Sustainability
ESG and Corporate Profit Performance

Cornelius Graubner ... The Financial Case for Sustainability: Three Studies You Should Know

Burgess COMMENTARY
Thank you ... an interesting and useful piece. However my own view of materiality in the face of many major long term existential risks suggests that thinking in terms of corporate ESG as being a significant driver of profits is dcounterproductive and possibly dangerous. I am not at all surprised that better profit performance arises with better ESG, but the world needs massive resource reallocation better to deliver the changes that are needed to achieve a sustainable responsible corporate business sector Peter Burgess http://truevaluemetrics.org
Peter Burgess

The Financial Case for Sustainability: Three Studies You Should Know

Money does not grow on trees.

Sustainability professionals have spent a lot of time over the last years establishing a strong case for corporate social responsibility initiatives as drivers of innovation, growth, and effective risk management.

Yet one of the most interesting discussions I am following these days is whether it is time to re-inject a moral dimension into the sustainability discussion. In Sustainable Brands, Andrew Winston makes the argument that focusing on the business case for sustainability alone means “overlooking something critical that motivates the decision-maker.” Rob Lake, a prominent responsible investment advisor, cites a colleague in his response to Wilson with “if [responsible investment] is reduced to picking a few data points that have predictive power, then we’ve won the battle but lost the war.”

The broader philosophical and practical points of these argument stand, but the reality is that most of us work in companies that are run on the notion that their primary purpose is to generate profit for their shareholders, and where different business units compete for limited financial and human capital. In a standard business environment, the most effective way to make an argument is by talking about it using concepts that your CFO understands: materiality, shareholder value, access to capital, and return on investment.

In a standard business environment, the most effective way to make an argument is by talking about it using concepts that your CFO understands.

Senior executives often intuitively agree with non-financial rationales put forward by internal and external sustainability advocates, but using pragmatic numbers-driven arguments will provide bullet points that they can use when taking the case to board members and shareholders.

With this in mind, three recent studies that provide rigorous evidence on the financial benefits of sustainability and that every sustainability manager should know are: Harvard Business School, 2015: Corporate Sustainability: First Evidence on Materiality. Link

Barclays, 2016: Sustainable Investing and Bond Returns. Research Study into the Impact of ESG on Credit Portfolio Performance. Link [pdf] McKinsey Global Institute, 2017: Measuring the Impact of Economic Short-Termism. Link

I provide a short rundown the papers below, including graphs for the key points. I recommend reading each of these studies in full, but feel free to make use of the highlights and visuals in slide decks and upcoming presentations.

Materiality: Investments in Sustainability Initiatives Create Shareholder Value

Materiality addresses the question of whether a transaction is significant to the overall performance of a business. The U.S. Supreme Court defines that information is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” For publicly listed companies, materiality is a fundamental principle of financial reporting, and describes the information that a company must disclose to investors and other users.

The study not only provides evidence to the argument that sustainability initiatives are good for shareholders, but also because the underlying framework provides managers with a clear idea of what kind of sustainability issues they should focus on.

Thinking about materiality is important because it helps managers sharpen their focus on factors most relevant to internal and external decision-makers when initiating a sustainability project. In 2015, a Harvard Business School working paper established for the first time that companies that perform well on material sustainability issues outperform companies that do not. The authors, Mozaffar Khan, George Serafeim, and Aaron Yoon, look at the stock performance of companies in relation to the their performance on sustainability issues. Using a materiality framework developed by the Sustainability Accounting Standards Board (SASB) and a sample of 2,396 unique firms from 1991 to 2013 for a total of over 14,000 firm-years drawn from the MSCI KLD data set, the authors distinguish between performance on material sustainable topics as well as immaterial sustainability topics, and then test how sustainability performance relates to stock return.

Serafeim and his colleagues find significant positive annualized alphas — return outperformance over a given index, in this case the complete sample the authors used — for firms that score well on material sustainability issues, and underperformance of firms that do not perform well on the same issues. Material sustainability champions beat the total dataset by 4.83% on an annual basis, while low performance on both material and immaterial issues results in -2.20% annual stock return compared to the total data set.

