The value of ESG
Environmental, Social and Governance
31 July 2018
…the concept of a company ‘doing well by doing good’ has now entered the mainstream as a valid determinate of long-term business performance
With environmental, social and governance (ESG) analysis fully embedded in our assessment of investee companies, we present the academic evidence on the value of corporate sustainability to businesses, investors and wider society.
This paper demonstrates evidence of the increasing
value of corporate sustainability for businesses, investors
and wider society. In our view, we are witnessing a
fundamental shift in ideology with regards to the role of
corporate behaviour in society. The neoclassical economic
view of a company’s objective (most famously espoused by
Milton Friedman) as being solely engaged in ‘activities
designed to increase its profits'0 now seems increasingly
anachronistic. By contrast, the concept of a company ‘doing
well by doing good’ has now entered the mainstream as a
valid determinate of long-term business performance.
- The Business perspective
- The Investor perspective
- The Society perspective
Download PDF version
0 ‘The Social Responsibility of Business is to Increase its Profits’, Freidman M. The New York Times Magazine (1970).
1) The Business perspective
There is a growing body of evidence showing that
companies which adopt effective sustainable
business practices, specifically through a
consideration of environmental, social and
governance (ESG) factors, enhance their
competitive advantage, increase their operational-cost
effectiveness, and ultimately, improve their
long-term financial performance. Many of these
factors are not captured by traditional accounting
practices, but can have a real impact on financial
metrics and long-term value creation.
The ESG efficiency advantage
The view that corporations can realise meaningful
cost and efficiency advantages through sustainability
initiatives such as production innovation, resource
efficiency and waste reduction is consistent with the
findings of Eccles, Ioannou, and Serafeim (2011)1. They
established that ‘High Sustainability’ companies
significantly outperform their ‘Low Sustainability’
counterparts, in particular, through an ability and
willingness to ‘engage in more product and process
innovations in order to be competitive under the
constraints that the integration of social and
environmental issues places on the organization’.
1 ‘The Impact of Corporate Sustainability on Organizational Processes and Performance’, Eccles R.G, Ioannou I., and Serafeim G. Management Science, Volume 60, Issue 11 (2011).
Companies with a strong ESG focus also tend to
display efficient processes in terms of cost
management. The number of corporate case studies
in this area is ever-increasing. Notably, Serafeim
(2014)2 highlights the examples of Dow Chemicals,
which reported savings of US$9.4 billion from energy
efficiency improvements over a 16-year period, and
General Motors, which claimed recycling and reuse
initiatives saved the company more than US$2.5
billion. Likewise, Unilever has reported that its
actions to achieve zero waste to landfill from its
North American facilities (through initiatives such as
improved inventory management, package recycling
and generating biodiesel fuel) resulted in cost
savings of more than US$1.9 million in 20133.
2 ‘Turning a Profit While Doing Good: Aligning Sustainability with Corporate Performance’, Serafeim G. Centre for Effective Public Management at Brookings (2014).
3 Unilever press release: 03/17/2015.
Dow Chemicals reported savings of US$9.4 billion from energy
efficiency improvements over a 16-year period
ESTABLISHING A LONG-TERM STRATEGIC
Importantly, the implementation of ESG practices in
other aspects of company management can be equally
impactful. For instance, Edmans (2011)4 analysed the
relationship between employee satisfaction and long-run
equity prices – determining that those firms with higher
levels of employee satisfaction generate superior longterm
returns. Edmans concluded that the ‘results are
consistent with human relations theories which argue
that employee satisfaction causes stronger corporate
performance through improved recruitment, retention,
and motivation, and existing studies of under-pricing of
intangibles’. Likewise, Verwijmeren and Derwall (2010)5
recognised that companies with leading track records in
employee wellbeing not only significantly reduce the
probability of bankruptcy by operating with lower debt
ratios, but also enjoy better credit ratings.
