Special

Article 3

Sustainable Investing –Addressing the Backlash

By Govinda Finn

Sustainable investing has been criticised for its theoretical flaws,
unverifiable objectives and excessive fees. Is this backlash justified?
The financial system seeks to transfer capital from savers toeconomic entities that require capital to spend or invest. In doing so,
it aims to maximize all participants’ utility. Sustainable finance is far
from incompatible with this conventional thinking. Why is it proving
so contentious?
In this paper, I argue that there is no fatal flaw in the “Sustainable
Investing” approach but identify an accumulation of informational
failures that is eroding its credibility. The case to improve disclosureand enhance incentives to integrate sustainability criteria into theidentification and maximization of the economic surplus iscompelling. I consider the nature of these challenges and address
whether the private sector can offer a better solution or whether thecase for greater regulatory intervention is now too compelling toignore?

Missing Information

Author Govinda Finnfunctionality of the price-setting mechanism. There are a number ofreasons why this mechanism may be flawed when it comes toaggregate, or social, utility maximization. The most obvious is a
failure to account for externalities, which may result in goods andservices being over- or under-supplied, or not supplied at all.
From an economic point of view, the best way to mitigate thisproblem is to put a price on these externalities. However, data
availability issues and difficulties making market aggregate
assessments mean it is not always easy to measure the impact of thisactivity in a way that is socially acceptable given existing conventions.
One example is a carbon tax. Raising the price for carbon-emitting
goods and services is an intuitive way to reduce demand andsubsequently carbon emissions. However, progress in implementing
carbon taxes has been much slower than expected (Chart 1). Thesetaxes have been criticised for their regressive nature with the poorest
cohorts of the population more affected. In addition, they must be
weighed against other considerations such as the cost of
adjustments, which include painful disruptions to economic activity
and the risk of structural unemployment.
A second type of resource is purely financial in nature withprofessional investors the primary guardians over the allocation offinancial assets. Market failures here relate more to the general issueof imperfections in information availability that means buyers and

The starting point is the literature of market failures. The standard
definition is that market failure occurs when the allocation of a goodor service by the free market is inefficient. While there are several
types of market failure, perhaps the most significant type involves“information failure”, given that allother market failures include some
CHART 1
form of information problem.
Carbon Tax falling short?
My question is how do information
failures impact the allocation of
All countries
resources from savers to borrowers?
Indonesia
BrazilThe answer depends on the nature ofChina
resources being allocated. I identify
US
two distinct types of resources,Japan
economic and financial, and highlight
Norwayhow the materiality of informationUK
failures differs across the allocation
Franceprocess.
India
First, let’s consider economic
GermanySouth Africa
resources allocated by decision-0.5
00.5
1makers at a company managementlevel. The ability of firms to deliver an
Carbon tax revenues, % GDP
optimum amount of goods andSource: “Pricing Greenhouse Gas Emissions”, OECD 2022
services is dependent on thehttps://www.jef.or.jp/journal/

1.5

2

2.5

3

Net energy tax revenues, % GDP

Japan SPOTLIGHT • January / February 2023

47

sellers fail to agree upon optimum allocations. Here the most
pertinent information problem is not externalities – which both parties
may be ignorant of – but an unfair information advantage for one
stakeholder over others. This so-called information asymmetry can
result in inefficient outcomes or no provision at all.
The appropriate way to mitigate this type of challenge is toestablish contractual obligations that minimize the advantage of
uneven information and mitigate costs associated with the delegationof decision-making authority to agents, known as agency costs.1
Of course, these legal contracts are contingent on future conditions
and can never be fully complete or perfect in nature. As a result, theability to reduce agency costs is enhanced by a mix of governancearchitecture and agreed best practices – often through the adoptionof soft-law regulation such as Corporate Governance or Stewardship
Codes.
Agency problems are not constrained to firm ownership andmanagement either. In recent years, greater attention has paid to
informational problems across the investment chain too. Assetowners and service providers in the investment chain face similar
information challenges and associated agency costs which can havean accumulated effect. To mitigate this problem, governancearchitecture and responsibilities have been extended throughout the
chain, with increased recognition that sustainability investment
begins with savers, i.e. end-investors and beneficiaries who
contribute the funds invested in the market.

