Impact investing is an increasingly popular approach to doing good. In this talk from EA Global: London 2019, John Halstead, head of applied research at Founders Pledge, discusses whether, and in what conditions, impact investing might be thought to succeed. John argues that impact investing is likely to have limited impact in large, highly efficient markets such as public stock markets. However, impact investing stands a better chance of impact if it involves VC or angel investing, includes companies that serve poor consumers or produce positive externalities, and/or exploits an investor’s informational advantage.
We’ve lightly edited John’s talk for clarity. You can also watch it on YouTube or read it on effectivealtruism.org.
I'm going to talk about impact investing, which is investing in for-profit companies with the intention of having social impact. The question is whether it succeeds in meeting that goal.
There are two ways to do impact investing. One is removing your capital from harmful companies. Another is investing capital into socially beneficial companies. [Impact investing is] getting more attention from philanthropists, and in the for-profit world there's much talk of socially responsible investing. So I think it's worthwhile for the effective altruism (EA) movement to consider how impact investing might do good.
It’s quite informative to look at the history of socially responsible investing. [One of the earliest and] most visible socially responsible investing campaigns was the boycott, divestment and sanctions movement against apartheid South Africa. It's often held up as a successful case of socially responsible investing. But if you look at the evidence, the divestment campaign didn't have much of an effect. Although it was associated with various restrictive regulations and political pressure being brought against South Africa, the total funds divested were quite small relative to the size of the country’s funds [overall].
In the 1990s there was a lot of attention directed toward tobacco divestment. The goal was to get investors to take their money out of tobacco companies. But again, the total amount of funds that were removed from tobacco was quite small relative to the industry’s market capitalization, so it didn't seem to have that much of an effect.
The most recent and prominent example is the fossil fuel divestment campaign. There are organizations like 350.org advocating for wealth and petrol funds to take their money out of fossil fuels. This has gained a lot more momentum, and you can argue it's having a more direct effect on the industry.
You can see the growth in investing that's calling itself “socially responsible.” A lot of it's not very strict; I think some of the labeling is a bit misleading. But nevertheless, there has been quite a bit of growth.
This is the proportion of the total stock market that I think is [strictly socially responsible]. The [SRI] assets under management in the world are valued at about $100 trillion, and maybe around 20% of that is what I would call socially responsible. I'll discuss why that is in more detail in a bit.
When we're looking at how impact investing has impact, we need to get clear on the conceptual background. There are two aspects to this. First, when you're an impact investor you're thinking, “How can I actually have an effect on socially beneficial practices in the world?” You have to think about “additionality” — the difference your investment makes in the performance of the company that you’re either divesting from or investing into. Another way your investments can have impact is through non-monetary effects. You might be able to provide non-monetary support to a company that helps it succeed, or there might be things associated with your investment that allow you to affect the wider world. As I mentioned earlier, in the case of apartheid South Africa, maybe the divestment campaign allowed people to successfully campaign against the apartheid government.
The second thing you must do as an impact investor is find an impactful company. That is harder than a lot of impact investors think it is.
Those are the two ways you can have impact as an impact investor. And for both, the counterfactual is key.
You can see [the actor] Gwyneth Paltrow [in the picture above from the movie Sliding Doors]. She just misses entry to a Tube carriage [in the London subway system]. What would have happened if her character had made it into that carriage and met [the actor] John Hannah, who is in the carriage? Similarly, that's the crucial thing when you're assessing the difference your investment can make: What would have happened otherwise, and what difference does the company [you’re investing in] make in [that alternate outcome]?
Typical EA wisdom about impact investing has been that in large public stock markets, it's very hard to affect the stock price of traded companies. The reason? With large public stock markets, there are a lot of traders trying to make money [based on] the same information. So if, for example, a divestment movement causes people to sell their stocks in a fossil fuel company, then socially neutral investors who don't care about impact will just come in and arbitrage away any effect on the price.
In the diagram above, the price falls in the short run and then reverts to the fundamental value of the stock. [The time it takes for the price to revert] depends on how efficient the market is. If the market's highly efficient, the demand curve for stocks is perfectly elastic, so it's horizontal — and changes in the demand for the stock don't have any effect on the price.
