Sustainable Finance and

3.1

Transmission Mechanisms to the

Real Economy
Ben Caldecott, Alex Clark, Elizabeth Harnett, Krister Koskelo,
Christian Wilson & Felicia Liu

19th April 2022

Oxford Sustainable Finance Group, Smith School of Enterprise and the Environment, University
of Oxford | Working Paper No. 22-04

ISSN 2732-4214 (Online)

Aligning finance with sustainability is a necessary condition for tackling the environmental and social
challenges facing humanity. It is also necessary for financial institutions and the broader financial system
to manage the risks and capture the opportunities associated with the transition to global environmental
sustainability.

The University of Oxford has world-leading researchers and research capabilities relevant to
understanding these challenges and opportunities. The Oxford Sustainable Finance Group is the focal
point for these activities and is situated in the University's Smith School of Enterprise and the
Environment. The Group is multidisciplinary and works globally across asset classes, finance
professions, and with different parts of the financial system. We are the largest such centre globally
and are working to be the world's best place for research and teaching on sustainable finance and
investment.

The Oxford Sustainable Finance Group is based in one of the world's great universities and the oldest
university in the English-speaking world. We work with leading practitioners from across the
investment chain (including actuaries, asset owners, asset managers, accountants, banks, data
providers, investment consultants, lawyers, ratings agencies, stock exchanges), with firms and their
management, and with experts from a wide range of related subject areas (including finance,
economics, management, geography, data science, anthropology, climate science, law, area studies,
psychology) within the University of Oxford and beyond.

Since our foundation we have made significant and sustained contributions to the field, including in
some of the following areas:

● Developing the concept of "stranded assets", now a core element of the theory and practice of
sustainable finance.
● Contributions to the theory and practice of measuring environmental risks and impacts via new
forms of geospatial data and analysis, including introducing the idea and importance of
"spatial finance" and "asset-level data".
● Shaping the theory and practice of supervision as it relates to sustainability by working with
the Bank of England, the central banks' and supervisors' Network for Greening the Financial
System (NGFS), and the US Commodity Futures Trading Commission (CFTC), among others.
● Working with policymakers to design and implement policies to support sustainable finance,
including through the UK Green Finance Taskforce, UK Green Finance Strategy, the UK's
Presidency of COP26, and the high-level Transition Plan Taskforce.
● Nurturing the expansion of a rigorous academic community internationally by conceiving,
founding, and co-chairing the Global Research Alliance for Sustainable Finance and
Investment (GRASFI), an alliance of 30 global research universities promoting rigorous and
impactful academic research on sustainable finance.

The Global Sustainable Finance Advisory Council that guides our work contains many of the key
individuals and organisations working on sustainable finance. The Oxford Sustainable Finance
Group's founding Director is Dr Ben Caldecott.

2
Acknowledgements

We would like to thank internal and external reviewers who provided many insightful
comments. We would also like to thank the following individuals for providing helpful feedback
and comments, and for their participation in expert interviews: David Bentley, Martin Bernstein,
Ulf Erlandsson, Ilmi Granoff, David Harris, Christopher Kaminker, Wolfgang Kuhn, Matt Scott,
Tim Stumhofer, and Han van der Hoorn. The views expressed in this paper are those of the
authors alone and are not necessarily endorsed by interview participants. Any errors or
omissions are the responsibility of the authors.

Suggested citation

Caldecott, B.L., Clark, A., Harnett, E., Koskelo, K., Wilson, C., & Liu, F. (2022), “Sustainable Finance and
Transmission Mechanisms to the Real Economy”, University of Oxford Smith School of Enterprise and the
Environment Working Paper 22-04

Disclaimer

The views expressed in this paper represent those of the authors and do not necessarily represent those of the
Smith School or other institution or funder. The paper is intended to promote discussion and to provide public access
to results emerging from our research. It may have been submitted for publication in academic journals. It has been
reviewed by at least one internal referee before publication.

The Chancellor, Masters, and Scholars of the University of Oxford make no representations and provide no
warranties in relation to any aspect of this publication, including regarding the advisability of investing in any
particular company or investment fund or other vehicle. While we have obtained information believed to be reliable,
neither the University, nor any of its employees, students, or appointees, shall be liable for any claims or losses of
any nature in connection with information contained in this document, including but not limited to, lost profits or
punitive or consequential damages.
 How Sustainable Finance Creates Impact:
Transmission Mechanisms to the Real Economy
Ben Caldecott, Alex Clark, Elizabeth Harnett, Krister Koskelo, Christian Wilson &
Felicia Liu
Oxford Sustainable Finance Group, Smith School of Enterprise and the Environment, University of Oxford

Abstract
When and how does sustainable finance contribute to a better world? In this paper, we outline
the mechanisms through which impact is transmitted from the financial system to the real
economy. We argue that, in order to have a positive environmental impact, financial institutions
must make a clear and measurable difference in one or more of the following ways: (i) reducing
(increasing) the cost of capital for (un)sustainable activities; (ii) increasing (reducing) access
to capital for (un)sustainable activities; and (iii) encouraging or enabling sustainable practices
by counterparties, such as companies, sovereigns, and individuals. We assess the availability
of impact across key asset classes, hypothesising a maximum potential for impact for each.
We call for financial institutions, and particularly large universal owners, to integrate the
development of “impact budgets” into strategic asset allocation. Future research could usefully
consider the implications for impact-oriented portfolio construction in more detail, as well as
seeking to develop empirical methods for further testing and quantifying the impact of the
different transmission mechanisms discussed here.
Executive Summary

When and how does sustainable finance contribute to a better world? Increasing numbers of
financial institutions are committing themselves to align with international goals, such as net-
zero greenhouse gas emissions by 2050 (or earlier). As sustainability issues rise up political
and social agendas around the world, serious questions remain around the practical role of
sustainable finance1 in supporting the delivery of these goals. Sustainability trends in the
financial sector are increasingly well documented, but the extent to which sustainable finance
and sustainable investments are directly transforming the real economy (notably, firms and
households) remains less clear. This has led to accusations of “greenwashing” and “impact-
washing” (Busch et al., 2021) where real-world impact cannot be convincingly demonstrated.

Within the emerging sustainable finance discourse many actors, including a wide range of
financial institutions, policymakers, regulators, and civil society organisations, have implicitly
or explicitly accepted the view that holding more sustainable assets proportionally equates to
having more of a sustainable impact on the real world. Financial institutions are therefore under
escalating pressure to increase their holdings of sustainable assets quickly enough to align
with environmental thresholds, such as the Paris Agreement. As a result, there is a large and
growing body of emerging regulation, target-setting frameworks and methodologies, and
literature focused on defining what sustainable activities are. Perhaps the most well-known
example of this is the European Union’s sustainable finance taxonomy and associated
regulations, which seek to influence investment flows and ultimately asset stocks, by labelling
assets as either sustainable or unsustainable.

In this paper we argue that definitional debates over “what” is green or sustainable actually
matter less than “how” financial products make the world greener or more sustainable. Building
on a nascent literature exploring how sustainable finance can have “impact”, this paper offers
a more critical exploration of the transmission mechanisms available to financial institutions to
exert real economy impact and examines how these apply differently across key asset classes.
The “transmission mechanisms” examined include the cost of capital faced by firms when
raising finance; access to liquidity, which affects corporate operations, planning and
refinancing, particularly when under financial pressure; and the financial sector’s role in

1
This paper focuses on “green” sustainable finance with goals relating to climate change and the environment,
although the analysis presented here is also applicable to other areas of sustainability.

1
changing corporate practices (Table ES-1). This paper examines five key asset classes: public
equity (i.e. of listed companies), fixed income (e.g. bonds and loans), private equity (i.e. direct
investment in unlisted companies, including venture capital), real assets (e.g. infrastructure
and real estate), and hedge funds.

Table ES-1: Transmission mechanisms through which sustainable finance can

influence the real economy

Mechanism Definition How this can result in real economy impact

Cost of The opportunity cost of Corporate cost of capital affects firms’ ability to
capital similar possible uses for finance capital expenditure. Sustainability
capital resources. In performance can affect the cost of capital where
theory, firms invest in investors seeking impact, or perceiving lower risks in
projects where returns sustainable firms, or both, offer cheaper financing (i.e.
exceed this opportunity lower return requirements) to more sustainable firms
cost. or projects, influencing how capital expenditure is
allocated. These preferences can be expressed in
traditional bond, loan, and equity markets, and in
dedicated markets for sustainable products, including:
A firm’s cost of capital is
the weighted average of ● Sustainability-linked bonds and loans, with
the cost of equity and cost coupons or interest rates tied to the achievement
of debt. of sustainability targets

● Green and sustainable bonds and loans, which

can price debt differently for sustainable versus
unsustainable firms or projects.

Access to The ease and speed at Restrictions on lending to unsustainable projects

liquidity which firms can access can constrain the supply of capital for
funding and working unsustainable activities. This includes both short-
capital. term liquidity from banks and longer-term liquidity from
financial markets associated with the ability to raise
capital from markets, and the cost thereof. Ultimately,
this can drive a wedge between the cost of capital for
sustainable and unsustainable projects and firms.

Firms can access a broader investor base by

participating in green or sustainable bond
markets. Relative to traditional bond markets, a wider
pool of investors can be willing to offer firms funding
for impact-aligned or impact-generating projects or
strategies. This potential widening of the investor base
can be particularly relevant for smaller firms, and/or
those with a limited track record in capital markets.

2
 Changing Influence over corporate Majority shareholders and coalitions of minority
corporate governance and shareholders can directly influence corporate
practices operations. Application of strategy, governance, and organizational
tools, including but not management. They can press firms to adopt more
limited to shareholder sustainable policies and practices, including through:
engagement and voting
rights, to persuade a firm ● Collaborative engagement with the management
to behave differently than of publicly listed firms and private firms
it otherwise would have.
● Filing of shareholder resolutions and proxy
voting requiring firms to adopt more sustainable
policies and practices.

● Signalling effects of publicised engagement

with, and/or divestment from, companies that do
not adequately alter, or commit to altering,
corporate practices.

