The idea that firms must trade profits and financial performance for better sustainability is a zombie, and it’s time to put it to rest for good. We’ve heard this for decades: “If companies have to pay attention to things like worker safety or greenhouse gas emissions or biodiversity, that will hit their shareholders right in the pocketbook. We’ll make you a lot of money on your investments and then you can donate it to all the causes you care about.” Such a choice: Take all my money, invest a lot of it in things that are unsustainable and harmful, and then, if I don’t have anything else to do with it, like retirement or sending children to college, I can spend maybe five percent of it on supporting the causes that motivate me. It’s time to kill the shopworn idea that we must invest in a bunch of harmful and unsustainable things to support enterprises that are more sustainable. In fact, it’s quite possible to use your entire portfolio in support of sustainability. It’s time for the zombie idea to die.
It is true that paying attention to those things isn’t free, and there’s also a lot of evidence that doing it right from a sustainability standpoint does have an impact on financial performance — but that impact is more likely to be positive than negative. There are hundreds of well-supported, well-designed studies that address this, and the majority conclude that companies and funds that are more sustainable tend to perform better than less-sustainable peers, or that there’s no need to sacrifice financially to be more sustainable; the vast majority of studies concludes at least one of these two things.
We’ll dive into some of the recent additions to the business-case literature in this paper. The financial and economic cases for sustainability are strong and are getting both deeper and broader. On the financial side, literature and research often link better sustainability performance with better financial performance. That body of work is also expanding beyond the standard correlations of sustainability rankings with standard measures of financial performance, to include other ways of looking at performance: corporate purpose and culture, innovation, diversity, human resource management and climate change, among other things.
When it comes to some of the more dramatic manifestations of risk, such as bankruptcy, tail risk and black swans, it’s useful to start with a simple perspective, which Generation Foundation summarized best in its 2017 report “All Swans Are Black in the Dark.” If you left your keys in the kitchen, looking for them under the lamppost will not help. Unsustainable practices do create risks of various types — regulatory, litigation, reputational — but if you’re not looking for those things, you’re bound to miss them, because their signals almost never appear in financial reporting, which is where most investors spend most time looking for mispriced risks.
Several recent papers have focused on these black swans. Shafer and Szado’s paper2 provides quantitative evidence that investors see strong ESG practices as a hedge against what we call a left-tail risk or a large drop in value. They opine that this could be because better sustainability practice reduces firms’ vulnerability to litigation and environmental disasters, both of which can make noticeable dents in companies’ reputational value. This study used ESG data and ratings from Sustainalytics, which covers firms from a wide range of countries.
So, would we expect to see any differences from country to country? At least one recent paper suggests that in at least one country — China — the theme that sustainability is a hedge against profound risks still works. Shahab, Ntim and Ullah report3 in a 2018 paper that better corporate sustainability ratings are associated with reduced distress levels in non-state-owned Chinese firms. The focus on both Chinese firms and non-state-owned firms is quite timely: Ever since the bankruptcy process was changed in China in 2007, there has been increasing focus on and concern over differences between Chinese accounting customs and the accounting norms used in developed markets worldwide. Investor interest in understanding what is really happening in Chinese firms, and what might signal financial distress, has sharpened. That interest is even more pronounced now that China’s economy is slowing, in part due to trade friction with the United States, and the impact of the trade war. State-owned firms are more protected from financial distress than non-state-owned firms. It is noteworthy, then, that these authors find that sustainability ratings provide a good indicator of future financial distress.
Not all risk is the black-swan variety, though. Everyday garden-variety risk is still important to investors. Lioui’s 2018 paper,4 which looked at how the market priced risk between 1992 and 2017, found that the market price of risk was -0.2% per month, which sounds tiny to everyone but investors, who know what losing 20 basis points every month for 25 years really means. It is common for lay people to believe that investors wish to avoid risk, and some do. But what’s more important to investors is that risk be understood well enough to be priced correctly. Investors don’t mind taking risk, as a rule, and some even seek riskier investments — provided that they are paid appropriately for taking those risks.