How true is this assumption? I think there's a lot of evidence of short-term efficiency. You can test this by looking at what happens to the prices of stocks that are included in an index. If a company is added to the Standard & Poor’s 500 Index, a lot of index funds (like those run by investment company Vanguard) are going to buy that stock. That creates a short-term increase in demand, and there’s evidence that this demand affects the value of that stock after three months. Nevertheless, there is also evidence that the stock reverts to its fundamental value, which is just the net present value of the future cash flows of the business. Basically, stock prices probably revert fully to where they were within about six months.
So if you're running a divestment campaign, though you do have a chance of having a short-run effect on certain stocks, they will eventually revert to where they were. That being said, if no one invested in fossil fuels, then the industry wouldn't exist. So there has to be some tipping point between the time at which you, as a marginal investor, make no difference in the stock price, and when there is a long-run effect on the performance of the industry. It's unclear when this tipping point occurs.
Suppose that 20% of industries in the stock market are harmful. You might think that in order to have an effect on the value of those stocks, 80% of the stock market would need to be divested from harmful industries. Otherwise, there'd always be socially neutral investors to move in and bring the stock price back to where it was. I think this is unrealistic for various reasons — namely, that there are constraints on the extent to which traders can move into different markets.
Maybe divestment campaigns will start having an effect when the size of the total divested funds is comparable to the market cap of the industry. So if fossil fuels are 20% of the industry, and 20% of the stock market is divested from fossil fuels, then that will start having an appreciable long-term effect on the stock price of those companies.
The tipping point may be somewhere in between. I think more research on this would be useful.
But to explore this question further, we need to understand how much of the stock market is good and bad, and how much socially responsible investing there is. How far away from any potential tipping point are we?
About 20% to 30% of the stock market is in fossil fuels. And you must add in tobacco, alcohol, and things of that nature. That's how much of the stock market is harmful.
In comparison, this [slide shows] how much socially responsible investing (SRI) there is. I think it's important to point out that a lot of socially responsible investing isn't very strict. The strictest form is shown in the bar chart at the bottom [of the slide], which [factors in] negative or exclusionary screening. It excludes an entire industry from your fund — fossil fuels, for example. And then as you go up this chart, the investments get less and less strict. ESG integration simply means accounting for environmental, social, and governance scores of different companies. Those are often not very strict. And then there are less important things further up on the chart.
So best-in-class ESG, which is a rather small part of socially responsible investing, just means that a company’s ESG is the best relative to others in its industry. If you're the most environmentally friendly tobacco company, that can mean you get a best-in-class ESG score. And as ESG ratings are currently calculated at the moment, they're not a good guide to social impact.
This information is from Yahoo Finance. You can see the ESG ratings for British American Tobacco and Lindt, the master chocolatier. The ESG rating for Lindt is actually lower than the one for British American Tobacco. So something's going wrong with these rankings. And that leads to certain funds that label themselves as socially responsible [despite] including companies like ExxonMobil. [Emphasis ours.]
Vanguard's socially responsible investing fund includes ExxonMobil. And that's quite a common thing. There's a lot of misleading labeling. Also, I think it's worth mentioning that some socially responsible investing firms exclude nuclear power, even though I think nuclear power is good for the world.
Where are we in relation to the tipping point? I think about 20% of investing is strictly socially responsible and 20% of the stock market is in fossil fuels. So we might be nearing the tipping point at the moment. And I think that the value of the oil and gas industry is upwards of $4 trillion. But according to 350.org, about $11 trillion has been divested from the fossil fuel industry. So you might expect this to start having a material impact on the stock prices of these companies.
Another point that's often made is that in large public stock markets, you're dealing with equity in secondary markets, which means that [your actions] won’t really affect the activities of a company whose stock is traded there. It just affects their shareholders, not their usable capital. For example, a big tobacco company gets a lot of its income from selling cigarettes, rather than raising capital from investors. Investors’ behavior would only affect you if you wanted to raise extra capital by selling additional stock.
