(This post is adapted from the Journal of Applied Corporate Finance article, “ESG Integration in Investment Management: Myths and Realities,” by Sakis Kotsantonis, Chris Pinney and George Serafeim. Download the full article here.)
Until very recently, there has been considerable doubt, especially among mainstream investors, that companies with high ESG “scores” could succeed in producing competitive returns for their shareholders. Studies of the last three decades of the 20th century have reported that what was then known as Socially Responsible Investing (or SRI)—an investment approach that worked mainly by screening out the companies with the lowest ESG scores or entire industries such as tobacco and alcohol—produced shareholder returns that were often below market averages. And this finding has in turn contributed to the widespread perception that corporate efforts to address environmental and social issues end up reducing shareholder value.
But according to the findings of a large and growing body of studies conducted in the past ten years, companies with above-average ESG scores have actually outperformed their competitors, both in terms of standard measures of operating performance and stock market returns. Of course, high ESG scores are not always associated with high returns, and many studies have shown that the superior performance of ESG-conscious companies tends to be concentrated in certain industries with certain kinds of customers and employees. Moreover, such studies always come with a warning to readers against confusing association with a causal relationship between high ESG scores and above-market shareholder returns.
But even so, a large and growing number of studies have developed and tested research designs that limit the possibility that their findings are driven by correlated (or “omitted”) variables, or by “reverse causality.” In a longer report, we attempt to dispel, along with five other common myths about ESG investing, the widespread misconception that corporate efforts to address environmental and social issues always require shareholders to settle for lower long-run profitability and value. Read the summary of these myths and realities below.
Myth Number 1: 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.
Reality: Only a relatively small subset of ESG issues is what might be described as “material” and hence “value-relevant” for each industry. Initiatives and investments designed to manage “material” ESG issues will produce results, in terms of increases in profits as well as stock returns.
Myth Number 2: ESG is well on its way to being integrated into mainstream investment management and capital markets with over $60 trillion in assets now subscribed to the Principles for Responsible Investment established by the UN (UNPRI).
Reality: Only a small percentage of those assets are taking into account ESG data in a systematic way; the overwhelming percentage is just using ESG screens.
Myth Number 3: Companies have little if any ability to influence the kinds of investors who buy their company’s shares. And because the main focus of the vast majority of investors is near-term reported earnings, with holding periods—and presumed time horizons—ranging from three months to a year, corporate
managers are often forced by market pressures to sacrifice sustainability goals to meet quarterly earnings targets.
Reality: Companies can and have influenced their investor base. A real example is the case of Shire, which managed to significantly change their shareholder
base within 5 years by using sustainability strategy and integrated reporting to resist excessive pressure for short-term performance.
Myth Number 4: It is nearly impossible to do good fundamental analysis taking into account ESG data because the data infrastructure is really lacking.
Reality: Progress on data availability and quality has been made over the last few years. Companies, investors, stock exchanges, data providers and NGOs have all played a key role in advancing ESG data infrastructure.
Myth Number 5: ESG is only about managing risk and reducing costs.
Reality: There are numerous examples of companies that have used ESG integration as an enabler to achieve long term value and grow their top line: Dow Chemical, General Electric, Unilever.
Myth Number 6: Consideration of ESG factors in investment portfolio construction is contrary to fiduciary duty.
Reality: Policy makers and multi-stakeholder initiatives are now working to promote reforms in the legal interpretation of fiduciary duty. Changes are already happening (Department of Labor, October 2015 new statement to acknowledge the relevance of ESG issues on economic value).