4 ‘Does the stockmarket fully value intangibles? Employee satisfaction and equity prices’, Edmans A. Journal of Financial Economics (2011).
5 ‘Employee well-being, firm leverage and bankruptcy risk’, Verwijmeren P. and Derwall J. Journal of Banking and Finance (2010).
The long-term strategic advantages of ESG have also
been evidenced more holistically. In 2015, Friede, Busch
and Bassen6 aggregated more than 2,000 empirical
studies relating to ESG and financial performance. The
conclusion of their vast meta-study was that a positive
relationship exists between ESG and corporate financial
performance and that therefore the case for ESG
investing is empirically very well founded. In particular,
they noted that ‘the orientation toward long-term
responsible investing should be important for all kinds of
rational investors in order to fulfil their fiduciary duties
and may better align investors’ interests with the broader
objectives of society’.
6‘ESG and financial performance: aggregated evidence from more than 2000 empirical studies’, Friede G., Busch T. and Bassen A., Journal of Sustainable Finance and Investment (2015).
What's more, longer-term competitive advantages are
correspondingly evident for companies that align their
operations towards a broad spectrum of stakeholders:
employees, suppliers, communities and customers as well
as shareholders. As we will talk about in the final section
of this paper, with the market and wider society
increasingly rewarding sustainable corporate behaviours,
brand strength and public trust become significant
determinants of long-term performance.
A positive relationship exists between ESG and corporate financial performance, therefore the case for ESG investing is empirically very well founded.
ESG AND REDUCED DEBT AND EQUITY
In terms of direct cost reduction, several academic studies
have identified a tangible link between ESG factors and
improvements in the costs of corporate financing. Bhojraj
and Sengupta (2003)7 showed that the default risk of a firm
(via bond yields and ratings) is directly impacted by its
corporate governance mechanisms. Specifically, their
analysis showed that the positive perceptions of effective
governance mechanisms could result in a reduction in
firms’ default risk and therefore its cost of debt capital.
Additionally, Schauten and van Dijk (2011)8 also determined
that the influence of effective governance in terms of
improved financial disclosure leads to lower credit spreads.
7‘Effect of Corporate Governance on Bond Ratings and Yields: The Role of Institutional Investors and Outside Directors’, Bhojraj S. and Sengupta P. The Journal of Business, Vol. 76,
No. 3 (2003).
8 ‘Corporate Governance and the Cost of Debt of Large European Firms’, Schauten M.J.B and van Dijk D. Erasmus Research Institute of Management Report Series (2011).
A company’s credit rating, and therefore its credit spreads,
are also enhanced by corporate social responsibility (CSR)
factors. Attig, El Ghoul, Guedhami and Suh (2013)9 noted
that a company taking a strong focus on stakeholder
interests including employee and community relations,
conveys important non-financial messages to ratings
agencies, thus indirectly lowering its financing costs.
9 ‘Corporate Environmental Responsibility and the Cost of Capital: International Evidence’, El Ghoul S., Guedhami O., Kim H. and Park K. Journal of Business Ethics (2016).
Additionally, Bauer and Hann’s (2010)10 analysis of
aggregate measures for the environmental strengths and
concerns of firms (in relation to the yield spread of newly
issued bonds, bond ratings, and long-term issuer ratings)
demonstrated that pro-active environmental practices are
associated with a lower cost of debt. Likewise, they proved
that those companies which did not address the
environmental risks and externalities of their operations
pay a premium on the cost of their debt financing. Similarly,
Chava (2014)11 also assigned a relationship between the
environmental profile of a firm and its cost of capital,
concluding that investors take account of a company’s
environmental risks, which then leads to higher cost of
equity and debt capital.
So from the perspective of running a business, it is clear
that there are multiple incentives for considering ESG
factors and implementing sustainable practices within a
10 ‘Corporate Environmental Engagement and Credit Risk’. Bauer R. and Hann D. Maastricht University ECCE Working Paper (2010).