Creditors without shareholder voting rights can

influence corporate practices through making
lending conditional on the adoption of sustainable
practices and can also engage collaboratively with
company management while negotiating future
funding agreements.

Impact by asset class: For each asset class we rank the potential impact on counterparties,
on a scale from negligible (1) to strong (5). We acknowledge that asset class is only one factor
among others that can ultimately affect impact, including firm size and maturity, and the
structure and type of a given transaction. Our indicative scoring, by asset class and
transmission mechanism in Table ES-2 (assuming an investor in that asset class of a typical
size), suggests that the most high-impact asset class is loans, followed by private equity, and
that the highest-impact mechanism is via firms’ adoption of practices. Public equity is the least
likely to generate impact when considering aggregated potential impact across each
transmission mechanism (although this does not account for different weightings of each
mechanism or the relative size of each asset class).

3
Table ES-2: Transmission mechanism strength by asset class
Fixed Fixed
Public Private Real Hedge
Income Income
equity Equity Assets Funds
(bonds) (loans)
Cost of capital 1 3
2
4
3
5
2
3
2
3
2
4
Access to 1 2 3 2 1 1
liquidity 3 3 5 4 3 4
Adoption of 2 1 3 3 2 1
practices 4 3 5 5 4 4

Scale: 1: negligible 2: limited 3: moderate 4: significant 5: strong

Variance in potential impact reflects the specific characteristics of each asset class. For
instance, in public equities, any given investor’s investment in (divestment from) the publicly
listed shares of green (dirty) companies is not likely to have an impact on the firm’s cost of
capital, as any one stake is typically small, and most listed firms have dispersed, diversified
ownership structures. Meanwhile in lending, where firms are reliant on fewer lenders or even
just one, the interest rate set by the lender can significantly determine the cost of capital that
firm faces.

The paper then sketches out ideal types of the maximum potential impact for investors by
asset class. For instance, an impact-maximising public equity investor would use active
engagement in coalition with other investors, building up to voting against management, or
ultimately divestment. A bond investor or lender would promote the uptake of sustainability-
linked bonds and loans. A private equity fund would impose more sustainable practices at
investee firms.

4
Figure ES-1: Illustrative relationship between asset class impact and risk-return profile

After examining each major asset class separately, the analysis concludes by considering how
financial institutions with multi-asset portfolios could pursue impact in their strategic asset
allocation (SAA), putting forward the notion of an “impact budget” to go alongside traditional
risk budgets. On SAA, asset owners seeking to maximise both impact and risk-return may
want to weight private equity and loans more highly in portfolios (See Figure ES-1).

These findings are relevant to investors seeking to exert impact on the real economy, and
especially for universal owners, large financial institutions who, due to their size and portfolio
composition, effectively “own the economy” and are less able to dampen the impacts of
macroeconomic trends. Further research could consider more detailed implications and seek
to develop empirical methods for testing and quantifying the impact of the different
transmission mechanisms discussed here and the relationships between them.

5
1. Introduction
When and how does sustainable finance contribute to a better world? Increasing numbers of
financial institutions are committing themselves to align with international goals, such as net-
zero greenhouse gas emissions by 2050 (or earlier). As sustainability issues rise up political
and social agendas around the world, serious questions remain around the practical role of
sustainable finance2 in supporting the delivery of these goals. Sustainability trends in the
financial sector are increasingly well documented, but the extent to which sustainable finance
and sustainable investments are directly transforming the real economy (notably, firms and
households) remains less clear. This has led to accusations of “greenwashing” and “impact-
washing” (Busch et al., 2021) where real-world impact cannot be convincingly demonstrated.

The concurrent rapid growth in sustainable finance instruments and investment strategies
reflects two separate trends: growing recognition by financial institutions that sustainability
risks, such as climate change, can affect financial returns, financial stability, and
creditworthiness of firms; and growing desire for “impact”, with stakeholders ranging from retail
investors to large institutional asset owners looking to make positive contributions to
sustainability goals through their investment decisions. A 2020 survey of large banks found
investor demand for sustainable products to be a major driver for integrating environmental,
social and governance (ESG) considerations into lending practices (OECD, 2020). In a 2019
survey of credit risk analysts that also cited investor demand, over 80% of respondents saw
ESG considerations as a central component of risk analysis. The European Systemic Risk
Board (2020) found that financial markets’ failure to fully price climate-related risks exposed
investors in high-emitting firms to significant losses from credit downgrade events.

In this paper, we contribute to addressing a gap in the sustainable finance literature by

exploring the “transmission mechanisms” through which finance can influence the real
economy, focusing on the role of investments. In doing so, we generate a set of hypotheses
for the “potential impact” that investments in major asset classes can have, drawing
implications for manager selection, strategic asset allocation, and universal ownership.

We critique the assumption that simply holding green assets is sufficient to contribute to
positive environmental outcomes. While definitional debates over “what” is green are

2
This paper focuses on “green” sustainable finance with goals relating to climate change and the environment,
although the analysis presented here is also applicable to other areas of sustainability.

6
important, we argue that this should not be the main source of contention if sustainable finance
is to support sustainable outcomes. What counts is “how” financial products make the world
greener. Without this criterion, investors cannot have confidence that their assets and
investments are making an impact and cannot reliably distinguish between genuinely
sustainable finance and greenwashing.

Busch et al. (2021) called for a “re-orientation of what impact investments are”, and we answer
this call through an asset class-specific typology of financial transmission mechanisms
whereby investor action generates a change in the real economy. Ultimately, we argue that
the real economy impact of sustainable finance should be judged on two broad criteria. First,
the financial product or investment approach should be encouraging sustainable activity,
and/or discouraging unsustainable activity. Second, it should make a clear and measurable
difference in one or more of the following ways: (i) reduce (increase) the cost of capital for
(un)sustainable activities; (ii) increase (reduce) access to capital for (un)sustainable activities;
(iii) encourage or enable sustainable practices by firms.

We begin by summarising current debates (Section 2), then outline transmission mechanisms
for investments from the financial to the real economy and their application to sustainable
finance (Section 3) as the basis for assessing the theoretical impact of sustainable investing
by asset class (Section 4) and positing ideal-type “impactful” sustainable finance strategies for
each (Section 5). Section 6 evaluates the implications for portfolios and strategic asset
allocation, and Section 7 concludes.

7
2. Literature Review: Sustainable Finance and Real Economy
Impact
Our paper builds on a nascent literature linking the real economy impact in investments to
sustainable finance, in which “impact” is not yet a well-defined concept (Busch et al., 2021;
Nicholls and Daggers, 2016). Authors from academia, public policy and finance have different
understandings of the means, motivations and outcomes of impact in this context. This has
been exacerbated by blurred distinctions between “sustainable finance” and “impact
investment”.

The “impact investment” market is estimated at US$502 billion by the most prominent network
in the field (Global Impact Investing Network, 2020). Meanwhile, the amount of assets
managed sustainably stood at US$30.7 trillion at the start of 2018 by a broad definition (Global
Sustainable Investment Alliance, 2019). Naturally, this raises questions regarding what counts
as impact investment, and whether sustainable finance ex-”impact” is really sustainable. Whilst
several classification typologies highlight impact investment as a distinctive sustainable
investment approach (O’Donohoe et al., 2010), it is often ill-distinguished from the broader
categories of socially responsible investment and/or ESG3 approaches. For example, the
Global Sustainable Investment Alliance (2019, p. 3) describes the impact investment market
as “a small but vibrant segment of the broader sustainable and responsible investing universe”.

To further distinguish impact investment from other sustainable investing strategies, Busch et
al. (2021) provide a useful framing of the evolution of sustainable finance, arguing that impact
investing and the shift towards consideration of investment outcomes and portfolio alignment
with sustainability goals can be viewed as “Sustainable Finance 3.0” (where “1.0” centred
around value-driven socially responsible investment, and “2.0” saw mainstreaming into
financial markets through ESG-based approaches to sustainable value creation). Broadly, the
literature agrees that impact investment requires focussing on the social and/or environmental
outcomes of investments, rather than solely on financial performance (Brest and Born, 2013;
Freireich and Fulton, 2009). Busch et al. (2021) go further, suggesting there should be
differentiation between impact-aligned investments and impact-generating investments. While
for impact-aligned investments, environmental and/or social outcomes can be claimed post
hoc (i.e. already-realized outputs measured against sector benchmarks, or degree of

3
ESG refers to the integration of environmental, social and/or governance factors in investment decision making
and is often used synonymously with the term “responsible investment”. See: Principles for Responsible Investment.

8
alignment with impact goals), impact-generating investments require that further impact be
achieved as a result of the investment.

Two remaining issues are particularly thorny topics of discussion in defining impact:
intentionality and additionality (Brest and Born, 2013; Findlay and Moran, 2019). Here we
address intentionality, arguing that financial institutions should be more rigorous in articulating
and documenting their theory of change for creating real economy impact. We do not explore
the concept of additionality (i.e. whether or not impact-aligned investments, and any further
impact that results, would have occurred anyway). Ideally, sustainable finance products and
funds should aim to generate (and measure) additional impact. But here we are content with
identifying criteria for demonstrating that a sustainable finance product, fund or investment
approach is actually having a positive impact, not whether that impact would have happened
anyway given a counterfactual baseline. The establishment of baselines for assessing impact
is also an important discussion, related to additionality (Gillenwater, 2012), but is beyond the
scope of this paper.

In summary, impact literature to date has focused on definitional issues and identifying
potential impact outcomes. Brest and Born (2013), for example, outline six kinds of capital
benefit that impact investors can provide. Here, we are more interested in “how” this real
economy change occurs. Busch et al. (2021) outline three mechanisms through which
sustainable finance can achieve impact (providing additional capital allowing firms or projects
to generate social/environmental impact; investing in companies with forward-looking targets
for impact generation; or prompting firms to change through engagement and voting rights). In
their review of channels for investor impact, Kölbel et al. (2020) identify shareholder
engagement, capital allocation and indirect impact, finding that the first is well supported in the
literature, the second “only partially”, and that claims of indirect impact currently “lack empirical
support”. Building on these foundations, we conduct an extended exploration of the
transmission mechanisms available to financial institutions to have real economy impact, and
seek to assess their relative potential impact through the lens of different asset classes. We
then offer recommendations for how this can influence manager selection and strategic asset
allocation.