The HBR study is important not only because it provides evidence to the argument that sustainability initiatives are good for shareholders, but also because the underlying SASB framework provides managers with a clear idea of what kind of sustainability issues are material. This contrasts with other sustainability reporting frameworks like the Global Reporting Initiative or Integrated Reporting, which are less useful in providing guidance to executives who would like to see their sustainability efforts create shareholder value.

Access to Capital: Good ESG Performance Lowers Credit Risk

Talking about environmental, social, and governance (ESG) criteria is how most finance professionals today discuss sustainability issues. For a long time, the ESG discussion was confined to equity investments, while bonds and other fixed-income securities were mostly left out or conceptualized as products for specific “green” sectors like renewable energy projects. Part of the reason was the absence of good data and research on the effect of integrating ESG criteria into fixed-income portfolios.

As banks increasingly integrate ESG considerations into their risk analysis, companies with a strong sustainability focus will be able to lower their cost of debt.

One of the first large studies to address this shortcoming was published by Barclays in November 2016 [pdf]. The bank’s research team looked at risk profile and return difference of fixed-income portfolios with high and low ESG scores.

The researchers used composite ESG score from two leading ESG data providers, MSCI and Sustainalytics, and constructed corporate bond portfolios that were identical at all important risk dimensions but displayed major differences in their ESG scores. They then ran their model using a 2009–2015 dataset with monthly index rebalancing. The paper finds a generally positive return premium for ESG factors, with a 0.42% per year return premium using MSCI ESG scores and a 0.29% per year return using Sustainalytics scores. In conclusion, Barclays’ research shows “(…) that portfolios that maximise ESG scores while controlling for other risk factors have outperformed the index, and that ESG-minimized portfolios underperformed.”

The positive performance of ESG-maximized fixed-income portfolios is important because credit analysts focus more on downside-protection than on upside potential. The more likely creditors think a company is to default on its debt the more the company will have to pay for debt financing it takes on.

The cost of debt is also a key input into the calculation for the weighted average cost of capital (WACC) of a company, which is an important measure that investors use to decide whether or not an investment is worth pursuing. The higher the WACC, the harder it will be for a company to convince investors to extend new lines of credits or buy their corporate bonds.

On the other hand, companies with well-run and communicated sustainability initiatives will score better in ESG ratings. A reasonable argument for sustainability professionals to make would be that as banks increasingly integrate ESG considerations into their risk analysis, companies with a strong sustainability focus will be able to lower their cost of debt.

Return on Investment: Managing for the Long Term Pays Off

One of the more difficult issues to navigate is the tension between the long-term nature of sustainability initiatives and the short-term horizons that financial professionals tend to think in. Investors — and CFOs — would like to see investment in business initiatives to pay out a handsome return after a period of one or two years max, while sustainability initiatives outside of energy efficiency and renewables usually create internalized value that pays out only over a longer term.

Companies managed for the long-term outperform their shorter-term peers on key fundamental and performance metrics.

One way to bridge that gap is to present sustainability initiatives as a long-term strategic play, and pointing out that managing for long-term value creation will deliver superior results. In January, McKinsey Global Institute (MGI) published a comprehensive discussion paper that provides plenty of evidence for this argument.

The MGI researchers assembled a proprietary Corporate Horizon Index drawn from 615 non-finance companies that had reported continuous results from 2001 to 2015 whose market capitalization in that period had exceeded $5 billion in at least one year. To distinguish between long- and short-term companies, they used five financial indicators — investment, earnings quality, margin growth, earnings growth, and quarterly targeting — based on hypotheses formed in earlier work. They then compared long- and short-term companies on performance and fundamentals indicators like revenue, earnings, profit, and market capitalization between 2001 and 2014.

The results of the MGI research show that managing for the long-term pays off in a dramatic fashion. Long-term companies outperform their shorter-term peers on fundamental and performance metrics. For example, by 2014, average revenue and earnings growth were 47% and 36% higher, respectively, and market capitalization grew faster as well. Long-term companies also added almost 12,000 more jobs on average than their peers over the period of the analysis, and contributed more to GDP growth. FinanceSustainabilityResponsible InvestmentCorporate StrategySocial Responsibility 4

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