The Market Solution

to invest heavily in disclosure provisions. Again, events in Europe
provide a useful example with the implementation of the European
Commission’s Sustainable Finance Disclosures Regulation (SFDR) for
asset managers having been delayed partly because of the costassociated with the acquisition of data needed to comply.
In the past, these up-front costs have proven prohibitively high,resulting in ad hoc and inconsistent disclosures in this area.
However, a combination to technological advances and shifting
generational preferences mean the market for information associatedwith Sustainable Investing has developed relatively rapidly in recent
years.
Demand for better quality information about how firms, asset
managers and service providers integrate sustainability consideration
into their decision-making has grown exponentially. Sustainable
Investing-related funds totalled $18.4 trillion in 2021 and are
expected to grow to $33.9 trillion by 2026.4 In response, there has
been a concerted effort to improve disclosure and assurance
standards.
In November 2021, the IFRS announced the merger of the Climate
Disclosure Standards Board and the Value Reporting Foundation –which houses the Integrated Reporting Framework and the SASB
Standards – and the formation of the International Sustainability
Standards Board (ISSB). The ISSB has a clear mandate to provide a
global baseline of sustainability disclosures and enable companies toprovide comprehensive sustainability information for investors. It has
since introduced a new building block approach to sustainability
disclosure, with high-quality standards designed to complement
jurisdictional initiatives (Chart 2).
From the investor side, nearly all major asset managers now
integrate Sustainable Investing into their process in some form. In
addition, new products and services have been created with greatertransparency is relation to ESG ratings, indices, and fundcomponents.
Another important development is the increase in verification ofdata between these two critical sources of information. For example,
it is now possible to compare a firm’s assessment between its current

If we accept that information failures occur frequently across theasset allocation chain, does it make sense to expect markets toefficiently direct the flow of money to sustainable outcomes?
A key decision criterion is whether the private sector has greater
capacity to reduce these informational problems. To answer thisquestion, I start with a simple observation that information efficiency
is a function of cost of information and market conditions, such ascompetition and ease of entry.2
Regarding the first of these
determinants, recent research suggests
CHART 2significant time and financial resources are
New standards for global baseline of sustainability
required to meet the data provision,
disclosurescompilation and analysis necessary for
Sustainable Investing. The brunt of the
Sustainability reporting (broader multi-stakeholder focus)
Jurisdictional initiatives
and/or GRI
Reporting on all sustainability matters that reflect significant positive
burden has been borne by the corporate
or negative impacts on people, the environment and the economy
sector. For example, costs associated withdisclosure requirements under new
Sustainability-related financial disclosures (investor focus)
ISSB
European Union legislation due to come
Reporting on those sustainability-related matters that may reasonably
into place in 2023, the so-called Corporate
create or erode enterprise value over the short, medium and long term
Sustainability Reporting Directive, is
IASB (140+estimated at no less than 3.6 billion euro,
Financial reporting (investor focus)
countries)
with 1.2 billion euro in one-off
Reflected in monetary amounts in the
Other
GAAP
financial statements
implementation costs alone.3(e.g. FASB)
Integrated Reporting
Asset managers and other supplies in
Source: ISSB’s proposed IFRS® Sustainability Disclosure Standards, 2022
the investment chain are also being forced
48 Japan SPOTLIGHT • January / February 2023

and committed net-zero trajectory with an investor’s assessment of
the same gap. As the quality and amount of information increases,
logic dictates that the efficiency of the market mechanism should too.

More to Be Done?

The Power of Regulation
Of course, it would be naive to think progress in the Sustainable
Investing I have discussed so far has been mainly market led. It isalso a reflection of a concerted campaign by governments across theworld to aggressively deploy sustainability-related regulation andstandard-setting.
In the next section I consider the impact of regulatory efforts todate and seek to answer whether government regulation offers amore effective solution to improving sustainability of economic
activity. I also seek to answer whether the private sector can evertruly be a reliable partner in efforts to improve the sustainability of
economic activity.

