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Why ESG investing generates value by having lower returns

Chendi Zhang, Director of the Exeter Sustainable Finance Centre, discusses the pros and cons of investing in ESG policies.

With the push towards a ‘green recovery’ post-pandemic, boards and investors are weighing up how ESG (environmental, social and governance) initiatives impact their bottom line.

Most big companies now incorporate social responsibility into their decision-making. Recent examples include Google’s commitment to renewable energy, Coca-Cola’s pledge to reduce emissions from its delivery trucks and Starbucks’ promise to hire veterans.

But confusion remains about whether they add value for investors and society.

Now, two new studies show that ESG generates value for society by reducing systematic risk in investments. This enables companies to invest more in green policies and become greener because the cost of funding is lower.

‘Green’ policies help companies weather the COVID-19 crash

In the first quarter of 2020, the US stock market crashed as a result of COVID-19. This provided a unique opportunity for researchers from universities in Exeter, Boston and Calgary.

We wanted to find out whether companies committed to social responsibility performed better or worse during a crisis.

We were fascinated to discover that in the three weeks between the start of the stock market decline and the US government’s 18 March bail-out package, firms with high ESG ratings outperformed those with low ESG ratings by 7.2 per cent.

In other words, having a strong ESG focus acted like a risk management policy, making them less vulnerable to the crisis. ESG firms appear more resilient during the COVID-19 crisis than investors expected before the crisis.

The financial effect of these policies was so strong that they represented at least half the impact of a cash balance or leverage.

But while ESG pays off when times are tough, it does not imply that ESG assets produce higher returns over the long term.

ESG makes companies less vulnerable to boom and bust

When combined with another study, published in Management Science, there is now compelling evidence that investment in ESG is a major factor in reducing systematic risk.

We analysed 4,670 US-listed companies from 2003 to 2015. Applying the Morgan Stanley Capital Investments’ Environmental, Social and Governance (MSCI ESG) database, we constructed an overall ESG score that combined information on the firm’s performance across community, diversity, employee relations, the environment, product and human rights attributes.

We estimated firms’ systematic risk using the Capital Asset Pricing Model for each year, before studying the effect of ESG scores.

We found that firms with high ESG scores had a lower risk profile compared to firms with lower scores.

Moreover, we found that the profits of firms with higher ESG scores were not so affected by the business cycle.

ESG assets have higher valuations today if their systematic risk is reduced, and therefore they should have lower expected returns for investors in the future. Investors hold ESG assets because they hedge climate and social risk.

Consumers drive valuation effects

The findings illustrate the importance of customer loyalty to the resilience of ESG stocks.

The model predicted that the reduction in systematic risk was stronger for consumer-oriented companies. These organisations spend more on advertising, which amplifies the effect of ESG initiatives.

We found that the reduction in systematic risk was 40 per cent stronger for firms that advertised a lot – and the effect on their valuations was 20 per cent larger.

The study suggests that firms investing in ESG:

  • Face less risk of demand for goods falling when they raise prices;
  • Can charge higher prices for their products, retaining bigger profit margins;
  • Have more loyal customers, who appreciate the company’s ‘green’ credentials and responsible products, and therefore not so swayed by prices;
  • Can use it as a form of product differentiation;
  • Have more stable profits, less linked to economic cycles;
  • Have reduced risk which increases valuations – by an average of five per cent.

Sustainable investments and cost of capital

In the past, companies have recognised that investing in ESG can mitigate short-term risks. These could include being sued by unhappy customers or helping to reduce penalties from environmental agencies.

Now our research suggests that ESG policies increase corporate resiliency by decreasing systematic risk.

Our results have important practical implications for boards budgeting for capital projects.

On average, companies who invest in ESG initiatives enjoy a 0.5% lower cost of capital. This will allow more investment in sustainability projects such as green buildings, technology or R&D. Therefore, ESG investing creates benefits to society.

The findings also affect investors who are considering portfolio selection, as including stocks with higher ESG would have the effect of lowering the overall riskiness of the portfolio.

Investment projects that increase companies’ reputation for ESG should be reflected in the lower cost of equity. Calculating the value of sustainable investments with a company’s overall discount rate would lead to underinvestment in these projects.

Such evidence makes it harder for boards and investors to remain doubtful about backing ESG policies. However, they only work if they help to set a firm apart in a crowded marketplace.


Photo by 贝莉儿 DANIST on Unsplash


Author

Professor Chendi ZhangProfessor Chendi Zhang is a Professor of Finance, Director of Research (Finance and Accounting) and Director of Exeter Sustainable Finance Centre