11 ‘Environmental Externalities and Cost of Capital, Working Paper’, Chava S. Georgia Institute of Technology (2011).
Back to summary
2) The Investor perspective
From the investor perspective, it follows logically that
improved company-level performance relating to ESG factors
should correspond with superior risk-adjusted, long-term
equity returns. Again, academic evidence to substantiate this
link is becoming increasingly well documented.
LONG-TERM VALUE CREATION
The positive transmission of corporate sustainability
practices to share prices has been clearly evidenced by the
work of Eccles et al. (2011). By analysing a sample of 180
companies between 1993 and 2009, their research showed
that half of the sample companies (those which had
implemented ‘a substantial number of environmental and
social policies adopted for a significant number of years’),
fared significantly better than lower sustainability firms, both in business as well as stockmarket performance.
High-sustainability firms outperform over the long term
Evolution of US$1 invested in the stockmarket
in value-weighted portfolios
Source: Eccles R.G, Ioannou I., and Serafeim G. Management Science, Volume 60, Issue 11 (2011)
The long period of time chosen for the data analysis is
notable. The research deliberately allowed for the longterm
organisational implications of ESG-orientated
business practices to take place. This view mirrors the
notion of ESG being a driver of long-term value creation
for businesses (and by extension shareholders) as
illustrated in the recent report from the Principles for
Responsible Investment – PRI (‘How ESG engagement
creates value for investors and companies’). The report
highlights the several areas in which ESG engagement by
investors with companies can create long-term shareholder
value and echoes the sentiment of Eccles et al. (2011), that
‘high sustainability firms generate significantly higher stock
returns, suggesting that indeed the integration of such
issues into a company’s business model and strategy may
be a source of competitive advantage for a company in the
ESG AND THE POWER OF POSITIVE CHANGE
The link between ESG-focused businesses to long-term
stockmarket outperformance is also supported by a recent
study (‘Foundations of ESG Investing’12) by MSCI, which
examined how ESG information embedded within companies
is transmitted to the equity markets. The research showed
that ‘high-rated’ ESG companies (based on MSCI ESG
Ratings data and financial variables) tended to demonstrate
higher profitably, higher dividend payments and lower
idiosyncratic tail risks. In addition, high-rated ESG firms also
proved better at managing company-specific risk and as a
result have a lower probability of experiencing incidents
which could affect their share price. These companies also
tend to have less exposure to systematic risk. Therefore, their
expected cost of capital is lower, leading to higher valuations
in a discounted cash flow (DCF) model framework.
12 ‘Foundations of ESG Investing’, Giese G., Lee L-E., Melas D., Nagy Z., Nishikawa L. MSCI (2017).
More pertinently perhaps, the research also showed the
transmission of change in companies’ ESG profiles was
linked to changes in financial indicators. Specifically, that
higher rates of improvement in ESG characteristics
(‘momentum’) were an important indicator of improved
financial performance which led to increasing valuations.
Significant outperformance of the top ESG
Cumulative performance differential of the
top ESG momentum quintile versus the bottom
ESG momentum quintile.
Source: 'Foundations of ESG Investing’, Giese G., Lee L-E., Melas D., Nagy Z.,
Nishikawa L. MSCI (2017).
Also of note here, is the work carried out by Kahn, Serafeim
and Yoon (2015)13 on the importance of materiality in an
investment case. Their findings point to a difference in the
investment outcomes relating to those firms which focus on
material rather than immaterial sustainability issues in their
business case. They concluded that, ‘firms with good
performance on material sustainability issues significantly
outperform firms with poor performance on these issues,
suggesting that investments in sustainability issues are
13 ‘Corporate Sustainability: 'First Evidence on Materiality’, Khan M., Serafeim G. and Yoon A. The Accounting Review, Vol. 91, No. 6 (2015).
