Corporate Sustainability and Financial Performance
Businesses that are more sustainable as determined by high scores on ESG indices have been shown to achieve greater financial results than their peers.[i][ii] Considering this data, how should business managers, boards of directors, and investors incorporate sustainable practices into their companies? This paper outlines the data regarding corporate social responsibility (“CSR”) and issues related to the environment, social and human capital, business model innovation, and leadership and governance (“ESG”) and the impacts of sustainable practices in business.
First, we will provide a business case for sustainability, examining scholarly research which links ESG and risk and, in turn, the effects on a company’s cost of capital in both debt and equity markets. We will also discuss the follow-on reputational effects and its impact on human capital, market appeal, and product positioning and pricing. Finally, we will examine the important area of operational and financial performance, noting the varying “materiality” of ESG issues depending upon industry sector, asset class, firm size, geographic market, and timing.
We will provide our own primary research on ESG’s relationship with financial performance and conclude that higher ESG scores provide superior risk-adjusted returns. Our research centers around sector variance. Two key findings in our research are echoed in the body of research:
· The more exposed a company is to risk, the more it benefits financially from incorporating ESG issues into their strategy on a risk-adjusted return basis.
o Thus, the variance is based upon the inherent risk of a sector and can be high.
o For example, energy companies have a much wider band of returns that skew negative when lagging in ESG ratings. However, energy companies have tighter bands of returns and skew positive when they are ESG leaders. In contrast, an industry like Real Estate operates in a much more narrow band and has roughly equal distribution among ESG ratings.
o The risk of an industry informs the importance of and types of ESG initiatives that should be undertaken to maximize both shareholder and stakeholder value.
· ESG bears a cost and, therefore, companies with a higher market cap and, thus, more resources are more likely to be rated ESG leaders.
· Since ESG is costly, practitioners should identify and implement issues with “material” significance to their organization.
o In fact, Russell Investments determined that less than 25% of traditional ESG items were material for the majority of the stock in their large-cap index, so practitioners can gain significant value by tailoring their efforts.[iii]
In conclusion, we will provide practical guidance for business managers, boards of directors, and investors for incorporating ESG issues in their associated firms, including real world examples of successful ESG initiatives. As these stories make evident, it is not only data, but real world experience that shows how sustainable practices can be “proactive, positive, and comprehensive” while accreting significant value. Abiding by these principles makes practical sense and should stimulate firm stability while generating alpha and lowering systemic risk through a higher risk-adjusted return.
The prevailing advice: companies should understand which ESG factors are most material for their firm primarily guided by industry and geographic jurisdiction and allocate the maximum resources to material issues and ensure they communicate these efforts adequately to all stakeholders. When material ESG issues are integrated into a company or portfolio, it generates alpha and reduces risk.[iv]
Seeking the long-run maximization of the value of the firm also means pursuing sustainability as tailored to the firm’s sector and circumstance. These sustainable, purpose-driven companies generate competitive advantages and mitigating risk, ultimately finding the equilibrium between shareholder maximization and stakeholder welfare and obtaining a premium in the market over the long-term.[v]
[i] “[A] convincing correlation exists between those investments that do well on a financial yardstick and those that show strong development results; moreover, integrating ESG criteria into the investment process appears to enhance financial performance.” Wilson, G. E. R. Enhancing Financial Returns by Targeting Social Impact. In World Economic Forum Investors Industries, From Ideas to Practice, Pilots to Strategy Practical Solutions and Actionable Insights on How to Do Impact Investing. Geneva: World Economic Forum. 2013.
[ii] “Using both calendar-time portfolio stock return regressions and firm-level panel regressions we find that firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on these issues. In contrast, firms with good ratings on immaterial sustainability issues do not significantly outperform firms with poor ratings on the same issues.” Khan, Mozaffar and Serafeim, George and Yoon, Aaron. “Corporate sustainability: First evidence on materiality.” The Accounting Review, 91(6), 1697-1724. 2016.
[iii] “Materiality Matters: Targeting the ESG Issues That Can Impact Performance.” Stocks and Bonds | Russell Investments, russellinvestments.com/us/insights/articles/materiality-matters.
[iv] “ESG in Equity Analysis and Credit Analysis.” The CFA Institute and the United Nations Principles for Responsible Investment. 2018.
[v] Jenson, Michael C. “Value Maximization and the Corporate Objective Function.” Harvard Business School, 2000. http://www.hbs.edu/faculty/Publication%20Files/00-058_f2896ba9-f272-40ca-aa8d-a7645f43a3a9.pdf.