From this grounding, we can begin to assess claims of sustainability outcomes made by
existing sustainable finance products and strategies against evidence of these outcomes.
Without rigorous evaluation, the risk of “impact-washing” will likely continue unabated. Impact-

9
washing refers to the use of the term “impact” and/or “sustainable” as a marketing tool to attract
capital or boost reputations without providing material solutions to environmental and/or
societal challenges (Busch et al., 2021). This can dilute the reputation and contribution of
sustainable finance to these challenges (Findlay and Moran, 2019; Harji & Jackson, 2012).

How, therefore, do investors who want to label their products as contributing to sustainable
goals actually make—and demonstrate—positive contributions to real-world changes?
Prevailing discourse and policymaking on green finance, for example, implicitly assumes that
holding assets defined as environmentally sustainable is sufficient to be sustainable. This view
is fundamental to the European Commission’s current approach (see Kahlenborn et al., 2017),
evident in the sustainable finance taxonomy proposed by the High-Level Expert Group on
Sustainable Finance (2020) and the EU Sustainable Finance Action Plan, as well as
collaborative efforts like the Science-based Targets Initiative (SBTi).

However, there is insufficient evidence that rebalancing a portfolio to hold a greater proportion
of green assets necessarily has any real economy impact. Most green assets are acquired
through secondary trading and are (at best) impact-aligned rather than impact-generating: any
impact (e.g. emissions reductions) has already been achieved. Further, divesting from high-
emitting or otherwise misaligned companies has been shown to have limited impact on real
economy emissions due to emissions “leakage” as alternative capital sources step in (Ansar
et al. 2013; Hunt and Weber, 2019). If we define impact as “the change that investor activities
achieve in company impact” (Kölbel et al., 2020), simply holding green assets, or not holding
brown assets, does not automatically imply any influence over the underlying companies’
activities. More to the point, there is no robust evidence that aligning a portfolio with a given
vision for the wider economy (e.g. Paris alignment, the EU sustainable finance taxonomy) or
according to a general set of principles (e.g. recommendations of the Task Force for Climate-
Related Financial Disclosures (TCFD)) is a compelling proxy for the real economy changes
required to deliver that vision.

Addressing the potential for impact-washing is a major priority for governments and regulators
– see, for instance, the UK government’s Roadmap to Sustainable Investing (2021); and more
recent guidance from by the UK’s Financial Conduct Authority (2021) introducing TCFD-
aligned disclosure requirements for asset managers and asset owners, and broadening the
pool of listed issuers subject to TCFD-aligned listing requirements. In general, however, the
approach endorsed by the EU taxonomy and implicit in most existing regulatory frameworks

10
does little to acknowledge the critical difference between portfolio alignment and the real
economy changes that must be made to meet impact targets. Taxonomy-based approaches
do not require investors to take responsibility for deciding what qualifies as “green”, nor do
they classify financial products to reflect the merits of the real economy activity underlying
them. “Climate alignment” of financial portfolios can be subject to many of the same limitations,
but should not be confused with impact-based strategies. Aligning an individual portfolio with
climate-related goals does not necessarily require an institution to have any real economy
impact. This does not make alignment incompatible with impact but does mean that not all
alignment strategies are created equal. An alignment strategy consisting of an aspirational “net
zero portfolio” objective that does not substantively alter decision-making processes, differs
markedly from “impact-oriented climate alignment” which focuses “decision-making on
facilitating rapid, real economy decarbonization” in line with specific time-bound climate targets
(RMI, 2022). While regulatory guidance on alignment claims will likely continue improving,
buyers of financial products still largely lack the means to assess whether an institution’s
alignment commitment is driving any real economy impact, or is simply a tool to avoid taking
short-term action. This paper seeks to accelerate consideration of these potential pitfalls for
sustainable finance-focused actors and offers a framework for defining real economy impact
more robustly.

11
3. Transmission Mechanisms for Real Economy Impact

We posit that impact is achieved only when a sustainable investment reaches the real
economy4 through at least one of three “transmission mechanisms”: the cost of capital faced
by firms when raising finance; firms’ access to liquidity, which affects corporate operations,
planning and refinancing, particularly when under pressure; and investors’ influence over
corporate management and practices. These three mechanisms are interlinked, and the nature
of the impact that results depends at least partly on these linkages. Exerting pressure on firms
through these channels may also improve or inhibit their ability to manage and mitigate risk;
and generate broader spill-over effects which in turn can trigger systemic feedbacks.

These three transmission mechanisms and their applications to sustainable investment are
described below and summarised in Table 1.

Table 1: Summary of transmission mechanisms through which sustainable finance can

influence the real economy

Mechanism Definition How this can result in real economy impact

Cost of The opportunity cost of Corporate cost of capital affects firms’ ability to
capital similar possible uses for finance capital expenditure. Sustainability
capital resources. In theory, performance can affect the cost of capital where
firms invest in projects where investors seeking impact, or perceiving lower risks
returns exceed this in sustainable firms, or both, offer cheaper financing
opportunity cost. (i.e. lower return requirements) to more sustainable
firms or projects, influencing how capital
expenditure is allocated. These preferences can be
expressed in traditional bond, loan, and equity
A firm’s cost of capital is the markets, and in dedicated markets for sustainable
weighted average of the cost products, including:
of equity, and cost of debt.
● Sustainability-linked bonds and loans, with
interest rates tied to the achievement of
sustainability targets.

● Green and sustainable bonds and loans, which

can price debt differently for sustainable versus
unsustainable firms or projects.

4
Although we focus on firms as a proxy for the real economy, the same logics could also apply to households,
governments etc.

12
Access to The ease and speed at which Restrictions on lending to unsustainable
liquidity firms can access funding and projects, can constrain the supply of capital for
working capital. unsustainable activities. This includes both short-
term liquidity from banks and longer-term liquidity
from financial markets associated with the ability to
raise capital from markets, and the cost thereof.
Ultimately, this can drive a wedge between the cost
of capital for sustainable and unsustainable projects
and firms.

Firms can access a broader investor base by

participating in green or sustainable bond
markets. Relative to traditional bond markets, a
wider pool of investors can be willing to offer firms
funding for impact-aligned or impact-generating
projects or strategies. This potential widening of the
investor base can be particularly relevant for
smaller firms, and/or those with a limited track
record in capital markets.

Changing Influence over corporate Majority shareholders and coalitions of minority

corporate governance and operations. shareholders can directly influence corporate
practices Application of tools, including strategy, governance, and organizational
but not limited to shareholder management. They can press firms to adopt more
engagement and voting sustainable policies and practices, including
rights, to persuade a firm to through:
behave differently than it
otherwise would have. ● Collaborative engagement with the
management of publicly listed firms and private
firms.

● Filing of shareholder resolutions and proxy

voting requiring firms to adopt more
sustainable policies and practices.

● Signalling effects of publicised engagement

with, and/or divestment from, companies that
do not adequately alter, or commit to altering,
corporate practices.

Creditors without shareholder voting rights can

influence corporate practices through making
lending conditional on the adoption of sustainable
practices and can also engage collaboratively with
company management while negotiating future
funding agreements.

13
3.1 Cost of Capital

The cost of capital, composed of cost of equity and debt capital, is influenced by a variety of
macroeconomic variables, including central bank interest rates, inflation, the business cycle,
and borrowers’ creditworthiness (Elton, 1994). It can also be driven by factors such as
secondary market liquidity, which has been shown to affect the cost (yield spread) of new bond
issuance (Chen et al., 2007; Goldstein et al., 2019) and the cost (fees) of new equity issuance
(Butler et al., 2005). The cost of capital can be calculated at project- and corporate-level. In
the latter case, the most common approach is the capital asset pricing model (Brotherson et
al., 2013; Brounen et al., 2004; Graham & Harvey, 2001).

Evidence shows a clear negative correlation between the implied cost of equity capital and
corporate investment (with higher equity costs associated with lower investment, consistent
with theory), but not for the cost of equity calculated according to factor-based approaches like
the capital asset pricing model (Murray and Shen, 2016; Byoun, Ng, and Wi, 2015). For the
cost of debt, there is clear evidence both at the firm level and the macro-level that corporate
investment is negatively correlated with the cost of debt capital (Gilchrist and Zakrajsek, 2007,
2012; Murray and Shen, 2016; Lin et al., 2018). Emerging evidence suggests that the overall
sensitivity of firm investment to the cost of capital is lower under conditions of greater economic
policy uncertainty, especially for smaller and unrated firms, and for those operating in less
transparent countries (Drobetz et al, 2018). However, for large, listed companies, ordinary
fluctuations in the equity cost of capital (via stock prices) are less likely to directly affect short-
term investment activity (Blanchard et al., 1993). Smaller, younger firms, unlisted firms, or
those in less-developed financial markets, are more likely to be affected by external financing
costs (Kölbel et al., 2020). Firms, particularly large ones, can also use internal finance (retained
earnings) to finance projects with little or no exposure to external funding costs (Allen and
Gale, 2000). Listed firms generally have enough cashflow and cash reserves to be largely self-
financing if required, such that the cost of (external) capital matters less to them (Kay, 2015).

There are indications that corporations’ cost of capital is being affected by their sustainability
performance, though this varies across asset classes. Zhou et al. (2021) show divergence in
the cost of capital between renewable and high-carbon energy companies. Evidence collated
in the same publication finds that ESG and CSR ratings that incorporate environmental
performance measures are associated with a lower cost of equity (Drobetz et al., 2018) and
cost of debt (Ge and Liu, 2015), as well as lower credit default risks (Kiesel and Lücke, 2020).
Similar associations have emerged for the cost of capital and carbon emissions (Chen and

14
Silva Gao, 2012; Kleimeier and Viehs, 2016) and may become more widespread and
pronounced as government and investor climate policies tighten. For instance, some financial
institutions now require a hurdle rate for new coal projects of 40%, up from 16% for recently
completed coal projects, and compared to 10% for wind or solar (Fattouh, 2019).

