Introduction

Sustainable investing strategies typically move capital from brown to green firms by altering financing costs. The authors introduce impact elasticity—a firm’s change in environmental impact in response to changes in its cost of capital. They find that green firms exhibit negligible impact changes, while brown firms become more polluting when financing costs rise, indicating a counterproductive channel in prevailing strategies.

Framework: Impact elasticity

Impact elasticity is measured as the level change in emissions intensity (scope 1 and 2 emissions per unit of output) due to changes in capital costs. Brown firms tend to choose short-term, high-emission projects when financing is constrained, whereas green firms, often in low-emission industries, show minimal change regardless of capital conditions.

Data

The study analyses firm-level data from 2002 to 2020 using S&P Trucost emissions data, Compustat financials, CRSP returns, MSCI ESG ratings, and mutual fund holdings. Firms are grouped into emissions intensity quintiles.

Results

Levels and changes in firm emissions: Brown firms emit 261 times more per dollar of revenue than green firms. Absolute changes in emissions are also far larger among brown firms, while percentage changes—more common in ESG reporting—can be misleading.

Impact elasticity: Brown firms significantly reduce emissions following positive financial shocks, while green firms do not. A 10% return increase leads to an 8-ton reduction per US$1 million revenue in brown firms. Over five years, these effects are even stronger.

• Financial returns: Firm and industry-level returns reveal that brown firms are more responsive to financing changes. Results are consistent across specifications, reinforcing a negative impact elasticity for brown firms.
• Financial distress: Distress indicators (e.g., low interest coverage, Z-score) are associated with 40–75 ton increases in emissions per US$1 million revenue among brown firms. Green firms show no significant response.
• Isolating the financial channel: Three approaches confirm causal effects: changes in implied cost of capital, leverage–productivity interactions, and variation in dividend demand. Brown firms consistently show large negative impact elasticities; green firms do not.
• Robustness to alternative measures:

  • Firm self-reported emissions: Findings hold when using only firm-reported emissions (excluding Trucost estimates). Despite smaller sample sizes, results remain statistically significant, affirming the elasticity gap between brown and green firms.

  • Industry-level emissions: Using EPA-based industry-level data, brown industries show emissions reductions following positive financial performance, while green industries do not, supporting earlier firm-level findings.

  • Cost of capital and investment: Firms cut general capital expenditure when financing costs increase. As green investment often requires new capital, this suggests capital constraints could reduce brown firms’ emissions-related upgrades. For context, green projects represented 15% of global capex from 2016–2019.

Incentive effects of the dominant sustainable investing strategy: Sustainable funds and ESG ratings reward percentage reductions, favouring green firms with little room to improve. Brown firms receive little reward for large absolute emissions cuts, weakening transition incentives.

Sustainability goals and the impact elasticity channel: To meet firm-level and economy-wide goals, capital should support greener brown firms. Current strategies underweight brown sectors entirely, including their most improved firms. This limits substitution of high-emissions output with greener alternatives.

Conclusion

The dominant strategy may unintentionally worsen emissions. Aligning capital with firms that achieve meaningful reductions—especially within brown sectors—would likely improve sustainable investing outcomes.