Over a 20-year period, the research demonstrated
investing in companies involving ‘high performance’ on
material factors and ‘low performance’ on immaterial
factors produced greater alpha than all other
investments, including those scoring highly on both
material and immaterial issues, as illustrated in the
AVOIDING VALUE DESTRUCTION
Perhaps the most obvious link between a company’s
ESG credentials, its financial performance, and
consequently its shareholder value comes from the
negative effects of ESG-related shocks. Unsurprisingly,
evidence in this area is most pertinently drawn from
real-life examples, and there is certainly no shortage of
instances of companies where ESG shortcomings have
caused major financial damage and destroyed
Estimated at over US$60 billion and a halving of BP's stockmarket valuation in the
immediate aftermath of Deepwater Horizon event
From an investor perspective, it is easy to claim
‘wisdom in hindsight’ from reviewing such events, but
these examples often demonstrate the value of
effective ESG management purely from its catastrophic
absence in a business model.
Take the oil spill at BP’s Deepwater Horizon drilling rig
in 2010, for example. Governance and cultural failures
featured heavily in the route to the disaster, as
overzealous cost-cutting, combined with poor controls
and a general lack of transparency materially raised
risks, not just for the employees who lost their lives and
the communities affected, but for shareholders.
Effect of Deep Water Horizon on BP share price
Source: FactSet and Martin Currie.
The financial implications were astronomical, with eyewatering
costs for BP estimated at over US$60 billion
and a halving in its stockmarket valuation in the
immediate aftermath of this event.
Back to summary
3) THE SOCIETY PERSPECTIVE
In today’s globalised, information-rich world, the number of
stakeholders in a business are vast and well informed.
As such, there is a far greater visibility, accountability and
immediacy of a company’s actions than at any point in
history. This means that real (or even perceived)
infringements of stakeholders’ interests can have significant
consequences for a company’s reputation and ability to do
business. More and more, companies therefore need to be
aware of the implicit ‘social contract’ that they hold with
Major international undertakings, such as the PRI and UN
Sustainable Development Goals (SDGs), also reflect a
broad consensus that a greater premium should be placed
on sustainability than has historically been the case. As a
result, the intangible assets which make up part of a
company’s book value, such as brand perception and
customer loyalty, are increasingly linked with their ESG
credibility. Lubin and Esty (2010)14 even go so far as
describing the heightened ‘sustainability imperative’ that
now exists in society as a ‘megatrend’ which ultimately will
‘force fundamental and persistent shifts in how companies
compete’. Similarly, Clark, Feiner and Viehs (2014)15 describe
sustainability as one of the ‘most significant trends in
financial markets in decades’.
14 ‘The Sustainability Imperative’, Lubin D.A. and Esty D.C. Harvard Business Review, May (2010).
15 ‘From the stockholder to the stakeholder. How sustainability can drive financial outperformance’, Clark G.L., Feiner A. and Viehs M. SSEE Research Report sponsored by Arabesque
Asset Management (2014).
Other commentators acknowledge the magnitude of this
societal trend as evidenced by demographically changing
values. Winograd and Hais (2014)16 in particular, point to the
generationally driven shift in sustainable business practices
demanded by Millennials, predicting that those ‘companies that dedicate their future to changing the world for the better
and find ways to make it happen, will be rewarded with the
loyalty of Millennials as customers, workers and investors for
decades to come. Those that choose to hang on to outdated
cultures and misplaced priorities are likely to lose the loyalties
of the Millennial generation and with it their economic
16 ‘How Millennials Could Upend Wall Street and Corporate America’, Winograd M. and Hais M. Governance Studies at Brookings (2014).
Businesses that therefore consider ESG factors and embed
sustainability within their operations are therefore strategically
better placed to manage stakeholders’ expectations and
maintain their unwritten licence to operate. In addition, a
positive reputation in regard to ESG matters can also prove to
be a differentiator for company performance.
Please be aware that the information provided should not be considered a recommendation to purchase or sell any particular
security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable.