Companies, along with their clients and customers, have become increasingly interested in the concept of ESG, which stands for “environment, social, and governance.” The idea is that sustainability initiatives provide a way for businesses to not just do well but do good.
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Asset managers, too, have faced pressure from investors to buy stocks of companies that focus on ESG.
“A lot of institutional investors are trying to incorporate ESG into their portfolio decision-making process,” says Aaron Yoon, an assistant professor of accounting and information management at Kellogg.
But the challenge, Yoon explains, is that there is no good way to quantify ESG programs’ link to stock returns. Understanding that connection would allow investors to make better decisions about the value of firms’ ESG initiatives.
So Yoon, along with Mozaffar Khan of the University of Minnesota and George Serafeim of Harvard Business School, set out to quantify this link. In doing so, they found that not all ESG investments are created equal when it comes to generating returns. The best bet, they found, is to buy stock in companies that prioritize ESG initiatives that are material to their core business practices.
“If investors are looking to understand firm ESG investments, this is how they need to assess it,” Yoon says.
The Case for Material ESG Initiatives
Many companies feel pressure from consumers to focus on ESG practices—such as using sustainable forms of energy, treating employees well, or ensuring their accounting methods are accurate.
That has led asset managers to feel similar pressure to buy shares of companies that are working to improve their environmental, social and governance practices.
But there has never been a consensus on whether focusing on ESG generates better returns for investors. Proving or disproving that would require measuring the value of ESG accurately—which is no easy task.
“You need to be able to quantify ESG meaningfully to look at its impact on investment returns.”
— Aaron Yoon
Much of the previous research in this area simply looked at whether firms undertook ESG initiatives. These studies didn’t find much of an association between a company’s ESG programs and stock returns.
Yoon and his colleagues’ approach, in contrast, uses the accounting-based concept of materiality to quantify ESG investments. Materiality captures whether a firm is undertaking ESG practices that are closely related to its core products or services.
To explain, Yoon offers two contrasting examples:
Say a company in the finance industry builds a new environmentally friendly headquarters. “That may be good for the environment, but it doesn’t really pertain to its core business, so it would be low in materiality,” Yoon says.
On the other hand, a food and beverage company that commits to sourcing ingredients in an environmentally conscious way is incorporating an ESG initiative that is material since it relates to its core business. Similarly, a non-renewables company that spends money to reduce greenhouse gas emissions would be making a material investment.
The researchers hypothesized that buying shares of businesses that undertook ESG initiatives with greater materiality would be associated with better returns.
Measuring the Value of ESG
To study this, the researchers created hypothetical portfolios of companies based on the materiality of those companies’ ESG programs.
Unlike prior studies that used aggregated MSCI KLD Score, a performance index which has 126 subcomponents on ESG issues, these researchers identified which investments were related to a company’s core business by using Sustainability Accounting Standards Board’s guidance on materiality.
Then the researchers ranked companies based on the materiality score. They created a portfolio of firms that scored highly on materiality and compared its stock returns to those of a portfolio of firms that scored poorly.
The difference in stock returns was clear over a 20-year horizon. Each year, the portfolio of firms that scored high on materiality delivered returns that were 3 percent higher than those of the other portfolio.
“Our paper shows that investing in ESG is not value-disrupting,” Yoon says, “as long as the ESG investments the companies make improve materiality.”
For companies, a key takeaway of the research is that spending money on material ESG initiatives can help create value.
For investors, there is a clear implication: asset managers have more reason to believe in the potential returns of firms’ ESG initiatives.
Yoon used to work as a trader and research analyst, and he recalls that most of Wall Street was very skeptical of ESG. “Looking back, one reason for the skepticism was because of the difficulty in quantifying firms’ ESG-related expenditures,” he says. “Our work suggests that there is now a way to better understand firms’ ESG-related efforts: with the lens of materiality.”
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