Would you like a side of warm glow with your investment?
A review of CSP’s latest research paper, “Do investors care about impact?” for private investors and sustainable investment practitioners.
Imagine your financial advisor presents you with two investment options: Fund A and Fund B. They both invest in stocks of large US companies, have the same risk classification, and are benchmarked to the same index, which has returned 5% per year to investors. The only difference between the two investments is that fund A respectably outperformed the benchmark by 0.5% for an annual return of 5.5%, while Fund B outperformed the benchmark by 5% for an annual return of 10%. In other words, Fund B performed ten times better than Fund A. Fund B is clearly doing something right, so how much would you be willing to pay for such extraordinary performance?
In their recent research paper, “Do investors care about impact?”, which has been accepted for publication in The Review of Financial Studies, co-authors Florian Heeb, Julian F Kölbel, Falko Paetzold, and Stefan Zeisberger surveyed 89 private investors to explore their willingness to pay. They found that they were willing to pay on average 9.5 times as much for Fund B, almost the exact multiple of the outperformance. This isn’t an earth-shattering result and confirms what one would intuit naturally. But what if this thought experiment was run on the sustainability-invested versions of the funds, where the only difference was how much carbon emissions were saved?
This is the central question that the authors from the Center for Sustainable Finance and Private Wealth at the University of Zurich answered. Their findings showed that private investors do care about the carbon emissions saved by their investments. While they are willing to pay a premium for funds that save carbon emissions, it appears that this result isn’t cumulative: they are not willing to pay more to save more emissions. The researchers came to this conclusion after asking 196 experienced and climate-conscious private investors how much in fees they would be willing to pay for two funds which were the same in every respect, except that Fund A saves 0.5 tons of CO2 emissions per year (low impact) while Fund B saves 5 tons of CO2 emissions per year (high impact).
Encouragingly, 93% of the participants preferred the high-impact option over the low-impact option and were willing to pay an average of €45.67 in fees for a €1,000 investment. However, unlike in the financial outperformance scenario, investors were only willing to pay €6.29 — about 15% — more for the fund that saved 1000% more carbon emissions. In other words, investors were willing to pay €81.25 per ton of CO2 emission saved via the low-impact option and only €8.38 per ton of CO2 emissions via the high-impact option.
This suggests that while private investors are willing to pay for sustainable investments, their willingness to pay does not increase proportionally with non-financial variables, in this case, carbon emissions. While one might have thought that private investors who care about sustainability are willing to pay more for more impact, the authors hypothesize that investors may be driven by positive emotions, seeking to achieve a “warm glow,” when choosing sustainable investment options rather than optimizing their decisions to maximize impact.
Building on this theory, the paper re-ran the impact experiment with a group of experienced high-net-worth individuals (HNWI) with median wealth between €1 million and €10 million who self-identified as “impact investors.” Interestingly, while these impact investors were willing to pay slightly more for sustainable investments, they responded that they would only pay €1.26 more for the high-impact option than the low-impact one. This could mean that this group is also susceptible to the “warm glow” effect of investing sustainably.
It turns out that the paper’s finding is not isolated to sustainable investments. A study by Christopher Hsee and Yuval Rottenstreich on the affective psychology of value, for instance, showed that in the case of donating money to save pandas, the amount given was driven by the emotional importance of pandas to the individual rather than the final number of pandas that would be saved by a given donation.
In a follow-up survey, the authors of the paper “Do investors care about impact?” further established the warm glow effect by asking investors how good it feels to invest in a sustainable investment compared to a non-sustainable one. They found that both the private investors and the impact investors agreed that it feels better to invest in sustainable options, with the impact investors reporting a higher level of positive emotions for investing sustainably. Tellingly, however, there was no difference found in the level of emotions between investing in the high-impact option as opposed to the low-impact option.
Understanding investor behaviour around why they are not willing to pay for increased impact is key to enabling more impactful sustainable investments to flourish. Generating impact can come at a cost, either in terms of fees or financial performance. Those seeking impact need to clearly evaluate performance across both financial and non-financial performance in order to most effectively achieve their goals. Financial institutions creating and selling impactful products also need to be aware of investor biases to be able to clearly advise their clients, generate demand for their products, and help their clients avoid investments only marginally than their traditional counterparts in terms of impact.
What does this mean in practice?
For the Financial Industry:
1. There is a high degree of incentive to achieve classification as a green or impact product to cater to investors’ desires to achieve the “warm-glow” effect. Nevertheless, for the many investors who clearly express their desire to maximize their impact, clear advice and frameworks for evaluating impact dimensions are required.
2. Financial institutions are unlikely to be rewarded through higher fees for dedicating additional resources via data gathering, specialized expertise, pursuing ESG voting and ESG engagement strategies, and other costs associated with generating higher impact in their investment products.
3. Financial institutions creating high-impact products and seeking to maximize their impact need to educate clients and client advisors on non-financial performance measures and include space in their conversations with clients to discuss non-financial performance metrics.
For Impact Investors:
1. Though achieving a warm glow might be a by-product of investing sustainably, developing a more quantitative approach to impact will serve you well if maximizing impact is one of your investment goals.
2. Try to quantify the metrics you care about and consider their value to you. Establish a framework to monetize the impact you are targeting, whether that’s CO2 emissions reduced or pandas rescued. Thinking about the monetary value of non-financial returns may help to evaluate investments with the same level of objectiveness as financial returns.
3. Having lots of low-impact sustainable investments that all generate a warm glow might create a lot of positive feelings, but taking the time to evaluate an investment’s impact potential and opting for the most impactful options can lead to more meaningful results, which may feel even better in the long run.
For sustainable investment professionals and product providers:
1. Be aware of investors’ tendency towards achieving the warm glow effect when creating high-impact products. When steering clients towards higher impact investments, it helps to make clear comparisons between products, including information about how they contribute to non-financial performance.
2. Develop clear impact metrics that allow investors to compare impact across products knowing that investors who have sustainability goals will opt for higher-impact products.
3. Be very transparent regarding why higher-impact products cost more. If more expertise, further data, increased administrative burdens associated with smaller investments in developing countries, and ESG voting and engagement raise the fees of higher-impact products, be prepared to explain this to clients and demonstrate why these differences pay off in terms of impact.
Interested in supporting your clients better in their sustainable investment decisions and understanding how sustainable investments can make an impact at your organization? CSP runs custom programs for clients, client advisors, and other financial professionals based on our academic research and extensive experience helping wealth owners build impactful sustainable portfolios. Get in contact with me to discuss your opportunity to help your clients make an impact at andrew.douglas@bf.uzh.ch