Recent survey evidence (Alessi, 2019) suggests that some investors are explicitly willing to
accept a lower remuneration for investments that are linked to more sustainable economic
activities. The advent and growth of sustainability-linked loans/bonds, where the
interest/coupon rate that banks/investors charge is tied to reaching pre-agreed thresholds on
sustainability metrics, are the clearest examples to date; and while the market for these is still
small and nascent, it is growing rapidly (Linklaters, 2019; Environmental Finance, 2022, p.28).

Green and sustainable bond issuance represented 11% of total bond issuance in 2021,
increased by 64% from 2020 to reach $992 billion in 2021, and is estimated to reach $1.35
trillion (and 15% of all issuance) in 2022 (Moody’s, 2022). The use of green and sustainable
bonds allows for financing of balance sheets with guarantees of “use of proceeds” and
mandatory impact reporting mechanisms. Evidence that these attributes lower cost of capital
for the activities being financed is mixed and context-specific (Brennan and MacLean, 2018;
Shishlov et al., 2016). Tang and Zhang (2020), for instance, find in a global study that although
stock prices rise in response to green bond issuance, this rise is not driven entirely by changes
in the cost of debt. Recent analysis of China’s green bond market provides strong evidence
that green bond issuance not only lowers corporate cost of debt, but is also associated with a
lower overall cost of capital for issuers (Zhang, Li and Liu, 2021). Leaving aside debates on
additionality, some studies show no difference in yield compared to conventional bonds
(OECD, 2017); others show a modest negative premium in the order of two basis points
(0.02%), giving issuers a marginally lower cost of capital (Zerbib, 2019). It is unclear whether
green bonds are less exposed to market conditions, although they can be used to refinance
impact-aligned projects favourably as green bond demand rises.

3.2 Access to Liquidity

Without access to liquidity, working capital, and funding, managing cashflow is more difficult,
and longer-term projects and investments will be disincentivised (Bencivenga et al., 1995).
The presence of investors and banks willing to provide liquidity allows firms to access capital
to grow and invest and adapt to changing circumstances. While the most direct channel for
liquidity to influence corporate activity is through primary issuance and short-term borrowing,

15
it is also important to recognise the importance of liquidity in secondary market trading in many
contexts, including its effects on corporate cost of capital (Chen et al., 2007; Goldstein et al.,
2019), its wider impact on the functioning of financial markets (Bruche and Segura, 2017), and
the benefits of sustainable products, such as green bonds, having become more liquid (Febi
et al., 2018). There is some evidence that secondary market liquidity affects the rate of
issuance, at least at a country level. In bond markets, changes in trading liquidity and pricing
can affect the amount and timing of further issuance (Arseneau, 2015; Hanselaar et al., 2019).

For access to liquidity to be an effective transmission channel from a sustainability perspective,

sustainable firms or projects would need to have greater or easier access to capital than their
unsustainable peers. Financial institutions’ lending policies are critical in driving this wedge
between the availability, hence cost, of capital for sustainable and unsustainable projects.
There is some emerging evidence supporting this conjecture in the case of oil and gas
divestment, where greater divestment pledges in a country have been associated with lower
domestic capital flows to oil and gas in that country, although this does not discount the
possibility of capital leakage into other jurisdictions (Cojoianu et al., 2020). Anecdotal evidence
suggests a similar pattern in coal power and mining, with a lack of liquidity directly slowing the
expansion of coal activity in Indonesia as the number of banks willing to back new coal projects
declines (IEEFA, 2019). At a more macro level, major stock exchanges (e.g. (Hong Kong Stock
Exchange, 2021; London Stock Exchange, 2020)) have implemented mandatory ESG
screening and/or green economy markers, which place some limits on access to liquidity to
firms that cannot demonstrate a minimum level of sustainability (Grabski and Miller, 2019).
Despite banks’ crucial role as the main providers of short-term liquidity to the real economy in
terms of working capital loans and rolling credit facilities, only a few US, European, and
international banks moved to actually cut off or limit access to capital for unsustainable firms.
Where they have, these policies have been applied only for select examples of notably climate-
misaligned projects with high reputational risks, such as coal, tar sands or Arctic oil exploration
(BankTrack, 2020). Beyond these cases, rather than directly limiting the amount of liquidity
available through negative screening, banks have so far moved primarily to tie sustainability
to pricing, e.g. through sustainability-linked loans.

In fixed income markets, primary issuance is much more frequent than in equity markets, with
large firms regularly rolling over and refinancing debt structures as market conditions change.
At present, fixed income funds channel a large proportion of capital flows through primary
markets into fossil fuel industries, including 14% of capital flows from the largest US Exchange

16
Traded Funds (ETFs) (Wilson and Caldecott, 2021). Large firms typically require ongoing
access to liquidity at favourable rates. If and when investors make their willingness to
participate in purchasing further issues conditional on sustainability criteria, this can have a
sizeable impact relatively quickly, particularly where the decision influences other investors’
behaviour. Since ease of access to finance is partly a function of the breadth and diversity of
a firm’s investor base, green bond issuers can not only (sometimes) benefit from tighter
spreads, but also, improved market access. Surveys of market participants have pointed to
the importance of access to capital as a motivation for issuing green bonds (Maltais and
Nykvist, 2020), and analyses of green bond issuance suggest that the label does indeed
facilitate access to a wider pool of investors than would otherwise be the case (Climate Bonds
Initiative, 2017, 2020). Anecdotally, market participants point to an additional benefit: they
argue green bond issuers are able to access capital through this broader investor base more
easily even during periods of market turmoil, thus insulating them to an extent against volatility
and uncertainty, for instance in Italy in 2018 (Martin, 2019) or in Asia in spring 2020 (Xu, 2020).5
A route for impact-misaligned issuers unwilling or unable to tap green bond markets is the use
of “transition bonds”, which require issuers to take concrete strategic action towards
sustainable outcomes6.

3.3 Changing Corporate Practices

Shareholders’ right to have a say in company management is as old as the development of

modern joint-stock companies themselves, from the 17th century onwards (Ferguson, 2008).
After a post-WWII lull, institutional shareholders started taking more interest in corporate
governance issues from the 1980s as their proportion of ownership in publicly listed firms grew;
institutional investor ownership share of US equities, for example, rose from 16% in 1965, to
47% by 1987 and then to 80% in 2017 (Cheffins, 2013; McGrath, 2017).

While divestment has a long history as a means for shareholders to express their views on
corporate activity (Chow, 2010), the notion of shareholder pressure for “good”, and the term
“engagement” itself, traces to the more recent idea of corporate social responsibility (CSR)
which became a mainstream concept in the 1990s and early 2000s (O’Rourke, 2003).

5
In addition, several market participants consulted for feedback on drafts of this paper independently emphasised
that it was easier to issue green over conventional bonds at times of market instability.
6
In the climate context, this may take at least two forms: (i) allowing a firm to continue the formation of high-carbon
capital (e.g. gas plants) providing headroom to manoeuvre into a stronger strategic position; (ii) financing the
formation of fixed capital assets necessary for decarbonisation (e.g. production of cement and steel for low-carbon
infrastructure).

17
Engagement has been recognised by institutional investors as a more effective transmission
mechanism than divestment, as it allows investors to retain influence over corporate climate
policies (Krueger, Sautner, and Starks, 2020). The ability of investors to encourage and
pressure companies to adopt sustainable practices is a transmission mechanism with
significant empirical support in the literature, although the strength and nature of the
relationship are highly context-specific (Bauer, Derwall and Tissen, 2019; Dimson et al., 2015
Gifford, 2010; Horster and Papadopoulos 2019). Traditionally, investor engagements with
firms have overwhelmingly involved equity holders pressing company management for
improved performance on sustainability issues and disclosure of sustainability policies through
the formal procedures of filing resolutions and voting on them (Goronova and Ryan, 2014).
Analysis of sustainability-related shareholder proposals requests from 1999-2017 shows they
enjoy success rates ranging from 18-60% (Kölbel et al., 2020), though it is worth noting that
with compliance cost being a key determinant factor of success alongside investor influence
and company ESG experience, environment-related issues have a comparatively lower
success rate than social and governance issues due to their high cost burden (Dimson et al.,
2015). Shareholder proposals have also been empirically linked to subsequent increases in
the ESG ratings of the targeted firms (Barko, 2017; Dyck et al., 2019). Flammer, Toffel and
Viswanathan (2021) found the filing of a shareholder proposal in itself signals investors’
concerns to managers and could subsequently lead to changes in corporate climate risk
disclosure. In the 2021 shareholder voting season, major proponents have been observed
withdrawing proposals, but only under the condition that firms acquiesce to shareholders’
demands, such as the implementation of net zero commitment and strategies, green energy
use, and production goals (Treviño et al., 2021). This does not necessarily imply changes in
how investment is deployed, although Bauer, Derwall and Tissen’s 2022 study evidenced that
proposal withdrawals have led to an improvement in targeted firms’ environmental
performance compared to non-targeted firms.

Filing formal public proposals and engaging privately with a company are not mutually
exclusive strategies. In fact, asset managers such as BMO and Legal and General have been
adopting “escalation” strategies, where tactics become increasingly severe as investee firms
fail to respond to investor demands, with divestment being the ultimate consequence of
inadequate responses. Collaboration amongst minority shareholders on sustainability-related
engagement is also on the rise. Since individual institutional investors rarely own majority
holdings in publicly listed firms, collaboration is a particularly important strategy for building
coalitions of investors with a substantial minority or majority holding to exert pressure to

18
change corporate behaviour (Dimson et al., 2015). Activist hedge funds have used
confrontational versions of this approach to target firms with high environmental impact, with
a notable example being Engine No. 1’s vote targeting Exxon Mobil’s board composition. There
are early signs of this disruptive model of driving corporate change being scaled up (Lipton,
2021).