Several new papers do document the importance of including ESG factors from a risk perspective. One recent article noted that ESG, while not a traditional factor (like, e.g., value) from a factor-investing or smart beta perspective, was known to reduce risk in portfolios. A 2018 report from MSCI5 illuminates that general finding, noting that investors are interested in how ESG integration changes both systematic and stock-specific risks in portfolios over multiple time periods (Figure 1). Portfolios with higher ESG ratings had better risk-adjusted returns than their parent indexes (Figure 2).
The business case for sustainability is solid, but the ethical case is even stronger.
The drumbeat of news that our increasingly unsustainable behavior is going to cost us bigtime never falters. A couple of trending stories include a report from the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) warning that human activity threatens more than one million species with extinction, and that we will need to overcome opposition from vested interests to make the transformative changes we need to protect biodiversity effectively. It’s easy to fall into the trap of thinking, “Hey, we saw passenger pigeons and dodos and Bramble Cay melomyses go extinct, and it hasn’t really harmed us,” and write this off as just more handwringing from the bunny-huggers. Easy, but profoundly wrong. Life on Earth is interdependent, and we shouldn’t treat it as if it’s a game of Jenga. You never know which block you can get away with removing without toppling the tower. It is, however, scarily likely that removing a million of them would pretty much do the job.
Another article that caught a lot of attention recently was the news that the ice caps on Antarctica and Greenland are melting far faster than we previously thought. If we go on with business as usual, this could displace maybe 200 million people by the end of the century. This century. If your mental librarian is now filing this fact under “long-term risk,” pull it out and refile it. Sea level rise is already happening, and while it will get considerably worse if we don’t reduce greenhouse gas emissions, it’s not going to wait a century to happen: it will simply keep getting worse, starting yesterday.
It’s time we stopped treating finance and investment as some kind of moral-free zone where only dispassionate decisions are legitimate. Really making a dent in climate change, which we have only just started to do — the tip of the iceberg, to use a perfectly suited metaphor — is going to take a lot more investment and effort than we’ve put into it so far, and that will cost money. Trillions of dollars, in fact.1 That investment will absolutely compete with unsustainable things that make money, such as producing fossil fuels, and as long as we, the human race, continue to depend on fossil fuels for lights and transportation and space conditioning and plastic feedstock, there will be investors who can’t resist making money on them. The sustainability journey is something that we can’t just outsource to our retirement plans: We all have a stone to contribute to the edifice, and investors, particularly, have a key role to play in the sustainable economy transition.
Figure 1: ESG Risk Types and Time Horizons
Source: Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltan Nagy and Laura Nishikawa, “Foundations of ESG Investing Part 2: Integrating ESG Into Benchmarks,” MSCI Research Insight, May 2018.
Past performance does not guarantee future results.
Source: Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltan Nagy and Laura Nishikawa, “Foundations of ESG Investing Part 2: Integrating ESG Into Benchmarks,” MSCI Research Insight, May 2018.
The effect of ESG integration on risk holds for many specific sustainability indicators as well as broad sustainability metrics. Bank of America’s 2018 report6 about gender and investing reported that companies that had higher scores on gender and diversity metrics (board diversity, women in management and company policies on diversity and inclusion) had lower subsequent price and earnings per share volatility than companies with lower scores.
Another way to look at risk is through the lens of capital cost. Companies that are riskier pay more for their debt and tend to have lower credit ratings as a result. Here, too, we see positive correlations with sustainability. Sikacz and Wolczek’s paper7 noted that of all the studies they reviewed that verified correlations between corporate social responsibility (CSR) ratings and the cost of capital, all 19 such studies showed a positive correlation between higher CSR ratings and lower costs of capital. Hermes Investment Management examined8 credit default swaps spreads (which the authors describe as the purest reflection of credit risk) and found that companies with better ESG scores had lower credit risk, even when controlling for credit ratings.
Does this credit/risk connection pay off for investors? Evidence shows it does. A new report from Barclays9 showed that tilting a credit portfolio to overweight high-ESG bonds, keeping other financial risk characteristics unchanged, resulted in higher performance in all three bond markets studied (European and U.S. investment-grade bond markets, and U.S. high yield bond markets). On the equity side of the aisle, MSCI’s report noted that ESG indexes not only had better risk characteristics but higher risk-adjusted returns as well.
