Green Dream with Yale’s Shue: Why we need to invest in ‘brown’ firms

Professor Kelly Shue says don’t naively reward firms with net-zero pledges

Kelly Shue, professor of finance at Yale School of Management


Natalie Kenway

Investors looking to support a greener planet may shun high-polluting industries or ‘brown’ companies, but instead they should be helping them transition by continuing to invest, says professor of finance at Yale School of Management Kelly Shue.

In this episode of the Green Dream video series, Shue takes us through the findings of her recent research paper that concluded that withholding capital to high-emissions firms, and incentivizing them to cut back, may actually cause them to pollute more.

Watch the full video interview above and read the transcript below.

NK: Hello and welcome back to the Green Dream video series. I am Natalie Kenway, editor in chief at MA Financial Media. Today, I’m delighted to be joined by Kelly Shu from Yale. Thank you so much for joining us. Could you tell us a bit about what you do?

KS: I’m a professor of finance at the Yale School of Management, where I teach corporate finance to MBA students.

I also do research in behavioral finance as well as corporate finance.

NK: Your recent research paper concluded that withholding capital to high emissions firms – or what we have been calling brown companies – is incentivizing them to cut back and might actually cause them to pollute more. So can you briefly explain that?

KS: What I think sustainable investors want to do is they know that brown firms have more of a negative environmental impact and they don’t want those brown firms in their portfolio.

And they also want to punish these brown firms in the hopes that they will then change their behavior and improve their environmental impact. Now, when sustainable investors exclude brown firms from their investment portfolios, that makes it more expensive for brown firms to raise money, which effectively makes them actually more short termist. If a brown firm becomes distressed, basically closer to bankruptcy or has more difficulty raising money from outside investors, it’s going to want to generate cash right now.

And the way that a brown firm can generate cash right now is actually to double down on existing brown production. Now, brown firms have an alternative investment possibility which could actually be profitable. It would be to transition to newer, greener production technologies. But that transition process usually requires purchasing expensive equipment upfront, which could payoff years down the line.

But if we make that brown for a very short term ends and worried about short term survival, these clean transition projects actually will appear less attractive to these brown firms.

NK: You also suggested in the paper that it could also motivate green firms to engage in trivial or greenwashing attempts to make themselves look more eco friendly. Can you explain that a bit more as well, please?

KS: Sustainable investors like to reward firms that have had large percentage reductions in their emissions. Now there’s a huge gap in just the level of emissions between brown firms, which tend to be your aunt energy, transportation, manufacturing firms versus green firms such as legal services or insurance. So if you compare brown and a green firm of the same size, the brown firm starts with about 260 times the level of emissions compared to the typical green firm.

And because the brown firm just starts at baseline with such a higher level of emissions, it’s hard for these brown firms to have a 50% reduction in emissions in a single year. That’s not practical, is not realistic, given the nature of their business. But if you look at a typical green firm so that could be a legal services firm, this is not a firm that’s engaged in much manufacturing, it doesn’t have factories, etc., it starts with an incredibly low level of emissions. It could plausibly reduce those emissions in a in a large percentage basis within a single year, possibly by buying some carbon offsets. So it looks really good on a percentage measure in terms of year-on-year reduction in emissions, but it’s not really a meaningful impact on the environment because it started with close to zero environmental impact in the first place.

NK: Okay. So what we’re saying is working with the brown firms will have a higher impact on the decarbonization of the economy, right?

KS: Absolutely. Brown firms account for the majority, the vast, vast majority of environmental impact. If they change their behavior even by a couple of percentage points, because they start out with such high environmental impact in the first place, I think they’re the ones that invest in sustainable investors should really try to engage with.

NK: Okay. And with that in mind, we have quite a lot of investors that say they want to be green and they want to exclude those types of companies from portfolios. What would you say to those about directing capital towards them for a greener planet?

KS:  I would encourage them to consider alternative strategies such as engagement so that that would involve possibly investing in firms that are brown, but actually trying to motivate their management to change their policies.

Even if it’s a small tweak, it could have a big environmental impact. The other thing to consider is possibly is instead of excluding entire brown industries, such as we’re going to exclude all of agriculture because agriculture on average is actually very high carbon emissions, it’s really not practical to want to shrink all of agriculture because people have to eat.

So instead, we could invest in an industry that on average is high polluting, but try to subsidize the greener firms within agriculture, even if those green firms within agriculture are still pretty high polluting compared to an insurance firm.

NK: And how do investors identify these types of companies and be assured that they aren’t greenwashing and just put a spin on these things?

KS: Looking at a firm’s emission intensity, which is greenhouse gas emissions scaled by amount of output, is a pretty reasonable measure of a firm’s environmental impact. However, investors should make sure to consider changes in emissions in the right units. So don’t just be impressed by a firm that has reduced its emissions by 30% because that firm could have started out with very close to zero in the first place.

Meanwhile, a very high polluting firm that managed to reduce emissions, let’s say, by only 2-3%. That firm could have still made a really good environmental impact. The other thing I think sustainable investors should be cautious about is not to naively reward firms that make net-zero pledges. So these firms that make net-zero pledges and are claiming they’re going to have zero net emissions, zero impact on climate change within a certain number of years… I think this is an admirable goal, but again, the types of firms that tend to make net-zero pledges are the firms that have close to zero environmental impact in the first place by the nature of their business.

NK: Some really interesting points there. So thank you very much for sharing your findings with us. We always end with the Green Dream, with this question, what’s your favorite sustainable drink or snack?

KS: I really like seafood, so I think seaweed is actually very good for the environment. And I love actually seaweed-based snacks as well as clams, mussels, all those kinds of snacks are actually a very delicious.

NK: Me too! Well, thank you very much for your time.

KS: Thank you. Take care. Bye.

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