I’ve been collecting articles that link sustainability to financial performance for a long time (when I started, people were hunting mammoths). There are now hundreds of papers in that database, and all of them show that there’s no reason to believe that being more sustainable is costlier, less profitable, or produces worse risk-adjusted returns. There’s a lot of stored-up wisdom in that database, so much that writing a summary of all of it would rival the Oxford English Dictionary in length. Communication experts assure me that this is a surefire way to fell a tree in an unpopulated forest, so I am planning to write periodic updates about what’s new and interesting in that body of knowledge. This is chapter one.
Financial returns are not the only reason to invest sustainably. There are all kinds of reasons to do it, including using wealth to build a more sustainable world for future generations, and to satisfy our need to do something greater than just exist. But it’s not philanthropy either: returns are important to investors. The idea that sustainable investing involves sacrificing returns is a kind of intellectual zombie, something that feeds on brains and deprives its victims of the power of thought. There are a few good additions to the literature on the returns to sustainable investing over the past few months.
- Bank of America Merrill Lynch’s second report on ESG highlights the risk-predictive value of ESG information. The report notes that ESG attributes are a better signal of future earnings volatility than any other measure the analysts had found, and states in the first paragraph that “ESG would have helped investors avoid 90% of bankruptcies” in the time frame examined.
- A new academic article explored the benefits of corporate social responsibility (CSR) to corporate bonds during the financial crisis, noting that firms with higher CSR benefited from lower bond spreads on secondary markets during the financial crisis, and were able to raise more debt capital on primary markets as well.
I’ve heard several times from people who know what ESG is that the G factor—governance—is the one least connected to either sustainability or performance. Two recent reports stand out for knitting sustainability and governance together in cogent, persuasive ways.
- An article from the National Association of Corporate Directors explored how boards cope with reputation risk, something that sounds like a soft factor to a lot of quantitatively-minded analysts, but can be a source of profound, even existential risk, especially these days, when intangibles account for 87% of market value for the S&P 500. Why? If the vast majority of your value is intangible, a reputational crisis can cost your company a lot of its value—just ask Volkswagen, BP, Equifax, and Chipotle—and there aren’t enough brick-and-mortar assets to make enough of a safety net to keep the company from becoming shark bait for hedge fund activists or takeover specialists. This paper explores how the impact of environmental and social factors are not on the radar of many boards, and that “unfortunately, many ESG and CR [corporate responsibility] risks are unknown to the board until an incident happens and it goes public—and possibly viral.” The article goes on to show how boards can better identify and manage such risks—and capitalize on reputational opportunities as well.
- That point is reinforced by a recent report from Ceres, Lead from the Top: Building Sustainability Competence on Corporate Boards, which describes how sustainability performance can be a disruptive risk, and describes strategies to build a sustainability-competent board. There are three strategies to do that: integrate sustainability expertise by bringing directors with that skill and experience onto the board; educate board members on sustainability, and engage with stakeholders and shareholders on sustainability issues.
In the entire galaxy of ESG factors, social factors are widely perceived as the ones most likely to be “soft”, which some in finance equate with “subjective.” It’s wise not to swallow that whole. Yes, there are at times subjective judgments applied to these factors, but there are just as many that are factual and objective, even if they’re not quantitative. Does a firm have a human rights policy for overseas factories that covers child, forced, and sweatshop factors? Does a firm provide parental leave? What percentage of senior decision makers are women or minorities? These aren’t subjective, they’re factual. The literature linking these factors to performance is growing. There have been a couple of recent additions to that literature.
- A recent academic article tackled the issue of “soft” skills directly, looking at whether efforts to educate garment workers in India in skills like teamwork, leadership, and cognitive information processing paid off. Garment factories are notorious for not investing in workers’ skills, in part because turnover is high, and in part because competitiveness is often built on low-cost, low-skill production. But the experiment described in this study showed that workers who were given such training were more likely to invest in further skill development, and were more productive, to the point where the program “pays for itself several times over by the end of the evaluation period.”
- Another article explored the performance of gender-diverse portfolios, showing that such portfolios may have smaller downside risk, smaller idiosyncratic risks, and better CSR ratings, which could act much like insurance in providing protection against certain types of risk.
- Another interesting academic paper found that firms whose employees believe that their work has meaning—which the paper notes is often characterized by positive impact on social and environmental issues—are more productive, and this pays off for firms with such qualities in higher future accounting and stock market performance.
Environment is usually well covered in the literature linking environmental quality or management to financial performance, in part because many environmental variables are inherently quantitative. Perhaps the most pervasive environmental issue of our time—and that of our children and grandchildren—is climate change, which affects nearly everything else. A recent paper from the Center for Social and Sustainable Products AG in Switzerland and South Pole Carbon examined the performance of eleven investment indices constructed to reflect climate-friendly policies of constituents, and noted that almost all had higher returns than their corresponding benchmark indices, and eight of the eleven had superior risk-return ratios than the corresponding benchmarks.
The statements and opinions expressed are those of the authors of this report. All information is historical and not indicative of future results and subject to change. This information is not a recommendation to buy or sell any security.