The recent developments are certainly a step in the right direction.
However, there is still much more that could be done to improve theavailability and accuracy of information required for Sustainable
Investing. I cover some of the potential enhancements in the next
section.
I begin by focusing on technology solutions. According to a recent
Oracle ESG global study, 91% of business leaders are currently facing
major challenges in making progress on sustainability and ESG
The Case for Intervention
initiatives.5 This primarily reflects challenges in obtaining ESG metrics
from third parties, a lack of data, and time-consuming manual
Given that sustainability problems are rooted in information-related
reporting processes.
market failures, I believe it is correct to be concerned about markets’
There is considerable scope for AI technology to increase theability to address the sustainability challenges of our time. The
granularity of firm reporting and identify data gaps related toevidence in recent decades in favor of more aggressive government
sustainability issues. AI-related technology is also a vital tool forintervention to correct market failures is as numerous as it istracking ESG criteria within portfolios. This includes not only thecompelling. Examples include the failure of fiduciary duties tofiltering of existing data but the improvement time-consuming
mitigate market excesses that led to the largest financial crisis sincemanual reporting processes.
the 1930s or the rapid rise in global greenhouse emissions andAnother important tool for those in the financial chain is the use of
projected global temperature increases (Chart 4).
scale to provide a broader and more consistent set of addressable
In the area of Sustainable Investing, a raft of regulatory initiatives
issues with firms. The widespread adoption of Sustainable Investinghas been introduced including in key areas such as taxonomy andapproaches is constrained by associated costs, especially for lower
disclosure regarding issuers, environmental, social and governancecost solutions such as ETFs. It can also increase asset managers’(ESG) fund products and rating agency and benchmarks. While wesusceptibility to home-biases and reinforce a preference for lowhave seen a divergence in approach by jurisdictions, no major
hanging fruit. This is not compatible with global investment mandates
economy has stood still. The EU has taken a lead through thethat portfolio managers are entrusted with. Greater efforts to deploy
renewed Sustainable Finance Strategy, an integral part of thesystematic practices that can address Sustainable Investing practices
European Green Deal, which will cover ESG data and ratings.
across multiple jurisdictions are necessary to ensure that principles
Initiatives in the United States are based upon the principles-based
are applied fairly across decision criteria (Chart 3).
Another tool in the fight for lower costs isthe need to outsource more costly components
CHART 3of the Sustainable Investing process either
Incentives to encourage Stewardship
explicitly to specialist functions or implicitly tointegration
activists. However, outsourcing does not comewithout risk. For example, ESG ratings that
0%
10%
20%
30%
40%
50%
60%
70%
80%
rank companies by how they are performing on
Organisation-wide policy
sustainability factors are often opaque, withratings providers incentivised to integrate nonpublic data into their proprietary scoring. There
Role-specific objectives
can also be methodological issues relating tometrics weighting, materiality and how toTeam-specific policy
consider missing information. Unsurprisingly,
this can lead to large inconsistencies in
Financial incentives
assessments of sustainability scores acrossproviders – undermining rather than enhancing
No incentives
information efficiency.
Source: Influence of UK Stewardship Code on practice and reporting, July 2022 FRC

