Why sustainability shouldn't reduce returns Zurich, 19 June 2017
By Nick Baltas, Executive Director for Quantitative Research, UBS Investment Bank
There are several misconceptions around the value-add of ESG criteria in investment decisions. With their recent paper at the Journal of Applied Corporate Finance, "ESG Integration in Investment Management: Myths and Realities", Sakis Kotsantonis, Chris Pinney and George Serafeim highlight six myths about ESG investing and subsequently refute them. For the purposes of this article, we review the first, and in our assessment the most important, of these six myths.
In the words of the authors, this myth is phrased as follows: "The net financial effect of corporate efforts to address environmental and social issues is the reduction of corporate returns on operating capital and, along with them, long-run shareholder value; and so, although ESG makes investors feel good, it effectively asks them to accept lower returns on investment."
Addressing social or environmental issues can certainly be rather costly for a company. The critical question is whether such a shareholder investment can turn out to be of competitive advantage for the company and therefore become eventually recognised by investors. A number of recent studies have shown that various corporate, social, environmental and sustainable business practices can indeed increase corporate cash flows and operating performance. However, the question of systematic superior stock performance as a result of such policies remains open.
The authors argue that negative screening cannot capture the value added by the various sustainability initiatives across companies and most importantly across industries. What becomes of greater importance is the distinction between "material" and "immaterial" ESG issues, in line with the definitions of the Sustainability Accounting Standard Board. To give an example, it is of critical importance for a company specialising in fossil fuels to manage its environmental impact ("material" ESG issue), as opposed to - for instance - financial institutions ("immaterial" ESG issue). Conversely, marketing or advertising is significantly more important for the latter.
Recent evidence by Khan, Serafeim and Yoon (2016), who use data for 2,000 U.S. companies between 1993 and 2013, shows that companies that make significant investments in material ESG issues (for their respective industry) experience high growth in profit margins and superior risk-adjusted stock returns. Conversely, companies that make significant investments in immaterial ESG issues show no sign of outperformance (and at times might also underperform).
All in all, it seems crucial to identify the ESG issues that have a material impact for the long-run value of a firm or an industry as opposed to agnostically screening out companies based on a broad ESG score. In that we would add the importance of distinguishing between correlation and causality. It is one thing to document correlation between financial outperformance and "material" ESG integration and another thing to argue that the financial outperformance is caused by corporate investments in material ESG issues. Future research should address these questions.
Khan, M., Serafeim, G., & Yoon, A. (2016). Corporate Sustainability: First evidence on Materiality. The Accounting Review, 91(6), 1697-1724.
Kotsantonis, S., Pinney, C., & Serafeim, G. (2016). ESG Integration in Investment Management: Myths and Realities. Journal of Applied Corporate Finance, 28(2), 10-16.