A review of 72 studies makes the financial case for ESG.
Since the mid-1980s, academic researchers have documented the importance of good governance for firms’ short- and long-term financial and economic performance. More recently, focus has turned to environmental and social responsibility. ESG (Environmental, Social and Governance) is shorthand for a firm’s performance across all three dimensions. CSR (Corporate Social Responsibility) refers to the E and S of ESG.
In this review, I find that ESG has a clear impact on the value and financial performance of firms. Below I discuss five key findings.
ESG performance is related to financial performance
The economic arguments in favor of improved governance are simple: good corporate governance reduces agency problems and improves the alignment of manager and shareholder objectives. Agency problems refer to the conflicts of interest that arise because the decision that is best from the manager’s point of view is not necessarily the best from the point of view of the firm’s owners, shareholders or stakeholders.
Studies show that firms with good governance systematically outperform firms with poor governance. Moreover, firms with stronger shareholder rights have higher profits, higher sales growth and lower capital expenditures – which translate into higher market value.
The economic arguments in favor of good CSR performance are similar, but less straightforward. On the face of it, increased concern with long-term sustainability should lead to long-term shareholder value and returns. However, the costs of improved performance may be steep, while the benefits can be uncertain and far into the future. Striking the right balance between the costs and benefits of improved CSR performance requires good governance.
Studies show that over the last 2 decades, the link between environmental and social performance on the one hand, and financial performance on the other has strengthened significantly. While 20 years ago CSR performance had little impact on firm performance, in recent years (especially during the financial crisis), firms with better CSR scores achieved superior financial performance and equity returns.
However, most studies fail to control fully for related factors that may affect firm profitability and returns. While the evidence shows a positive relation between CSR performance and financial performance, it does not establish conclusively whether CSR engagement actually causes improved financial performance. A further difficulty is that there is still no consensus on how to measure CSR performance.
Nevertheless, an increasing number of studies suggest that better CSR does in fact lead to higher firm value, better deals in mergers and acquisitions and cheaper credit, and therefore has a positive impact on stakeholder wealth, and that this positive relation is stronger for firms with better governance.
Negative ESG events significantly affect firm value
While the ESG performance of normal corporate operations is difficult to assess, unexpected events may shed light on weaknesses or strengths in a firms CSR behavior.
For example, environmental accidents like BP’s Deepwater Horizon well failure provide observable evidence of the strengths or weaknesses of corporate environmental risk mitigation policies. Other examples would be the publication of independent investigative reports on questionable labor practices, poor social policies or inadequate environmental compliance, at the parent company level or at the subsidiary or sub-contractor level.
Such events have a strong negative effect on stock value, especially for social and environmental events. Moreover, negative ESG events tend to affect shareholder returns directly, because they often lead to liability claims that take precedence over shareholder payouts.
Investors’ reaction to positive ESG events is more nuanced. Stock returns react positively if a positive ESG event follows an earlier negative event, for example independent news of a successful rapid containment and cleanup of an accidental discharge.
Likewise, investors react positively when positive ESG events occur to firms with good corporate governance. However, for firms with poor corporate governance, investors react skeptically to positive ESG events because they view such events as possible signals of mismanagement and over-expenditure on ESG.
Governance is critical
The evidence discussed above suggests that the link between a firm’s CSR performance and its financial performance is stronger for firms with good governance than for firms with poor governance. Moreover, firms with better governance experience smaller stock value declines following negative ESG events and greater stock value increases following positive ESG events than firms with poor governance.
Therefore it is not enough for firms to address CSR, they must also address governance. Good governance is crucial for good CSR.
Shareholder engagement to improve ESG positively impacts security values
Several studies document a positive impact of ESG motivated investor action on security values. For example, companies that responded to institutional pressure to participate in the Carbon Disclosure Project experienced increased shareholder value when the likelihood of climate change regulation rose.
Successful engagement may lead to improvements in the target firm’s operating performance and profitability, a reduction in stock volatility, improvement in governance scores and increased institutional ownership. Successful engagement increases stakeholder value and often shareholder value as well. Equally importantly, failed engagement does not decrease firm value, and hence does not have a negative impact on shareholder returns.
Stock values increasingly reflect ESG concerns
In the 1990s and early 2000s, as the focus on responsible investments and sustainability became more mainstream, funds invested in stocks with high ESG ratings generated higher returns for their investors than funds whose holdings had poor ESG ratings. In the last decade, the return advantage of high ESG funds has declined or disappeared.
This suggests that stock valuations now at least partially reflect corporate value and profitability implications of high ESG performance. In other words, responsible investing has gone mainstream and companies would do well do pay due attention to their performance on CSR and governance.