The bulk of investor engagement has focussed on public equity shareholders. Investors in
other asset classes, including bonds, private equity and real assets, also hold leverage over
corporate practices. Although bondholders do not have voting rights, they do (as capital
providers) have direct access to company management through roadshows, at debt issuance,
and in collaborating on their engagement strategies with other bondholders (World Bank,
2018). Bondholder engagement can be particularly effective where it is strategically timed to
coincide with key points in a company’s business cycle where it seeks to tap debt markets, for
instance, in withholding expected refinancing (UNPRI, 2018; World Bank, 2018). In a 2019
survey by Russell Investments, 89% of surveyed asset managers with equity and bond
offerings, and 71% with bond-only offerings, claim they often or always discuss ESG topics
when speaking with investee companies, suggesting it is now a mainstream strategic tool for
influencing corporate practices across debt and equity alike (Phillips, 2020).

In the private equity world, general partner funds tend to hold controlling or significant minority
shares for defined ownership periods, which affords them significant leverage in driving change
in investee companies. This potential is increasingly, albeit gradually, being realised by private
equity funds. A recent PwC survey finds that 56% of surveyed funds engage the executive
board on ESG issues more than once a year (PwC, 2021).

Beyond public equity, potential investors can therefore engage with companies before they
commit funds, making adoption of sustainable practices a condition of their investment. Whilst
they are a creditor of, or hold a stake in, the company, they can encourage change by playing
a stewardship function to improve the governance and practices of the company. Further
research is, however, needed to study the relative effectiveness of different configurations of
engagement strategies, especially in determining the effectiveness of collaborative
engagement involving investors of different sizes and different asset classes, deploying a
range of engagement strategies. As our conceptualisation of what “engagement” entails
broadens, there is a further need to establish a comprehensive and rigorous methodology to
track the impact of engagement.

19
3.4 Interlinkages between Transmission Mechanisms and Firms

We recognise that these transmission mechanisms are not separate and independent, but
rather closely linked to one another in overlapping and interdependent ways, such that
changes in one can influence or simply be correlated with the other, depending on a firm’s
unique circumstances (see Figure 1). For instance, firms with easier access to liquidity from a
wide pool of investors are also more likely to face a lower cost of capital and to have corporate
practices acceptable to the market, whereas firms with lower access to liquidity (e.g. due to
reliance on a small or shrinking pool of investors), are also likely to face a higher cost of capital
from those investors who are still willing to lend. Investors’ unwillingness to lend, or demands
for greater returns, may in turn reflect unsustainable corporate practices, or a failure to change
these practices as a result of prior engagement from financial institutions. Meanwhile, through
instruments such as sustainability-linked loans and bonds, direct links also exist between
corporate practices and cost of capital; these instruments “reward” good practices with a lower
cost of capital or “punish” for non-achievement of targets with a higher cost of capital. All of
these processes affect the risk environment faced by the firm, hence also affecting its decision-
making. Where the firm’s decisions or the preferences of its investors generate spill-over
effects on the wider universe of firms, investors and regulators, this in turn may trigger actions
that feed back into investor preferences and the firm’s risk environment, driving further change
(e.g. where investors choose to collaborate following the success of a particular engagement
campaign, or where a firm’s impact-focused activities generate positive externalities for other
firms, or inspire regulatory changes).

20
Figure 1: Transmission Mechanism Interdependencies: A Firm Perspective

21
 4. Potential for Impact Across Asset Classes

Building on the mechanisms discussed, in this section we discuss the theoretical impact that
an individual investor in a particular asset class can have through each mechanism. This first-
principles assessment can help financial institutions better understand their current impact,
and devise allocation strategies across complex portfolios that can maximise the effectiveness
of their impact strategies going forward. To do this, we analyse five key asset classes: public
equity (i.e. of listed companies), fixed income (bonds and loans), private equity (direct
investment in unlisted companies, including venture capital), and real assets (infrastructure
and real estate). These asset class universes vary quite significantly in size and this should be
taken into account when designing a high-impact strategy. At the end of 2020, total bond
markets outstanding totalled approximately US$124tn, with the largest national market being
the US, followed by the EU, Japan, and the UK. Global stock market capitalisation totalled
$105.8tn (SIFMA, 2021). Private equity assets under management are an order of magnitude
smaller, standing at approximately US$7.4tn globally, and the value of real estate and
infrastructure assets owned by investors through funds is estimated at just under US$2.0tn
(McKinsey and Co, 2021).

We differentiate here between active and passive public equity strategies, as they lead to a
different relationship with firms, which can alter potential impact and available transmission
mechanisms, and we treat fixed income loans and bonds separately. We also analyse the role
of hedge funds as actors, given their unique role in the financial system, even though they can
and do trade in multiple asset classes.

In Table 2 we present an indicative ranking, by asset class and transmission mechanism, of

the potential impact an individual financial institution may theoretically have. On our scale of 1
to 5, 1 is “negligible impact” and 5 is “strong impact”. Table 2 provides an overview of the
criteria used. In designating a score, we considered the potential, likelihood, magnitude and
persistence of real economy impact. Expert interviews were conducted to calibrate our
qualitative assessments and validate our assumptions. Table 3 outlines the results, using
deeper shades of green to denote greater potential impact7 for additional clarity. We recognise

7
Progressively lighter shades of green represent high impact scores (3 – 5), medium impact (2-3), and low impact
(1-2).

22
that the impact actually realised also depends on several other important factors, including the
type and size of the investing financial institution, willingness of the company to engage, and
policies and regulatory structures in local jurisdictions. Where relevant, we allocate a range for
potential impact where specific examples of impact variation within the asset class exist.

Table 2: Potential impact rating marksheet

Rating Descriptor Example

1 Negligible: A single investor with a minority share in a listed

● Potential for impact: low to none company is unlikely to have any significant
● Likelihood of impact: low to none effect on the firm’s cost of capital by simply
● Magnitude of impact: small to none divesting its position without coordinating with
● Persistence of impact: limited, if any other investors.

2 Limited: Hedge funds operate mostly in secondary

● Potential: possible markets. They are unlikely to significantly
● Likelihood: low impact a firm’s ability to access liquidity through
● Magnitude: small primary bond issuance or bank loans.
● Persistence: weak Exceptions apply for severely distressed firms,
and specialist distressed debt funds.

3 Moderate: Private equity funds can arrange better access

● Potential: yes to liquidity to firms they control, for instance,
● Likelihood: medium through debt facilities with private debt
● Magnitude: moderate investors or through connections to a greater
● Persistence: variable breadth of banks than would be accessible to a
typical small or medium-sized enterprise.

4 Significant: Active public equity investors can generate

● Potential: yes significant change in corporate behaviour in
● Likelihood: high firms where they are large shareholders and
● Magnitude: medium vocal about the strategy informing their actions,
● Persistence: strong especially in coordination with other
investors.

5 Strong: Private equity investments resulting in a

● Potential: yes controlling share in the company or asset have
● Likelihood: high a strong impact on investee/acquired firms’
● Magnitude: large adoption of sustainable practices, as the private
● Persistence: strong equity owner can simply dictate them.

23
Table 3: Potential Impact Rating Scorecard

Fixed Fixed
Public Private Real Hedge
Income Income
equity Equity Assets Funds
(bonds) (loans)
Cost of capital 1 3
2
4
3
5
2
3
2
3
2
4
Access to 1 2 3 2 1 1
liquidity 3 3 5 4 3 4
Adoption of 2 1 3 3 2 1
practices 4 3 5 5 4 4

Our scoring results, visualised by asset class and transmission mechanism in Figure 2,
suggest that the most high-impact asset class is loans followed by private equity, and that the
highest-impact mechanism is via firms’ adoption of practices. Public equity is the least likely to
generate impact when considering aggregated potential impact across each transmission
mechanism, although this does not account for different weighting of each mechanism, which
could be addressed in further work.

Figure 2: Potential Impact by Asset Class and Transmission Mechanism

24
Next, we detail our justification for the potential impact for each transmission mechanism
against this scorecard, before outlining an “ideal type” of investor seeking to maximise impact
in each asset class in Section 5, and discussing the implications and limitations of these
findings on impact-conscious strategic asset allocation in Section 6.

It should be noted that in commenting on the potential impact across asset classes, we are
assuming that the financial institution in question is of average size and influence, and
operating in a realistic, fairly competitive market environment. Potential for impact would be
enhanced in an oligopolistic or monopolistic financial market as financial institutions would
have greater leverage in the market. Further, through our focus on asset classes, we are
agnostic on the role of geography and sector in determining the impact of financial products.
However, when considering impact-oriented tactical and strategic asset allocation, it is likely
that investing in emerging markets and encouraging transition in heavily polluting sectors could
generate important impact, though this will depend on the sustainable priorities and desired
outcomes of individual investors and financial institutions. Exploring these dynamics is out of
scope for this paper but could usefully be addressed in future research.

4.1 Cost of Capital

● Negligible to moderate (1-3) impact from public equities. Any single investor’s investment
in (divestment from) the publicly listed shares of green (dirty) companies is not likely to
have an impact on the firm’s cost of capital unless it holds (or would hold) a significant
proportion of the firm’s shares when it takes the decision. There is little to no potential for
impact in most cases because a typical investor’s stake is small, and most firms have
dispersed, diversified, ownership structures. The magnitude of impact of any given
investor’s actions when acting alone is very minor, potentially small enough to be lost amid
the “noisiness” of public equity pricing signals, which are influenced as much on shorter
timescales by market sentiment and shorter-term trading arbitrage as by company
fundamentals. Moderate impact could occur in cases where there is a strong market signal
conveyed by a group of investors (e.g. blacklisting), or when ownership is concentrated
such that equity trading directly affects the terms of capital, such as during an IPO or
around the time of new equity issuance. Passive investors following widely-used indices
are unlikely to affect the cost of capital, though large investors following their own indices,
and index providers, exert control over the composition of indices that passive strategies

25
 follow, which can affect equity cost of capital by featuring or overweighting (excluding or
underweighting) specific sustainable (unsustainable) companies in indices and funds.