Japan SPOTLIGHT • January / February 2023

49

financial agents is a selection bias. This can
2100 warming projections
result in disclosure not being truly
Emissions and expected warming based on pledges and current policies
representative of day-to-day activity. To
counter this problem, financial agents should
be mandated to report on their sustainable70
related work on a more systematic basis,
60
Warming projected
allowing for random sampling that is moreby 2100
representative of firm activity.
50
Historical
An important question is whether these40
goals should be driven by legislative efforts
Policies & action+2.5–2.9℃
or soft law practices? There are plenty of30
2030 targets only
examples of legislation of socially
2030
+2.4℃
ambition gap
20
unacceptable activity. This can be achieved
19-23 GtCO e
Pledges & targets
through either blanket bans or through the+2.1℃
10taxation of products and services with highOptimistic scenario
0+1.8℃
social costs or the subsidisation of sociallybeneficial activity.
1.5℃ consistent
-10
+1.3℃
A common feature of government-20
intervention across jurisdictions has been a1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100
preference to cooperate with market
Source: Climate Action Tracker (2021). 2100 Warming Projections: Emissions and expected warming based on pledges andparticipants to improve standards and best
current policies. November 2021
practices. In particular, regulators haveengaged with large institutional investors toapproach to overseeing disclosure of non-financial information by
improve market functioning. In contrast, legislation has widely been
publicly-listed companies. The SEC is addressing Sustainableconsidered only as a last resort.
Investing through several avenues, including enhancing disclosures
Unsurprisingly, this has led some to conclude that these
related to ESG factors considered by funds and advisers, and to also
regulations have been applied in a way that is consistent with a status
expand the regulation of the naming of funds with an ESG focus.
quo framework, rather than providing a comprehensive alternative
In Japan, while there are no specific regulations that directly
view of the role of financial markets in society. To some this is aaddress Sustainable Investing, ESG disclosures or businessmissed opportunity to head off an inherent conflict between profitoperation, a number of laws and regulation touch on issues relating
maximizing financial agents and an allocation of resources that is
to corporate disclosures and improving the long-term investing
optimum for a sustainable society.
landscape. Japan has also compiled the world’s first Code of Conduct
In the next section, I consider the origins of this conflict and how it
for ESG Evaluation and Data Providers. The Financial Services Agency
sits within a wider economic framework.
has also recently published its proposal for sustainability disclosure
Markets as Specialists
with enhancements on emissions and gender diversity disclosures in
the pipeline.
To understand why some argue financial market objectives andMore Regulatory Worksocially optimum objectives are irreconcilable one must migrate
further into financial market theory. The conventional view embedded
In much the same way that private sector progress on sustainablein finance theory is that investors should always adopt practices torelated issues has been insufficient, government regulations remain
maximize firms’ profits and shareholder wealth.6 This partly reflects
the principle of specialization familiar in other fields of economics.
insufficient to meet stated sustainability goals. Next I look at what
Through this prism, the introduction of sustainability goals serves
more could be done on the regulatory front to improve the availability
to undermine the price discovery mechanism. This is because under
and accuracy of information required for Sustainable Investing.
a unified objective assumption, prices are a pure reflection of the
One critical consideration is the establishment of clearer
financial fundamentals. If the assumption investors seek to maximize
obligations of agents across the financial chain. As stated previously,
financial returns is invalid, it is less clear what prices will be
there has been a growing awareness of the accumulation of agency
informative about.
costs across the investment chain. This is certainly the spirit of the
For example, a decision to remove single-use plastic from a
recent shift in soft law codes to outcome-orientated targets. However,company’s supply chain may represent a positive buy signal for aa more explicit formulation of fiduciary duties along the investment
sustainable investor but represent a sell signal for a traditional
chain may avoid a buck-passing mentality.
investor. Because the two investor groups seek to learn different
Another problem in reporting activity that extends across firms andGlobal greenhouse gas emissions GtCO2e/year

