Sustainable investing (or impact investing) is arguably the hottest topic in global finance. Morningstar reports that ESG-oriented mutual funds’ net capital inflows quadrupled in 2019 to $20 billion, and signatories to the Principles for Responsible Investments (PRI) had $86 trillion assets under management (AuM) in the same year.
However, the economics of sustainable investing are contentious among practitioners and academics. While many industry reports point to the high net capital inflows and favorable valuations of ESG assets, financial economists warn that the sustainable investing hype could be driven by an unsustainable demand effect. The current focus on ESG could result in these assets underperforming once the high net capital inflows begin to subside (and other unsustainable effects, such as “greenwashing,” start to wear out).
In line with the above skepticism, Schumpeterian economists argue that society will only transition to become more sustainable if new, more sustainable businesses disrupt incumbents via the dynamics of “creative destruction.”
However, the same Schumpeterian economists have yet to answer the question of how to finance ESG-oriented creative destruction. The problem at the core of the debate is that sustainability-oriented startups face several additional constraints without being able to fully appropriate all the positive externalities from the good that they do. For example, a sustainable fishing startup incurs additional costs by getting certified and faces restrictions on where, when, and how to fish, yet it will not fully benefit from the long-term benefits of healthy oceans.
The example illustrates the core problem of sustainability-oriented creative destruction: it may simply not be profitable in our capitalist society (at least as long as consumers and investors do not show a greater willingness to pay for more sustainable products). Therefore, large-scale government subsidies may be needed to effect sustainable change.
Our recent research addresses the question of how economically attractive it is for entrepreneurs and investors to engage in sustainable venturing. We looked at more than 1,000 crowdfunded projects that sold digital blockchain tokens to fund their sustainable startups. This allowed us to obtain both valuation data during the crowdfunding and performance data after the crowdfunding (because tokens are typically traded in liquid markets). We also developed a machine-learning approach to measure the startups’ ESG properties (which is publicly available via an easy-to-use web app).
Our results reveal a pronounced valuation premium for startups with salient ESG goals. If a startup increases its “ESG-ness” by one standard deviation, it can raise 28% more financing. The result is important insofar as it implies that entrepreneurs have a strong economic incentive to adopt ESG goals in the first place.
Given that sustainable venturing is attractive for the average entrepreneur in our sample, the question is whether it is also financially attractive for investors to finance sustainable startups. The answer is: no.
Our study suggests that the more pronounced a startup’s sustainability orientation, the lower the investor returns after the crowdfunding event. Yet, despite the underperformance of ESG-oriented startups, investors still fund them. In fact, our analyses suggest investors are willing to accept financial losses of 16–31% per standard-deviation increase in sustainability orientation.
Overall, our study paints a relatively optimistic picture. Although sustainable entrepreneurship leads to relative financial losses for investors, investors are willing to accept underperformance to a certain extent and still reward ESG-oriented entrepreneurs with higher valuations, thus incentivizing entrepreneurs to adopt ESG goals. Therefore, assuming startup investors remain willing to pay for ESG, Schumpeterian dynamics of creative destruction may be a key catalyst for our society to transition to a more sustainable one.
Paul Momtaz is a Finance Ph.D. Student at the UCLA Anderson School of Management
Sasan Mansouri is a Ph.D. Student in Economics at Goethe University Frankfurt
This post is adapted from their paper, “Financing Sustainable Entrepreneurship: ESG Measurement, Valuation, and Performance in Token Offerings,” available on SSRN.