Does It Pay Off to Invest in Companies That Engage in Sustainable Practices?
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Social Impact Finance & Accounting Nov 6, 2018

Does It Pay Off to Invest in Companies That Engage in Sustainable Practices?

New research helps to quantify the value of “ESG” initiatives.

Quantifying the value of sustainable practices.

Michael Meier

Based on the research of

Mozaffar Khan

George Serafeim

Aaron Yoon

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 mate­ri­al­to 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.”

Mate­r­i­al Returns

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.”

Featured Faculty

Aaron Yoon

Assistant Professor of Accounting & Information Management

About the Writer

Sachin Waikar is a freelance writer based in Evanston, Illinois.

About the Research

Khan, Mozaffar, George Serafeim, and Aaron Yoon. 2016. “Corporate Sustainability: First Evidence on Materiality.” The Accounting Review. 91(6): 1697–1724.

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