● Limited to significant (2-4) impact from bonds. Secondary trading in bonds does not
directly affect the coupon paid by the issuer on those bonds, but it does affect secondary
market yields, in turn influencing the costs of future issuance, meaning that even at the
lower bound, there is some potential for impact of at least a small magnitude. At the upper
bound when a particular investor is among a firm’s largest creditors, and largest
participants in new bond issues, that individual investor’s risk and return preferences (or
decision to sit out a particular new issue) will, with high likelihood, have a substantial impact
on the firm’s cost of capital with a persistent effect. Meanwhile, the structure of
sustainability-linked bonds, where the coupon rate is linked to the achievement of
sustainability targets, or transition bonds incorporating specific use-of-proceeds or other
conditions, can affect cost of capital of the issuer much more directly on an ongoing basis
(although this market segment is still in its infancy). As such, impact will depend on the
instrument used.

● Moderate to strong (3-5) impact from loans. Loans are a crucial source of capital for all
firms, and even more important for smaller firms where they are usually the only source of
debt and generally not tradable. The interest rate set by lenders is based on the risk-return
profile of the company. Where the pool of available lenders is small, the rate set by a
specific lender can influence the firm’s cost of capital where it has few other borrowing
options, exerting a large impact with strong persistence. For bigger or more mature firms
that can access loans from multiple sources, can tap bond and equity markets, and are
likely to have access to a wider group of banks, the impact of the decision of any one lender
is likely to be more moderate, with more variable persistence. Where the lender provides
a sustainability-linked loan, the cost of capital can be tied directly and dynamically to a
firm’s performance as measured by sustainability key performance indicators (KPIs).

● Limited to moderate (2-3) impact from private equity. For a leveraged buyout, the actual
loan facility to buy a company depends more on the creditworthiness of the buyer (i.e. the
private equity firm) than of the portfolio company. There is thus a relatively low likelihood
that PE will in itself impact the cost of capital of the firm involved, and the persistence of
any effect is weak. However, for early stage companies relying mainly on equity, not debt,
financing, the cost of capital set by a venture capital firm can be significant, and persist

26
 until affordable refinancing options are available. In addition, if a PE/VC firm manages to
help a company develop strong sustainability disclosure relationships with bank lenders,
this effect may persist and contribute to a lower cost of capital even once the PE firm has
sold the company.

● Limited to moderate (2-3) impact from real assets. Real assets investors own a significant
portion of all commercial real estate, as well as a portion of residential real estate. Many
real asset funds tend to invest in project equity rather than project debt, or buy pre-existing
(brownfield) assets on the secondary markets, where there is limited to moderate potential
for impact on the cost of capital of the firm selling the assets. If the assets are purchased
from developers, sales on secondary markets provide them with capacity to reinvest in
additional projects. If markets perceive these transactions as establishing or enhancing a
secondary market for the assets, this may lower the risk – hence cost of capital –
associated with future projects undertaken by the developers. Given the relatively limited
pool of capital seeking real asset exposure and the capital-intensive nature of most real
asset projects, the conditions under which funds are willing to invest equity or debt capital
in new greenfield projects or purchasing existing assets on secondary markets, have the
potential to have a moderate impact on the cost of capital faced by these projects (though
banks have an even greater role in this capacity).

● Limited to significant (2-4) impact from hedge funds. Hedge funds that trade in shares or
derivatives for arbitrage or other purposes in large, liquid markets do not have a strong
effect on the underlying firms. However, hedge funds that trade in the distressed debt
(bonds or loans) of companies that are close to bankruptcy or have trouble finding creditors
are highly likely to have a significant impact on the cost of capital those firms face.

4.2 Access to Liquidity

● Negligible to moderate (1-3) impact from public equity. The extent to which active
investors can influence capital availability through investment (divestment) decisions for
publicly listed firms has little to no potential for impact, nor is this impact of any notable
magnitude, relative to the scale of liquidity available to listed firms through financial
markets. At the higher end of potential impact for public equity, impact has the potential to
be moderate where a large shareholder works in concert with other investors to either
expand or restrict access to investor funding, particularly in cases of young companies
seeking capital through an IPO, or distressed ones seeking equity capital through a rights

27
 issue. Passive investing ETFs can also affect access to capital for individual companies
depending on their focus and funding levels.

● Limited to moderate (2-3) impact from bonds. The majority of bond investors buy and sell
on secondary markets, not affecting firm-level access to liquidity directly, though there is
the potential for secondary market trading to affect primary market issuance, which is the
means through which bond markets allow access to new liquidity. At the upper bound,
when a particular investor is among a firm’s largest creditors and/or largest participants in
new bond issues, that individual investor’s willingness to lend, or decision to sit out a
particular new issue has the potential to have a moderate impact on the firm’s ability to
access capital. Green bond markets provide an example of how bond issuance can
improve access to liquidity: issuing green bonds has provided some smaller, less well-
known issuer firms with a broader investor base that can improve their ability to access
new capital, including at times of market dislocation.

● Moderate to strong (3-5) impact from loans. Most firms, large and small, rely on loans for
working capital, and thus loans play a crucial role in providing firms with access to liquidity.
At the lower bound, for larger firms able to access capital markets and typically working
with a consortium of lenders, the decision of any one lender to stop lending would only
have a moderate impact on the firm’s access to capital. At the upper bound for a smaller
firm, which may be heavily reliant on a single lender, that lender’s decision can determine
the firm’s access to capital and thus have a strong impact.

● Limited to significant (2-4) impact from private equity. PE firms certainly can certainly
provide access to capital and liquidity, but the importance of the impact depends on the
situation. At the lower bound, for a large firm with many sources of capital—and even more
so for a publicly listed one that is taken private by PE—the PE buyout has limited impact
on the firm’s access to capital. But in the case of smaller firms, such as family-owned
businesses too small to access capital markets, there is a high likelihood for the capital
provided by a PE buyout to have a significant impact. Not only does the buyout directly
matter, but for these smaller firms, the PE buyer can also offer connections to a broader
range of banks or private debt investors than the firm would otherwise have had access to.

● Negligible to moderate (1-3) impact from real assets. In the same way real asset funds
can affect developers’ cost of capital, funds that purchase existing assets can provide
developers with liquidity for reinvestment in additional projects. Funds that participate in

28
 arranging project financing for greenfield development projects (e.g. buying land), to then
build a residential building, warehouse, or toll road on top of it) have the potential to have
a moderate impact on a developer’s access to liquidity through their role in structuring and
conditioning the release of funds at different project stages.

● Negligible to significant (1-4) impact from hedge funds. Most types of hedge funds trade
exclusively in assets on secondary markets, thus not directly influencing the ability of firms
to access new funding, e.g. through primary bond issuance or through bank loans. In
distressed debt specifically, hedge funds are sometimes in a sense the “funder of last
resort.” However, in distress situations debt often ends up converting to equity, in which
case HFs exert control through adoption of practices more than through being a liquidity
provider per se.

4.3 Changing Corporate Practices

● Limited to significant (2-4) impact from public equity. Through active ownership, public
equity investors can have a moderate effect in encouraging change towards more
sustainable corporate practices. The main channels through which impact can be achieved
are regular direct engagement, the filing of shareholder resolutions and the use of voting
rights. Important factors for determining the extent of the impact are the size of the investor
and their ability to convince other investors to join in pressuring corporations. Acting on its
own, a small to medium sized financial institution has a low likelihood of having an impact,
and it will be small even if it succeeds. At the upper bound, in the case of investors owning
a large stake in a given company and/or having successfully built tight-knit investor
coalitions, the impact can be significant. Threats of divestment and/or blacklisting by large
financial institutions if the company does not respond positively to engagement can also
act as an incentive for managers of companies to change corporate practices to avoid
reputational risk and (potentially) reduced cost of capital and liquidity (see above).

● Negligible to moderate (1-3) impact from bonds. Since bondholders do not have
shareholder rights, their interaction with firms is limited to engagement and, at most,
refusing to participate in new issuance. At the lower bound, for an issuer with a broad
investor base, attempts by a small bondholder to engage company management or
threaten to withhold investment if certain practices are not adopted are unlikely to have an
impact. At the upper bound, when a particular investor is among a firm’s largest creditors
and/or largest participants in new bond issuances, if that investor makes participation

29
 conditional on changing practices, this has the potential to have a moderate impact.
Sustainability-linked or transition bonds can present opportunities for more direct impact
on firms’ practices, especially if bond investors engage with firms on the rigour of KPIs and
the design of sustainability performance targets (SPTs) prior to investment. Engagement
is also likely to be more impactful if carried out by larger investors, and/or by investors who
are both shareholders and bondholders in the company.

● Moderate to strong (3-5) impact from loans. Small firms are deeply reliant on loans, and
even large companies depend on them to a significant extent, though they do have other
sources of financing. At the lower bound, where firms have access to a consortium of
lenders, decisions by any one lender matter less and have only a moderate impact. At the
upper bound, where smaller firms may be reliant on one lender, and if that lender makes
lending conditional on project-level characteristics or company practices, this is highly likely
to have a strong impact on the firm. The rise of sustainability-linked and transition finance
loans is another way in which loans are becoming more deeply tied to company practices,
with loan repayment rates linked to the changing corporate practices and the meeting of
sustainability targets. As mentioned above, potential impact on corporate practices is likely
to be higher for those who hold both the equity and debt of a company.

● Significant to strong (4-5) impact from private equity. Start-ups typically have a few VC
firms involved in providing equity finance, and buyout PE firms almost always buy a
controlling stake. In both cases, but especially with a buyout, the PE/VC firm(s) have a very
large say in how a company is run and what sort of practices it adopts. Even at the lower
bound, for instance in deals involving several VC or PE firms, each one individually still
has a substantial stake in the firm and its wishes are highly likely to translate into a
significant effect on company practices. But at the upper bound, with one PE firm buying
near-full ownership of a firm, there is very little to stop it and its preferences essentially get
translated directly into corporate practices, thus exerting a strong impact.

