A “three-stage rocket” analogy to have E&S investing impact

Here’s a note from Alex Edmans:

Tom Gosling and Harald Walkate have developed an excellent “three-stage rocket” analogy to highlight the three steps needed for sustainable investing to have environmental and social impact:

1. The investor’s activity (e.g. engagement, divestment, tilting) must affect companies
2. The compaies must respond to the effect and change their actions
3. The impact of those companies’ actions has a system-wide effect even after second- and third-order effects are taken into account.

For example, for divestment to have impact on oil and gas companies, we would need:

1. Divestment to have a significant effect on the cost of capital. (But it may not, since investors can only sell if others investors buy).
2. The cost of capital has a significant effect on company investment. (But it may not, since oil and gas companies are often flush with cash, and their investment decisions are much more affected by demand and likelihood of regulatory action than the cost of capital. And firms’ perceived cost of capital differs from their actual cost of capital, as research by Niels Joachim Gormsen and Kilian H. shows).
3. Any reduction in oil and gas production persists even after competitors respond. But a reduction in investment by one oil and gas company may be met by a competitor stepping in and expanding investment.

This does not mean all doom and gloom, and that SI can never have any effect. Rather, the framework is useful to evaluate which actions are most likely to be effective – unfortunately, these are not the actions that are typically captured in simple metrics. The authors highlight that most effective is likely to be “limitations-aware engagement” – a phrase they coin, and that I very much like – to describe engagements that have realistic expectations. Convincing companies to abandon profitable business lines is unlikely to succeed, no matter how much of a media splash you make from trying to do so, but influencing within companies’ “zone of discretion”, such as investor action on tailing dam safety in the mining industry, may well do.