Researchers interested in the payoff to sustainability are also looking for impact in places that haven’t been well illuminated in the past. One of those places is innovation.
There is little question that innovation has driven the U.S. economy for many decades. Yes, we still rely on things such as endowments of natural resources and a large, relatively well-educated population for our competitive advantage, but the soul of competitiveness for many years in a lot of developed market economies has been technology and innovation.
Source: Kirsten A. Cook, Andrea Romi, Daniela Sanchez and Juan Manuel Sanchez, “The Influence of Corporate Social Responsibility on Investment Efficiency and Innovation,” Forthcoming in the Journal of Business Finance and Accounting, Social Science Research Network, Nov. 2018.
We’ve often used technology to solve sustainability problems, and we will need to lean on it even more to achieve a more sustainable economy. We need to find ways to store electricity economically, treat water, reduce waste and pollution, and use artificial intelligence in ways that help us to use human potential without reinforcing existing patterns of discrimination and bias. We need to repair and replace crumbling infrastructures in ways that also help restore ecosystem functions that older infrastructures harmed. We need to find ways to grow more food without the chemical pollution that came with the Green Revolution, and without harming our already impaired soils. And so much more.
What’s interesting about the business-case literature is the emerging strain that shows links between measures of sustainability and innovation, beyond the technology-as-sustainability-fairy-dust story. Cook, Romi, Sanchez and Sanchez provide evidence10 that companies with better performance on corporate social responsibility measures are not only more efficient at investing their own capital but generate more patents and patent citations as well. How does that work? First, CSR widens the number of key stakeholders that corporate managers serve — beyond the financial stakeholders who hold ownership stakes and provide capital to include employees, customers, suppliers, communities and the planet. Balancing all these stakeholders, they say, improves the efficiency of managerial decision-making, and that shows up in both investment efficiency and innovation (Figure 3).
The links between a more diverse set of voices important to decision-making and innovation also show up with increasing prominence in the literature on diversity itself. Lorenzo and Reeves surveyed11 more than 1,700 companies in eight countries (the U.S., France, Germany, China, Brazil, India, Switzerland and Austria) and collected data on various measures of management diversity and revenues coming from products introduced during the last three years. This is a different view of innovation than we saw in the previous paper, but the general conclusion is very similar: In all eight countries, there was a statistically significant and positive relationship between managerial diversity and innovation outcomes (Figure 4).
Source: Rocio Lorenzo and Martin Reeves, “How and Where Diversity Drives Financial Performance,” Harvard Business Review, Jan. 30, 2018.
Diversity is increasingly linked to a number of financially relevant outcomes, and we’ve mentioned two already: risk management and innovation. There are other links, as well.
Meggin Thwing Eastman’s work at MSCI notes12 that companies with more women on boards tend to be better managers of talent, as well. This work rated companies on how well they manage the talent pool of their employees using several measures, including regular engagement surveys, leadership training and support for continuing education. The companies that were ranked as “Talent Leaders” were far more likely to have three or more female directors for at least three years. Talent laggards, on the other hand, were “much more likely to have few or no women on board.” See Figure 5.
Source: Meggin Thwing Eastman, “Women on Boards: One Piece of a Bigger Puzzle,” MSCI, March 6, 2018.
McKinsey also notes, in its work “Delivering Through Diversity,”13 that companies with more diversity on their executive teams are also better able to attract top talent and rank better on employee satisfaction. Diversity, in this work, was measured in multiple ways, including gender, ethnicity and culture, and the research looked at more than 1,000 companies across 12 countries.
A different take on the importance of human resources came from Gartenberg, Prat and Serafeim.14 The authors created a measure of corporate purpose from around 500,000 employee survey responses and found that corporate purpose took two forms: camaraderie between workers and clarity from management. Companies with high purpose had systematically higher future accounting and stock market performance.