● Limited to significant (2-4) impact from real assets. Real asset funds, particularly those
with a role in arranging and securing financing for greenfield projects, have significant
latitude to shape the corporate practices of the project developer, ranging from
environment and safety practices to sustainability commitments. Even for existing physical
assets (e.g. toll roads, airports, or buildings), day-to-day operations are often handled by a
management company. Real asset funds can and do exert a large degree of control over

30
 the adoption of practices for how to run these assets, typically through holding majority
ownership over the project and having the ability to instruct, sanction and replace
management companies.

● Negligible to significant (1-4) impact from hedge funds, depending on their strategy. Most
HF strategies do not affect company practices significantly, because these kinds hedge
funds engage in price arbitrage in secondary markets, with no transmission into company
practices. However, activist hedge funds, which buy significant minority stakes in
companies and then seek to build investor coalitions, can use the resulting considerable
clout to strongly influence how companies are run, including what sorts of sustainable
practices they adopt. In May 2021, with an 0.02% shareholding, the impact-focused hedge
fund “Engine No. 1” successfully nominated three of its preferred candidates to oil major
ExxonMobil’s 12-person board at its annual shareholder meeting, by building a coalition of
investors around its nominees including the asset manager BlackRock, and pension funds
CalPERS, CalSTRS and the New York State Common Retirement Fund (Hiller and Herbst-
Bayliss, 2021; Mufson, 2021).

4.4 The Usefulness of an Asset Class Lens

We hope that this analysis initiates a discussion around the potential transmission mechanisms
and impact that each asset class can have in the sustainable finance context. Importantly, we
have shown that many of these asset classes may have only limited opportunities for impact
in the real economy, or that this impact is contingent on coordinated action and/or a confluence
of factors over which investors in a given asset class have only partial control. This provides
theorisation behind our earlier statement that holding “green” products is insufficient for
generating environmental outcomes, and that a theory of change is required. Potential for
impact for a given investor may vary considerably depending on portfolio composition.
Furthermore, the potential for overall impact will depend on the relative allocation of capital.
We discuss this, and the implications of our findings, further in Section 6.

We recognise that considering asset classes separately as we do here is an over-

simplification, and further research could explore empirical evidence for our assessment and
seek to understand the transmission mechanisms of multi-asset portfolios, or
interdependencies between asset classes. There are also other cases in which transmission
mechanisms may combine in complex ways, such as if a change in company behaviour as a
result of engagement leads to spill-over effects from subsequent corporate leadership.

31
However, this can quickly lead into debates as to the extent of additionality of the investor, and
although this is an important question, it is out of scope for this paper.

4.5 Discussion: Risk Management and Spill-over Effects

Changes in firms’ cost of capital, access to liquidity and corporate practices all affect the risk
context in which they operate. By reducing the risk burden that firms face, investors can help
firms free up resources otherwise dedicated to managing these risks, and facilitate additional
sustainable activity. While it is unusual for investors (as opposed to sellers of risk products,
like insurance and derivatives) to help firms manage risk directly, changes in risk are implied
in the three transmission mechanisms identified. Impact-seeking investors can help firms
manage financial risks by rewarding sustainable activity with a lower cost of capital and greater
access to liquidity; by contributing to improved corporate practices, they can also have a
broader impact on the sustainability outcomes generated by a firm. Conversely, investments
that facilitate the continuation or expansion of unsustainable activities can drive a deterioration
in sustainability outcomes.

Investors’ approach to impact can also generate spill-over effects (and subsequent feedback
effects) on the wider economy in a number of ways, divided into two broad categories. First,
the generation of public goods (or bads) derived from either sustainability outcomes, or the
manner in which they are produced. For example, if a drop in the cost of capital accelerates a
firm’s deployment of renewable technologies, positive spill-overs can result from a decline in
the cost of the technology (prompting further deployment, and so on); and from reduced
climate risks associated with lower greenhouse gas emissions. In aggregate, the activities of
impact-seeking investors may ultimately reduce climate-related risks faced by the wider
economy. This is of particular relevance to “universal owners” (see Section 6). Where investor
activity results in greater financial and/or sustainability-related disclosures by firms, greater
information is made available to other investors. In turn, this can improve decision-making,
enhance risk-adjusted returns, and drive demand for the relevant data (see Spatial Finance
Initiative (2020)).

This can also work in the opposite direction: where impact-seeking investors fail to affect real
economy change, increased systemic risks and persistent mispricing of underlying risks can
result. Campaigns by financial firms to promote their sustainable offerings could also lead to
changing consumer awareness of the environmental relevance of finance and drive broader
behavioural change (Baker and Nofsinger, 2012).

32
The second category of spill-over effects relates to the ability of finance actors to influence
political decision-making. Investors have considerable influence over sustainability-related
policy, both in support of, and in resistance to, changes that affect them. In turn, policy changes
relating to disclosure, carbon pricing and other areas of sustainability can have a wide-ranging
impact on real economy activity. The finance sector can be an influential source of support for
policies that facilitate sustainable economic activity. In February 2021, the Institute for
International Finance, representing leading banks, asset managers and insurers, added its
voice to calls for carbon pricing in the US (Kerber, 2021). Tomlinson et al. (2018) find that
financial sector interests are also important determinants of regressive sustainability policy
positions. In Germany, the perceived threat of TCFD to the competitiveness of national
financial centres and the cost of capital of key national firms has seen some finance actors
actively slowing implementation. In the US, long-standing opposition to regulation in the
finance sector (InfluenceMap, 2021) remains a brake on greater transparency, although the
Financial Stability Oversight Council’s identification of climate change as “an emerging and
increasing threat to U.S. financial stability” in October 2021 and the Securities and Exchange
Commission’s establishment of a Climate and ESG Taskforce to examine regulation of
sustainability claims signals much more active regulatory engagement and has prompted calls
for mandatory ESG disclosures in financial filings from large investing firms including Pimco
and Invesco (Verney, 2021).

Through these and other channels, investors have the potential to drive significant real
economy spill-over effects by supporting regulations and policies that affect companies’
behaviour directly (e.g. through carbon pricing) or indirectly (e.g. through the impact of
mandatory disclosure on their cost of capital).

33
5. Sustainable Finance Ideal Types by Asset Class

In this section, we draw on the above analysis, a series of interviews with leading practitioners,
and feedback from a presentation to participants in the 2020 Global Research Alliance for
Sustainable Finance and Investment (GRASFI) conference, to posit ideal type sustainable
finance strategies for impact within a fund consisting of a particular asset class.

5.1 Ideal Public Equity Strategy: Active and Passive

The “ideal type” investment strategy for equities differs depending on whether the equity fund
in question invests on an actively or passively managed basis. Both types of fund should send
strong signals to markets, particularly stock exchanges and index providers, by publicly
announcing targets to align with net zero emissions pathways by 2050 or earlier and articulate
a transition strategy for meeting this goal. Remuneration and performance targets should be
aligned to this strategy. Similarly, both passive and active equity funds should use their
ownership rights to clearly outline expectations of investee companies, including a time-bound
engagement strategy and escalation processes where expectations are not met. This could
include voting against management, building coalitions with other investors, and, for actively
managed strategies, ultimately divestment and public blacklisting of individual companies or
activities (e.g. new coal power and oil and gas exploration). Equity investors should also
engage with investee companies to improve sustainability reporting and increase the ambition
of performance targets. This includes both direct engagement and participation in collaborative
engagements with other investors and civil society and government stakeholders. Finally,
investors should work with policy makers and financial regulators to create a supportive
environment for sustainable investment, both directly and through collaborative investor
initiatives.

Active equity investors specifically should integrate observed and predicted climate and
environmental impact data into strategic asset allocations and equity investment decisions. An
active investor would also seek out companies that are aligned with sustainable solutions, to
increase their access to liquidity and lower their cost of capital. Passive equity investors have
less scope to proactively allocate assets but can include sustainability considerations in the
index selection process. This may include investment in climate-focused indices (e.g. those
screening out high-emitting companies, and/or investing in climate solutions) or adjusting
constituent weightings in standard indices to account for climate risk profiles of companies.

34
5.2 Ideal Fixed Income Strategy: Bonds and Loans

An impact-maximising bond investor or lender should actively promote the use and
standardisation of sustainability-linked and transition bonds and loans and engage closely with
key issuers on bond design and loan conditions, key performance indicators and sustainability
targets, including on both structural characteristics (i.e. the relationship between performance
targets and coupon rate/loan conditions) and on the level of ambition of the targets themselves.
Internally, the ideal bond investor or lender would earmark a minimum percentage of the bond
portfolio/loan book for sustainable and green bonds/loans, with this segment growing over time
in line with a strategy consistent with net-zero emissions by 2050 or sooner. The
investor/lender would systematically engage with specific issuers and other investors by
requesting and interrogating information on (i) sustainable long-term strategy (including by
indicating continued investment is conditional on progress towards it); and (ii) mitigation of
climate-related physical and transition-related risks (including by accelerating retirement of
high-carbon capital assets), in order to influence future issuance and lending decisions and
pricing. Subject to the results of engagement, it would exclude the worst-performing firms
according to published criteria that would also get more stringent over time, and under/over-
weight the remaining portfolio according to performance against sectoral or financial
benchmarks and the ability of the company’s business model to facilitate, and/or succeed in,
a long-term low-carbon transition. The investor would establish internal hurdle rates for
different levels of climate risk to guide bond selection strategy.

Externally, the bond investor or lender would demonstrate to the market, through research,
reports and returns, any lower downside risks associated with sustainable bonds and loans
and/or reductions in systemic risks associated with sustainable bond investment and
sustainability-linked lending to lower the cost of capital for sustainable issuers. The investor
would also articulate and publish a net zero-compatible active stewardship strategy and
communicate it clearly to the market. It would push actively for the creation of sustainability
risk-adjusted versions of major indices and facilitate greater inclusion of green and climate-
aligned bond issuances in standard indices, particularly for project and infrastructure finance.

Finally, the investor or lender should maximise long-term financing for new sustainable
projects, participating in refinancing only where the proceeds either (i) lower the cost of
financing sustainable projects; or (ii) directly reduce capital costs for issuers specialising in
sustainable products or services.