Nevertheless, there are reasons for these companies to care about their stock price — namely that shareholders care about making money, so they're going to put pressure on the company to change. It's also going to be important for new and growing businesses. A startup cigarette company will find it harder to succeed if a lot of investors have divested from them. But I think this point is generally less important.
Another key thing to think about if you're doing socially responsible investing in the stock market is whether you lose out financially. If you lose out, then the opportunity cost is money that you could have donated to something effective. The reason for thinking that SRI involves financial sacrifice is you're arbitrarily foreclosing part of the stock market, and any rational investor wants as many options as possible. According to modern portfolio theory, you want as big a portfolio as possible. That reduces risk.
The opposing argument is that ESG ratings might correlate with financial performance for other reasons. Maybe fossil fuel companies are going to face additional litigation and regulation, consumer boycotts, and the like in the future.
As you might expect, the empirical evidence is mixed; it’s very noisy. When looking at the performance of SRI funds and other standard investment funds, there are a lot of different things going on. It's hard to tease out the various confounders. The analyses that exist show that there is not much of an effect of SRI on financial performance, if any. And the benefits to diversifying across the whole stock market are actually quite small. If you own 50 stocks, you get 90% of the diversification benefits that you would have received if you had access to everything. So it's pretty modest.
There's also evidence that “sin stock funds” — funds that only buy companies in industries like tobacco, alcohol, and gambling — consistently outperform the market. But again, it's hard to say why. It might be because they face a higher risk of litigation, so there's additional risk [and the potential for additional reward].
I think it's reasonable to think that if a socially responsible investing campaign or program gets close enough to a tipping point, you could, at best, have a modest effect on the stock prices of targeted companies. And you probably don't have to sacrifice very much financially to do that. But the existing evidence is muddled — and it doesn't suggest that you should do socially responsible investing instead of effective donating.
Where you could have greater impact is in inefficient markets with fewer traders and imperfect information — markets like venture capital and angel investing. If there's a very small number of investors who know about an opportunity, that means there's less opportunity for people to move in. This counterfactual factor is not as big as it might appear, but you still need to think about what your investment could add, or what difference it could make. A lot of impact investors don't really do that. They just think about what the company did. They also need to think about what happens as a result of their investment.
There's also some evidence that divestment campaigns have been correlated with restrictive regulation of harmful industries, but I would be surprised if that turned out to be the most effective way to target an industry. We initially divest for other reasons, and then say it's good because it raises awareness. I think there are probably better ways to raise awareness.
That covers the concept of “additionality,” or what your investment can add.
Finding impactful businesses to invest in
Also, you need to think about how to find an impactful business. Something that a lot of impact investors don't consider is that calculating profit is very different from calculating social impact. With profit, all that matters is whether or not you win. With counterfactual social impact, what matters is what someone else or another business would have done.
If I'm Facebook, I need to ask, “What would have happened if a different social network had taken control of the market rather than me?” It might be that I actually do harm, even though a lot of people are happy to pay money for my services, if the business that had arisen instead of Facebook was better than Facebook. Just because you take over the market doesn't mean that you're having a significant counterfactual social impact.
Finding impact for companies is very difficult, and, from what I’ve seen, I think that's often neglected in the impact investing space. It's not just about casually totting up social KPIs [key performance indicators] and conducting casual impact analyses. In comparison, consider what organizations like GiveWell do. They put hundreds of hours every year into evaluating charities in a very rigorous way.
Overall, optimizing for impact is hard. Optimizing for profit is hard. So optimizing for both is very hard. And as we've seen, ESG ratings aren't much of a guide if you want to optimize in public stock markets.
I think the best approach to finding companies that have enterprise impact is finding those that produce positive externalities, serve very poor consumers, or provide products that are undervalued by consumers. If you think about companies that provide products to consumers who are very well off — those served by companies like Amazon and Uber — they have a high willingness to pay. And so the social value that those companies provide is reflected in the share price.