There have also been a fair number of new studies emerging that talk about climate change, one of the most important aspects of sustainability and an area in which progress is simply essential to maintain our economic and social cohesion. Investors are increasingly aware that climate change poses many different types of risk to companies and financial performance, ranging from regulatory and litigation risks that primarily affect the largest greenhouse gas (GHG) emitters to physical risks that can affect any company. Investors are also increasingly aware that a transition to a low-carbon economy means that we cannot afford to use all the known reserves of fossil fuels as energy feedstocks and that creating an energy infrastructure that does not involve carbon emissions will require significant investment.
The financial and academic literature shows that all this burgeoning awareness is showing up in financial performance. Work done by As You Sow15 and Corporate Knights shows that the Carbon Clean 200, a group of 200 publicly listed companies that are providing solutions for a clean energy future has outperformed its fossil fuel benchmark, the S&P Global 1200 Energy, since 2016 (Figure 6). That fund, like nearly everything else, suffered in the fourth quarter of 2018. It is also noteworthy that the Carbon Clean 200 ex-China has outperformed the same benchmark by a healthy margin since 2016, and also outperformed a broad market benchmark, the S&P Global 1200, except in the fourth quarter of 2018. The situation in China, where many producers of clean energy equipment gained market share by keeping prices low, made it difficult for producers outside of China to compete. In 2018, China began to cut its subsidies for wind and solar, which hurt Chinese equipment manufacturers in particular. The Carbon Clean 200, by focusing on clean energy solutions, includes a broader array of industries and sectors, including information technology and consumer sectors as well as the expected industrials, materials and utilities sectors.
Past performance does not guarantee future results.
Source: As You Sow, “Carbon Clean 200™: Investing in a Clean Energy Future,” 2019.
The business-case literature has been focusing more heavily on climate risks, especially as the scientific community is increasingly able to attribute specific current events such as floods, storms and droughts to climate change. That developing science helps investors better understand that physical climate risk, often classified as a long-term risk factor, is already happening, and thus poses risks that are understandable and able to be modeled in the short term as well.
One interesting new take came from a 2019 paper from Engle, Giglio, Lee, Kelly and Stroebel,16 who showed that a portfolio of companies chosen by examining their exposure to climate risk provides a better way to hedge climate change risk than hedging strategies based primarily on industry tilts. For those who still believe that climate change is primarily a long-term risk factor, the fact that this strategy works in the present should be a wake-up call.
Another new paper focused on tail risk,17 a topic we took up at the beginning of this paper. The authors found that the downside risk for companies in the S&P 500 with higher carbon emissions was higher than for lower emitters between 2010 and 2017, and that market uncertainty regarding firm fundamentals was also greater for the big emitters. The downside risks were also significantly increased by the Paris Agreement.
This paper provides a bit of insight into a sample of the literature linking financial performance to sustainability. There is far more literature with similar findings than the papers included in this report, and that, too, is a conclusion echoed in the literature: There are far more studies showing that companies and funds that are more sustainable outperform peers than papers demonstrating underperformance. That should not be surprising, now that more and more financial analysts regard the business case for sustainability as solid and well-documented.
But it should also not be a surprise that there is still literature documenting underperformance among more sustainable companies and funds. Very few things in modern finance — or science of any stripe, for that matter — are monolithic. There are times when sustainable companies and funds do underperform, because there are simply no strategies or companies that outperform 24/7/365. Investor sentiments, world events, economic performance and even at times animal spirits can influence financial outcomes just as surely as any stock-picking discipline, valuation method or fund strategy — for a while. What matters is what happens most of the time, and what we know from decades’ worth of literature is that, most of the time, incorporating sustainability into investing does not involve any financial sacrifice.
It shouldn’t. With a population of more than seven billion heading for 10 billion, humans have never placed this much stress on our endowments of natural resources, nor have we ever faced this much competition for well-being and wealth. If we do not learn to be far more sustainable, we’re cruising for disaster. The fact that that shows up in financial markets is heartening, and speaks to the fact that, over the long run, there really is rationality in financial markets.
1 Andrew Steer, Helen Mountford and Molly McGregor, “Low-Carbon Growth Is a $26 Trillion Opportunity: Here Are Four Ways to Seize It,” World Resources Institute, Sept. 5, 2018.
