own an oil company. That is a values decision. Your investment portfolio belongs to you, and there is nothing wrong with wanting the companies you own to reflect your values.
This article is about finding a way to maximize positive environmental impact working with the current system.
Before getting into it, though, we need to sort out some terminology.
SRI, ESG and Sustainable Investing
Socially Responsible Investing (SRI) is the older term and traditionally focuses more explicitly on values. An investor might choose not to own tobacco companies, weapons manufacturers, gambling companies, fossil-fuel producers, or other businesses that conflict with their values.
ESG (Environmental, Social and Governance) investing is broader. Rather than simply including or excluding companies, ESG frameworks attempt to assess companies across a range of sustainability characteristics. Companies can effectively move up and down the scale.
There are also terms like ethical investing, responsible investing, impact investing and sustainable investing, all of which overlap without meaning exactly the same thing.
This blog will specifically focus on the E (environmental) portion of ESG investing because that’s what the paper does, and also because it’s just easier to look at one thing in isolation.
The Problem With Rewarding Companies That Are Already Green
Hartzmark and Shue divide companies into groups based on greenhouse-gas emissions per unit of revenue.
The highest-emitting 20% are what they call brown firms. The lowest-emitting 20% are green firms, with the remaining companies sitting somewhere in between. Interestingly, these middle firms look much more like the green companies than they do the brown ones.
And the difference between the extremes is enormous. After adjusting for company size, the average brown firm in their data emits about 261 times as much greenhouse gas per dollar of revenue as the average green firm.
That creates a problem for the way we often think about environmental improvement. Imagine a financial-services company that produces very little pollution to begin with. If it cuts its emissions by 80%, that sounds fantastic.
Now imagine a cement manufacturer reduces its emissions by only 2%. On a percentage basis, the financial-services company looks vastly better. But the cement company may have prevented far more actual pollution.
Yet ESG investment funds tend to reward companies for large percentage reductions in emissions, while showing little response to reductions measured in absolute levels. The researchers also find that sustainable investors reward green companies more strongly than brown companies for similar percentage improvements.
Which creates a strange incentive. We may be congratulating a company that was already clean for becoming slightly cleaner, while overlooking the company doing the difficult work of cleaning up an inherently dirty business.
But Isn’t Punishing Dirty Companies the Whole Point?
There is an obvious response to all of this. Surely the reason we avoid brown companies is precisely because we want them to change. If enough investors refuse to own their shares, their cost of capital should rise. Eventually management looks around and says: This is getting expensive. Maybe we should clean up so investors will come back.
That makes intuitive sense. But there is a complication. Becoming cleaner often requires exactly the thing we are making harder for these companies to obtain: capital.
A cement company cannot become cleaner through good intentions alone. It may need billions of dollars to build lower-emission infrastructure. These investments often involve large costs today in exchange for benefits years into the future. And when the cost of capital rises, future benefits become less attractive relative to immediate cash flow.
The researchers found that when financing becomes more expensive, brown firms tend to become more polluting per dollar of revenue. Meanwhile, already-green firms show little environmental improvement when financing becomes cheaper.
So, a common sustainable investing strategy may contain an uncomfortable contradiction. We want companies to spend enormous amounts of money becoming cleaner, while simultaneously trying to make that money harder and more expensive to obtain. And directing cheaper capital toward already-green companies does little to reduce their emissions further.
We Probably Can’t Simply Eliminate the Brown Economy
Another possible response is fine, let the brown companies disappear. For some industries or technologies, that may eventually be exactly what happens. But many of the highest-emitting industries also produce things society currently depends on: agriculture, transportation, steel, cement, fertilizer, mining and other basic materials.
If every high-emission producer phased out over the next decade or so, we would notice. The realistic environmental challenge is therefore not simply eliminating brown industries. In many cases, it is making them dramatically cleaner.
But wouldn’t forcing brown companies out of business at least reduce pollution?
The authors acknowledge that sufficiently severe financial pressure could cause brown companies to shrink or disappear, reducing their total emissions. Their modelling shows situations where sustainable investing reduces overall emissions, even as the remaining brown production becomes more emissions-intensive.
But they also find plausible situations where the increase in emissions intensity outweighs the reduction in production, resulting in higher overall emissions.
This is not to say that sustainable investing increases global emissions. It shows that the relationship is considerably less straightforward than “less money for dirty companies equals less pollution.”
Reward the Transition
Instead of simply asking: Which companies are green? We might ask: Which companies are becoming meaningfully greener?
Perhaps brown companies will willingly make those investments because they know becoming greener will eventually give them access to ESG capital. The problem is that the current system does not appear to reward that transition particularly well.
Sustainable funds tend to underweight entire high-emission industries. Even more strikingly, Hartzmark and Shue find that they tend to underweight even the cleanest 20% of companies within those high-emission industries.
Suppose two cement companies produce the same basic product. One is investing heavily in cleaner technology and has reduced its emissions dramatically relative to its competitors. The other has done very little. If both are still classified as “brown” compared with a bank, healthcare company or software business, sustainable investors may ignore both.
Yet from an environmental perspective, the first cement company may be exactly the company we want capital flowing toward.
If the goal is actual transition, we need a financial incentive for the cleaner cement company to outperform the dirtier cement company.
Traditional energy companies are major contributors to green innovation. In The ESG-Innovation Disconnect: Evidence from Green Patenting (Cohen, Gurun & Nguyen, 2026), researchers found that just five major oil and gas companies, ExxonMobil, Shell, BP, ConocoPhillips and Chevron, produced 9,343 green technology patents between 1980 and 2020. Traditional energy companies were also early innovators in carbon capture and storage technology, accounting for 13 of the 20 earliest patents identified in the study. Energy companies’ green patents were also more frequently cited by subsequent inventors.
Yet these are precisely the companies that sustainable investment funds often exclude.
Do We Want Green Portfolios or a Greener Economy?
I think this gets to the central question: Do we want green portfolios, or do we want dirty companies to become greener?
As I mentioned in the intro, your investment portfolio belongs to you, and there is nothing wrong with wanting the companies you own to reflect your values. Beyond environmental impact, this can include things like firearms and tobacco, which are not considered in this article.
But that is a different objective from saying: My decision not to own this company will reduce global emissions. The causal chain there is much less certain.
I don’t think sustainable investing is misguided, but I do think that we should be more precise about what we expect it to accomplish. If the goal is real environmental change, then simply rewarding companies that are already green may not be enough.
The greatest opportunity may lie in rewarding the best of the worst: the companies in our dirtiest industries doing the hard work of becoming cleaner. As for the worst of the worst? Maybe they can go out of business.