That's not always true because companies like Impossible Burger and Beyond Meat have externalities that affect animals. By reducing meat consumption, they reduce animal suffering. And that's a type of benefit that's not captured in the transaction. That's the way a company can have an impact that's not commensurate with its market value. The same is true for Tesla, arguably.
The other factor is whether a company serves poor consumers — and by that, I mean the very poorest consumers in the world. There's greater value in serving the poorest consumers in the world versus the wealthiest. You can see life satisfaction relative to income [in this slide], indicating that it's much better to improve consumer welfare in India than it is to improve consumer welfare in the United States, because people in the United States are much better off.
Also, providing undervalued products can provide social value in a way that isn't reflected in the value of your company — for example, by providing CBT [cognitive behavioral therapy] or something like that.
In conclusion, the best kind of impact investing — the kind of impact investing that I think stands the greatest chance of having a positive impact — involves venture capital or angel investing. It involves investing in companies on the brink of financial viability, where your funding actually makes a genuine difference in the survival of the company, and [in companies which] produce positive externalities, serve poor consumers, or provide undervalued products. Those are the key principles.
One big question that's relevant for effective altruists is: How does impact investing compare to donating? This is a question that philanthropists are asking themselves, and obviously there's a lot at stake. It's hard to make any general claims, because the answer depends on each concrete case. I can imagine cases in which impact investing is better than donating. But I can also imagine cases the other way around.
The general advantages of nonprofits are that they can provide public goods. Public goods [typically] can't be provided by for-profit companies, or where the market mechanism isn't set up in a way that would allow them to do so.
That's a picture of Hilary Greaves [in the slide above], who does research for the Global Priorities Institute. They produce knowledge about how to [prioritize different issues in terms of their global impact]. There are no private incentives for anyone to do that.
Another advantage of nonprofits is that they can provide goods to people who are very badly off when there's no market viability. There are famous studies of charging people for bednets, which causes demand for them to [sharply decline]. And if you give them away, people will use them. So there doesn't seem to be [any reason, in this case, for a for-profit company to provide bednets]. Also, nonprofits are usually more neglected because there's no profit involved. That's one factor in favor of nonprofits.
The main advantage of for-profits is they aren’t subject to a principal-agent problem. One example of this is the PlayPump [a device connecting merry-go-rounds to water pumps in Africa, such that water is pumped into a storage tank when children play on them]. It looks good, but didn't go well. And the reason why is that the people whom the project was trying to serve didn’t pay for the project. Donors did. As a result, PlayPumps didn’t receive the kind of consumer feedback that [are inherent to] for-profit businesses.
I think [assessing this] depends on the cause. In the case of animal welfare, I can see it being true that 30 years ago it would have been better if a lot of the animal advocacy money had gone into meat-alternative research. Trying to create for-profit companies like Quorn, Impossible Foods, or Beyond Burger might have been better than funding nonprofits. That's an interesting test case of a situation where SRI might be better than donating. It's probably not true anymore, just because it seems like a very crowded space. It's hard to find unfunded opportunities.
In addressing global poverty, you can fund things like remittance companies. Again, you need to consider “additionality” — whether socially responsible investors would invest anyway if you didn't do so. It's hard to generalize. I think the general standard of impact evaluation by socially responsible investors is not that high at the moment. So there's reason to be cautious.
In long-termism, there's the issue of the climate. You can do a lot, such as fund clean energy providers or electric cars. You can also fund higher-risk ventures, but it seems like a lot of the best options are public goods that are hard for the market to provide.
I’ll stop there. Thanks very much.
Nathan Labenz [moderator]: You covered a lot of ground, but one thing that you didn’t address in your talk is the possibility of doing more local social impact investing, such as becoming a landlord in a community that's underserved, or somewhere you think you could make an impact.
John: I'd be surprised if that was better than investing in global development or something along those lines, just for the usual reasons.
Nathan: The usual reasons being?
John: People here [in the United Kingdom or United States] are much better off [than in developing countries]. There’s less consumer value [in doing something like that].