2 Michael Shafer and Edward Szado, “Environmental, Social and Governance Practices and Perceived Tail Risk,” Social Science Research Network, Nov. 1, 2018.
3 Yasir Shahab, Collins G. Ntim and Farid Ullah, “The Brighter Side of Being Socially Responsible: CSR Ratings and Financial Distress Among Chinese State and Non-State-Owned Firms,” Social Science Research Network, March 12, 2018.
4 Abraham Lioui, “Is ESG Risk Priced?” Social Science Research Network, Nov. 15, 2018.
5 Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltan Nagy and Laura Nishikawa, “Foundations of ESG Investing Part 2: Integrating ESG Into Benchmarks,” MSCI Research Insight, May 2018.
6 Savita Subramanian, Jill Carey Hall and James Yeo, “Women: The X-Factor,” Bank of America Merrill Lynch, March 7, 2018.
7 Hanna Sikacz and Przemyslaw Wolczek, “ESG Analysis of Companies Included in the Respect Index Based on Thomson Reuters EIKON Database,” Social Science Research Network, Research Papers of Wroclaw University Economics 2018, Dec. 26, 2018.
8 Mitch Reznick and Dr. Michael Viehs, “Pricing ESG Risk in Credit Markets: Reinforcing our Conviction,” Hermes Investment Management, Take Note, Q4 2018.
9 Barclays, “The Case for Sustainable Bond Investing Strengthens,” Impact Series 04, Oct. 22, 2018.
10 Kirsten A. Cook, Andrea Romi, Daniela Sanchez and Juan Manuel Sanchez, “The Influence of Corporate Social Responsibility on Investment Efficiency and Innovation,” Forthcoming in the Journal of Business Finance and Accounting, Social Science Research Network, Nov. 2018.
11 Rocio Lorenzo and Martin Reeves, “How and Where Diversity Drives Financial Performance,” Harvard Business Review, Jan. 30, 2018; and Roció Lorenzo, Nicole Voigt, Miki Tsunaka, Matt Krentz, and Katie Abouzahr, “How Diverse Leadership Teams Boost Innovation,” Boston Consulting Group, Jan. 23, 2018.
12 Meggin Thwing Eastman, “Women on Boards: One Piece of a Bigger Puzzle,” MSCI, March 6, 2018.
13 Vivian Hunt, Lareina Yee, Sara Prince and Sundiatu Dixon-Fyle, “Delivering Through Diversity,” McKinsey & Company, Jan. 2018.
14 Claudine Gartenberg, Andrea Prat and George Serafeim, “Corporate Purpose and Financial Performance,” Social Science Research Network, Oct. 9, 2018.
15 As You Sow, “Carbon Clean 200™: Investing in a Clean Energy Future,” 2019.
16 Robert F. Engle, Stefano Giglio, Heebum Lee, Bryan T. Kelly and Johannes Stroebel, “Hedging Climate Change News,” Social Science Research Network, Jan. 17, 2019.
17 Emirhan Ilhan, Zacharias Sautner, and Grigory Vilkov, “Carbon Tail Risk,” Social Science Research Network, July 19, 2018.
Credit default swap is a financial derivative or contract that allows an investor to “swap” or offset his or her credit risk with that of another investor.
Earnings per share – Earnings per share is a company’s profit divided by the outstanding shares of its common stock.
Information ratio measures the consistency of excess returns relative to a benchmark.
The MSCI ACWI ESG Leaders Index is a capitalization-weighted index that provides exposure to companies with high environmental, social and governance performance relative to their sector peers. MSCI ACWI ESG Leaders Index consists of large and mid-cap companies across 23 Developed Markets (DM) and 26 Emerging Markets (EM) countries. The MSCI ACWI Index is a market capitalization-weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI ESG Universal Index is based on the MSCI ACWI Index, its parent index, and includes large- and mid-cap securities across 23 Developed Markets (DM) and 26 Emerging Markets (EM) countries. One cannot invest directly in an index.
Price per share is the cost of a share of a company’s stock.
Price to earnings ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Tracking error is the difference between a portfolio’s returns and the benchmark or index it was meant to mimic or beat.