35
5.3 Ideal Private Equity Strategy

Private equity (PE) and venture capital (VC) funds play a specific role in the financial system
and have much greater scope to shape and engage with investee companies than those in
public markets (even if their overall market prominence as measured by assets under
management, and thus total footprint, is smaller). PE/VC funds, especially buyout PE funds,
typically operate by buying controlling stakes in investee firms. An impact-maximising private
equity firm should focus its energies on “transition turnaround investments”, acquiring stakes
in unsustainable firms with high potential for decarbonisation (e.g. steel producers able to
switch to clean fuels, manufacturers with scope for much greater efficiency and electric utilities
standing to benefit from early retirement of high-emitting assets and heavy investment in
renewables). To garner public support for these efforts and minimise hostility from investee
company management, the PE fund should partner with governments, academia and/or civil
society to research and address the socioeconomic consequences of failing to transition and
have a fallback plan in place for companies that fail to transition to ensure that their bankruptcy
does not lead to long-term suffering for workers left unemployed.

The PE investor should have a dedicated fund segment focused on growing green industries,
investing in firms and technologies likely to benefit from a rapid, large-scale transition (e.g.
renewable energy firms, electric mobility, hydrogen, ammonia, carbon capture). A venture
capital fund would invest in early-stage start-ups, while a growth-focused fund would seek out
established, rapidly expanding firms.

PE investors also have scope to influence the capital structure and capital-raising practices of
investee firms. They should encourage the use of sustainability-linked loans and bond
issuance where possible to ensure accountability against green targets and develop internal
reporting and monitoring capacity. Similarly, they should work with portfolio companies to
integrate the use of granular sustainability data into processes and decision-making, establish
firmwide targets for alignment with net zero by 2050 or sooner, and build up internal expertise
on climate risks and opportunities, dedicating permanent staff resources to this purpose.
Where relevant, PE investors should sign up to industry initiatives and encourage portfolio
firms to do so.

3.5 5.4 Ideal Real Assets Strategy

Real assets are typically less liquid and less standardised than competing asset classes,
presenting investors with greater challenges. Real assets also play a central role in

36
infrastructure investment pathways and reducing carbon lock-in, suggesting they may play a
high-impact role in an ideal investment strategy. An impact-maximising real assets investor
would therefore approach every new investment through the lens of sustainability risk and
opportunity, investing only in assets that either already are, or can be put on, a path to adapt
and transition effectively. Thus, they would avoid investments exposed to excessive physical
or transition-related climate risk without the potential to transition or adapt (e.g. assets subject
to imminent sea level rise). Any assets invested in today must still be viable in 20-30 years; for
example, even if an argument can be made that natural gas is in some instances a transition
fuel away from coal to renewables, investing now in new gas infrastructure does not make
sense.

The investor would also systematically work to reduce the exposure of its existing assets to
climate and environmental impacts, including through efficiency retrofitting, adaptation
measures such as flooding protection, and transition planning. These measures should be
financed, where possible, with sustainability-linked/green loans and bond issuance. The
investor should actively partner with local stakeholders to address the exposure of surrounding
areas, especially where this enhances portfolio returns by reducing overall localised risks (e.g.
flood walls, heat dissipation measures).

These direct engagements would be complemented by the use of sustainability data and
metrics to set targets for investee projects (e.g. project finance vehicles for large infrastructure)
and firms (e.g. property management companies) and build capacity for reporting
sustainability-relevant information.

5.5 Ideal Hedge Fund Strategy

Impact-maximising hedge funds have the potential to generate significant pressure on firms to
accelerate or improve their net zero transition strategies. An activist fund should, similarly to
private equity, focus on investments in undervalued, unsustainable firms with high
decarbonisation potential, and work with other shareholders to pressure firm management to
draw up and execute a turnaround strategy. Where shareholder pressure fails, the hedge fund
should work to replace company management by building a coalition of activist investors. For
distressed debt investment, the fund should leverage its buying power to influence company
management and tie loan/bond conditions to sustainability outcomes. Where this strategy fails
or has low chances of success, the fund should short-sell firms with insufficient or non-existent

37
sustainability strategies, particularly those with high short-term stranded asset risks, sending
negative price signals to other investors to encourage either divestment or transition.

Funds active in commodity markets should expand trading in carbon credits and emissions
permits: this should allow the fund to both make healthy returns as climate policies tighten,
and also to smooth volatility and promote the maturing and development of these markets.
Simultaneously, funds should contribute to sustainability standards and practices in the trading
of existing commodities, expand trading in labelled products, and restrict trading in products of
uncertain or unsustainable provenance. Those active in bond markets should similarly expand
trading in green and sustainability-linked bonds, restricting trading in bonds that are not linked
to additional sustainable activity. These activities should be underpinned by the use of
sustainability metrics and targets at the fund level, which can also be used to attract further
investment by differentiating the fund from the wider market.

38
6. Implications for Manager Selection, Strategic Asset
Allocation and Universal Ownership

So far, this paper has outlined three transmission mechanisms available for generating real
economy environmental impact. In particular, we have outlined how the availability and
strength of these transmission mechanisms differ across asset classes and further expanded
a theoretical “ideal type” of action within each asset class to deliver maximum impact. This
analysis can support financial institutions seeking to develop impactful strategies across
individual and multiple asset classes. In this section, we outline the implications for asset
owners.

Asset owners could implement these findings in both their choice of their asset managers,
and/or in their strategic asset allocation.

Firstly, asset owners can use the above framework to select internal and/or external asset
managers who present strategies and capacities that are most closely aligned with (or have
strategies in place to build towards) the “ideal type” of strategy highlighted across different
asset classes. This could drive demand among asset managers to further align their own
investment products and services with impact-maximising strategies and apply the range of
actions outlined above.

Secondly, those responsible for impact-driven portfolio construction could use the above
analysis to allocate capital towards asset classes shown to generate the most impact. Strategic
asset allocation (SAA) is the process through which financial institutions periodically set
target allocations to various asset classes (Brennan et al. 1997; Campbell et al. 2002). These
allocation decisions are usually based on a range of factors such as the investor’s risk
tolerance, time horizon, and investment objectives. If a key investment objective is to generate
sustainability impact, SAA decision-making should consider which asset classes available to
the financial institution can drive the most impact and then overweight these in their SAA
decision. Conversely, those asset classes with the lowest potential impact would be
underweighted. As such, we call for financial institutions interested in impact generation to
consider adding an “impact” budget, allocated across their portfolio using this framework to
identify a clear theory of change, alongside the traditional risk and return budgets used to
develop SAA decisions. Examining the extent to which this step would be compatible with

39
fiduciary duties in different jurisdictions is an important area for future research, perhaps
building on the “legal framework for impact” published by Freshfields (2021).

Based on our analysis in Section 3, an impact-focused SAA should allocate more of its “impact
budget” to fixed income (especially through sustainability-linked loans and bonds) and private
equity and allocate less to passively managed public equity investments. An impact-
maximising asset owner may also seek to implement their strategy by holding assets across
multiple classes in the same company, particularly where equity and bond strategies previously
diverged (e.g. firms that may have continued to hold long-duration bonds in an oil major while
underweighting its shares in their equity portfolio). Joined-up strategies can increase leverage
by combining voting power with the ability to affect cost of future issuance and refinancing.
Conflicts of interest between equity holders (taking risks to increase upside) and bondholders
(seeking protection against downside) complicate this process, but consistency across asset
classes is needed to achieve lasting real economy impact through corporate transformation
and avoid sending mixed signals to corporate management.

These are important findings at a time when there is growing investment in passive listed equity
strategies as financial institutions seek lower fees and costs (Mercer, 2019; Pleye et al., 2020;
Anadu et al., 2020). Such a shift is not necessarily going to support the drive towards a
sustainable financial system, though there are opportunities for passive investors to generate
impact whilst also securing lower cost strategies. This is why we believe it useful to have
outlined the “ideal type” of investor for each asset class. However, these decisions, as noted
above, are often not made with the sole aim of impact, so Figure 3 demonstrates (illustratively)
how such an analysis might be considered in alignment with the risk-return profile of each
asset class. This suggests that portfolios with the same risk-return profiles can have different
environmental impact and that higher potential impact portfolios do not have to mean lower
risk-return expectations. Further empirical work is required to evidence this.

40
Figure 3. Illustrative relationship between asset class impact and risk-return profile

These findings are perhaps particularly important for “universal owners”, large financial
institutions who, due to their size, effectively “own the economy” and “therefore, bear the costs
of any shortfall in economic efficiency and reap the rewards of any improvement” (Hawley and
Williams, 2000, p.45). As a result of their size and their exposure to the global economy,
universal owners have both the means and motive to maximise their real economy impact
across their portfolios (Hawley and Williams, 2000; Quigley, 2019).

41
7. Conclusions

Holding green financial assets is not sufficient for investors to have an impact on the real
economy. In this paper, we introduce three possible transmission mechanisms linking the
financial and real economies in application to sustainable finance, contributing to the nascent
discussion on how sustainable finance activities can generate impact. We develop a novel
approach to assessing the potential impact of each transmission mechanism across major
asset classes and consider how the mechanisms might interact with one other and generate
spill-over effects on other firms, investors, and the regulatory environment. Our findings
suggest that fixed income, notably sustainability-linked bonds and loans, could present the
greatest opportunity for impact, and hedge fund strategies the least. We then present possible
“ideal types” for each asset class to help guide a high-impact strategy for each as well as
highlighting the opportunities for broader political economy and public good spill-over effects.
Finally, we suggest how this analysis might be applied to strategic asset allocation by investors
with multi-asset portfolios, calling for the addition (and tactical allocation) of an “impact budget”
to these decisions. This cross-asset class analysis could also usefully inform targeted
investment and engagement among financial, policy and corporate decision-makers to further
reduce barriers between financial services and the real economy and extend the potential
impact available from the growing field of sustainable finance. Future research in this area
could consider the implications in more detail and seek to develop empirical methods for
testing and quantifying the impact of the different transmission mechanisms discussed here
(for individual investors and investor coalitions) and how interactions between them serve to
reinforce or weaken overall real economy impact.

42
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