Nathan: I was surprised to see that $20 trillion out of $100 trillion is designated as strictly socially responsible. You covered some problems with that, but just to make sure I even have that correct (and the audience does too), that’s basically investments excluding tobacco?
John: Yeah, I think so. It's hard to get particularly good data on it, but it excludes specific industries. Some [investors not included in the strict portion] might have [classified their investing as SRI] for selfish reasons, or because they can see the way things are going for the tobacco industry. It's going to be legislated out of existence.
Nathan: It seems like overall you're bearish on the concept of impact investing. You had a bit more hopeful tone around early-stage venture capital investing, but otherwise didn’t seem positive. But do you think that there is something to be said for taking a concrete stand and [using impact investing] to make a statement about money that goes beyond speech, and is, in a sense, a form of more effective advocacy because there's money behind it — even if ultimately, the stock price reverts to the mean, as you said?
John: Maybe. I still think that just funding advocacy directly and thinking about the best way to make that point through other kinds of funding would be the best way to do it, rather than taking a circuitous approach. Unless you can actually have a material effect on the bottom line of the companies you’re investing in, [I don’t think impact investing can make that kind of statement]. There still might be room for cases where socially responsible investing is good, though.
Nathan: One last question (and I'm hearing my sophomore year economics professor ask it, as well as one of the audience members): It seems like ultimately you’re recommending that people invest for profit and then donate those profits. That seems to be, aside from a limited number of cases, the recommendation that you would make.
John: I wouldn't say that definitively. I think it's still a bit unclear. There might be cases where impact investing is a good thing to do. One needs to sit down and figure it out. This talk is more about laying out the conditions under which impact investing could be effective, and allowing us to think about how to assess whether it could be better than donating. It’s still an open question. I know there are a few people who are working on that question, and I think it needs a bit more attention.
Nathan: All right, awesome. Thank you very much. Great job.
It seems like you are fairly confident from your research that impact investing will tend to have little impact in publicly traded markets. I briefly looked into the theoretical literature on this, and I'm not seeing why we should be so confident in that idea. For example, this paper from 2019 claims:
They then cite four theoretical papers in support of that claim (note: I haven't actually read through these papers. I just glanced at the introductions and the setups of their models. It could be that these are bad papers).
Were you aware of this literature when writing your report? Why should we be so confident in the arbitrage argument?
Hi, Thanks for this. There seems to be agreement that demand curves are perfectly elastic on the 6 month timeframe. I looked at the paper you sent and it doesn' present any of its own evidence but cites some other papers, which I don't have time to look at. Our report on impact investing goes into this in more detail.
Thanks for the reply.
You're right that the paper I posted doesn't present direct evidence. I just thought it was important that in their literature review they claim that prior studies show that demand curves are not perfectly elastic (at least in theory. They aren't citing empirical papers).
On the empirical side, I'm surprised to hear you say that there seems to be agreement that long-run demand curves are perfectly elastic. On page 18 of the founder's pledge report, you seem to say that there is expert disagreement on this, and you cite multiple recent studies on both sides of the issue. Has more evidence come out since the report was published?
Thanks for the talk and the report. I think this it's a very interesting topic and an important one to work on, given how many socially-minded people seem to care about impact investing.
I have a few more questions in addition to the one about perfectly elastic demand curves:
1. You note that if public markets are efficient then it will take nearly the entire population of investors to divest for the divestment movement to impact stock prices. This seems to make sense: it only takes a small group of socially-neutral investors to drastically increase their investments in the bad company in response to divestment from others. However, if we consider a movement to increase investment in a socially-good company, it seems like this idea doesn't apply. Let's say that the good company makes up .001% of the total stock market. It seems like if .001% of investors are willing to accept lower returns for investing in that company, then they should be able fund the company all on their own. In equilibrium no socially-neutral investors will hold that company's stock, and the stock would yield lower returns than socially-neutral stocks. So perhaps movements which promote investment in good companies are more likely to succeed than divestment movements are.
2. From your research it looks like the current ESG ratings are very low-quality. Given how big of a market impact investing is, do you think that there would be value in trying to improve those ratings?