The executive chair of a UK solar energy company, Jeremy Leggett, recently launched a scathing attack on institutional investors after the short-term profit scramble in the Coal India IPO. The stock was 15 times oversubscribed and closed up nearly 40 per cent on the first day of trading. His gripe revolved around institutional investors, such as investment managers and superannuation funds, who seemingly ignored the long-term consequences of burning coal in favour of windfall gains.

Coal India is state owned and it offered 10 per cent of its stock in the IPO. It has a virtual monopoly on coal supply in a country that has a vibrant growth outlook and where energy will play a vital role in achieving its future prosperity. Per capita emissions in India are less than 30 per cent of the global average and a mere fraction of those in developed, western countries.

Leggett’s view is understandable for someone who is passionate about the risks posed by climate change and whose business is aligned with solar energy. Given that institutional investors act on behalf of their beneficiaries – who are ultimately ordinary citizens like you and me – what are they thinking when they provide capital to carbon intensive companies?

On the other hand, there is nothing illegal about coal mining, so why shouldn’t an institutional investor pursue financial gain for its beneficiaries? This is the investor’s dilemma.

An institutional investor can attempt to solve the problem by installing a set of ethical judgments into the investment process: “Coal is bad, therefore we will exclude coal”. This approach may seem fine in principle but its gets tricky when you have to figure out where to draw the line. Do you also exclude companies that manufacture coal mining equipment, even if it is only a small part of their business?

Also, consider issues such as the manufacture, supply and use of weapons, human rights abuses, uranium mining, tobacco, alcohol and gambling. Put a random group of superannuation fund members in a room and they will seldom have a common view about which ones are acceptable and which are not. Taken to the extreme, we could rule out investing in Australian government bonds because we have an army that uses weapons.

An ethical approach can work when the beneficiaries have a well-aligned set of values, but it is less likely to work when they are part of a diverse industry or corporate superannuation fund. Some funds offer ethical investment options to cater for members who like to know their money is invested with ethical values in mind. Due to data limitations, it is still too early to call whether ethical funds achieve better quality returns than mainstream funds.

Adding to the Coal India situation is the fact that India is committed to 2°C degrees of warming as the upper target for broad policy. It possibly has an incentive to reduce its own exposure to such assets if it believes valuations are too high. The Indian government may be cashing out at the expense of incoming shareholders and few would have sympathy for institutional investors if they get caught on the wrong side of the market further down the track.

A prudent investor should systematically seek to understand and place a value on the risks posed by carbon intensive activities. This is what we would expect from the institutional investors who bid for Coal India stock. It is fair to ask them what scenarios they use to evaluate carbon price risk and how they integrate the results into their valuation models. Can they justify the valuation given the considerable risks that exist? Institutional investors will seldom agree on their estimates for share valuations, but their beneficiaries can at least expect them to utilise a robust investment process.

However there is a bigger issue at play, a concept called the universal owner. All decent-sized superannuation funds own shares in a wide range of major companies in the market. Collectively, these funds own a significant portion of the investment market; and studies show that market returns are linked to economic performance. So by providing capital to companies engaged in high-carbon activities, they are putting future economic performance at risk, which means that funds are undermining their own future returns by making such investments. Mr Leggett’s comments are more insightful when seen in this light.

On reflection, calling this the investor’s dilemma may be misplaced, because institutional investment firms are driven by their own various motivations and incentives which may be at odds with their underlying beneficiaries. It is critical to align the interests of those carrying out the investment function with those whom they represent. The issue is perhaps better described as the beneficiary’s dilemma – as it is one that affects us all.

Phil Preston is the Principal of Seacliff Consulting, a firm offering specialised consulting services in the financial and responsible investment fields. His prior work includes 17 years of financial research and portfolio management in the funds management industry.