This article was first published in the Q4 2022 issue of Morningstar Magazine. To subscribe to the magazine, please visit https://www.morningstar.com/products/magazine
In his pathbreaking book, The Structure of Scientific Revolutions, Thomas Kuhn argued that science does not advance by the simple accretion of knowledge through experimentation and observation. There are periods when there is broad consensus that the current theories explain the phenomena they are intended to explain. “Normal science,” as he calls it, is practiced in the context of the prevailing scientific paradigm. However, periodically anomalies lead scientists to change their understanding of the facts that shape their disciplines. Such ruptures—such as the discovery that the Earth revolves around the sun, not vice versa— pave the way for the emergence of new scientific theories. Kuhn dubbed these transformational moments “paradigm shifts.”
Not surprisingly, the growing importance of sustainable investing has motivated practitioners and academics to grapple with questions about its implications for finance theory and our understanding of risk. Can it be assimilated into current theory? Is it explained by a different theory? Are we in the midst of a paradigm shift in our understanding of investment risk? We consider these questions from three distinct perspectives: Modern Portfolio Theory and the capital asset pricing model, behavioral finance, and system-level risk.
The Rise of Sustainable Investing
The publication of Amy Domini and Peter Kinder’s Ethical Investing in 1986 and Investing for Good: Making Money While Being Socially Responsible (with Steven Lydenberg) in 1993 presaged what we now call sustainable investing. Known at the time as ethical investing or socially responsible investing, SRI, the authors advocated an approach that “examines the business interests and practices relating to such ethical concerns as minority hiring, environmental hazards, and weapons manufacturing, and explains how to make profitable investments without sacrificing personal ethics.” So, SRI is about enabling individuals and financial advisors to align investment decisions with personal values associated with their vision for a better world.
In 2004, the United Nations Global Compact published a report endorsed by 20 major financial institutions, along with the World Bank and the International Finance Corp. “Who Cares, Wins: Connecting Financial Markets to a Changing World” articulated “guidelines and recommendations on how to better integrate environmental, social and corporate governance issues in asset management, securities brokerage services and associated research functions.” The report reflected growing demand from global asset owners and asset managers and offered a blueprint for integrating these issues across different actors in the investment value chain.
Framed in the vocabulary of mainstream finance, the report was a catalyst in shifting the conversation from the values orientation of SRI to a focus on value—specifically, risk and opportunity associated with environmental, social, and governance factors in the context of the fiduciary duties of institutional investors. And it gave the world a new initialism, ESG.
Today, sustainable investing encompasses a range of strategies including ESG, climate, and impact investments. It is premised on the view that every investment has real-world effects, whether positive or negative. While diverse, these approaches share the objective of leveraging capital markets to generate more sustainable outcomes. They also acknowledge implicitly or explicitly that companies have an impact on the world at the same time as the world has an impact on companies.
What distinguishes sustainable investors from investors exclusively focused on financial considerations is their intention to integrate analysis of ESG risks and opportunities, address negative externalities of market activities, and achieve positive impacts. In short, they seek to change the framework and time horizon for investment decision-making, though achieving such ambitious aspirations remains a work in progress.