CHART 4

2

50 Japan SPOTLIGHT • January / February 2023

information from the price, they trade differently on similar signals.
This cross-purposing can serve to raise the cost of capital and reduce
the economic surplus.
Unsurprisingly, much of the criticism of Sustainable Investing
concepts such as ESG has related to the importance of non-financial
objectives in the allocation of financial assets. Both Texas and Florida
have sought to limit state fund managers from investing in funds orcompanies that make investment decisions based on sustainability
factors. In Florida, the State Board of Administration adopted aresolution updating their fiduciary duties to direct them only to weigh“pecuniary factors”.
However, according to economic theory this problem should not be
so difficult to solve. As stated previously, the investment chain serves
to maximize the utility of both savers and borrowers through dynamic
allocation efficiency.
We have become used to using wealth generation as the common
goal of investors, but this is not always a sufficient benchmark tomeasure investor utility or the economic surplus. Recent evidence
indicates that investors derive pecuniary and non-pecuniary benefits
from investing in assets. Economists are now taking seriously thepossibility that investors might value positive societal externalities inutility, or disutility, in addition to wealth.
This is not a problem for traditional models if Sustainable
Investments require a trade-off between financial and societal returns.
However, it is not always the case. There is also an important role for
Sustainable Investing decisions that cannot be understood through azero-sum game framework, i.e. where investors avoid nonsustainable activities even when there is no price impact.7 This raises
a final, and much neglected, information problem. Are we accurately
measuring end-beneficiaries’ utility derived from financial assets, andhow it changes over time and with changes in tastes?
The information problem associated with sustainable financemakes it hard for the standard proxy for utility curves, so-called
indifference curves, to capture utility maximization. Indifference
curves are extremely useful in understanding dynamic allocation but
they cannot perfectly replicate utility curves, especially wheninvestors are free to reconsider their plan based on shifting
preferences.
It is important to build a clearer picture of financial well-being
preferences and how they evolve over time. For example, the EU’s
MIFID II regulations include a sustainability preference assessment toensure clients better articulate their interests. Of course, it will taketime and information to test whether this added requirement
improves the ability of financial agents to allocate resources in a way
consistent with end-beneficiaries’ preferences. If it proves effective, itwill provide a template for how to better integrate utility maximizing
criteria that can be used across the investment chain and in otherjurisdictions. This may upset conventional finance thinking but would
remain consistent with the spirit of dynamic utility maximisationpreference central to economic theory.

Conclusion
Progress on the adoption of Sustainable Investing practices has
been stymied by high short-term costs associated with information
provision, compilation and analysis when compared to the potential
longer term and uncertain benefits. This reflects a number of
information-related market failures that have rightly triggered
government intervention. However, the improvement in the market
for sustainable information cannot be explained solely by regulatory
action. Technology and changing preferences mean that the private
sector has reduced the cost of information and improved theoperation of the market for Sustainable Investing-related information.
The prospect of the public and private sector working hand-in-handto further reduce the impact of information failures has not convinced
everyone. However, if the uniform wealth maximization objective
embedded in financial literature is relaxed it becomes much easier toaccept a greater degree of social responsibility in financial agents’decision-making.
Of course, it is easier to make commitments to Sustainable
Investing goals than it is to implement them. The capacity to verify
investment outcomes with investment goals is critical and to track
credibility gaps so that those who free-ride or engage ingreenwashing are not allowed to flourish.
1 Jensen, M., Meckling, W. (1976). “Theory of the firm:
Managerial behavior, agency costs and ownership structure”,
Journal of Financial Economics, Vol. 3, Issue 4, pp. 305-360.
2 Eugene F. Fama, 1970. “Efficient Capital Markets: A Review ofTheory and Empirical Work”, The Journal of Finance, Vol. 25, No.
2, Papers and Proceedings of the Twenty-Eighth Annual Meetingof the American Finance Association New York, N.Y. December,
pp. 383-417.
3 EC staff working document accompanying the document Proposal
for a Directive of the European Parliament and of the Council
amending Council Directives 78/660/EEC and 83/349/EEC as
regards disclosure of non-financial and diversity information bycertain large companies and groups, 2013.
4 PwC’s Asset and Wealth Management Survey, 2022.
5 “No Planet B: How Can Businesses and Technology Help Save theWorld?” 2022 ESG Global Study, Oracle.
6 Friedman, M. (1970). “The Social Responsibility of Business Is to
Increase Its Profits.” New York Times Magazine, Sept.13, 1970,
pp. 122-126.
7 Zerbib, O (2022). “A Sustainable Capital Asset Pricing Model(S-CAPM): Evidence from Environmental Integration and Sin
Stock Exclusion”, Review of Finance, Vol. 26, Issue 6, pp. 13451388.
Govinda Finn is a “Next-Gen Pioneering Research Programme” scholar under
the Japan Science and Technology Agency based at the University of Kobe’s
Graduate School of Economics. He is a former Japan & Developed Asia
Economist at Aberdeen Standard Investments based in Singapore and prior tothat at the Multi-Asset Investment Team based in Edinburgh. He is on theinternational advisory board of the Asia Scotland Institute.

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