For investors focused on profit, investing in environmentally friendly firms may not seem like the most lucrative strategy. They may worry that adopting greener practices could hurt a company’s share price.
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But in a new paper, Kellogg researchers argue just the opposite. Paying attention to firms’ sustainability—captured in metrics called environmental, social, and governance (ESG) criteria—can actually improve the share price, the paper concludes. Green companies may not be raking in the cash now, but they are more likely to outlast sudden industry shake-ups, such as new pollution regulations or consumer-driven demand for eco-friendly products.
“They can adapt better to these kinds of changes,” says Ravi Jagannathan, a professor of finance at the Kellogg School of Management. “Firms that are truly doing better along those dimensions are safer.”
The research builds on previous work suggesting that well-governed firms—those that score high on the governance part of ESG ratings—perform better. Jagannathan and coauthors focused their attention on the environmental aspect of ESG ratings.
For investors, paying attention to environment-related risks is particularly important in the age of social media, the authors say. Today’s consumers can communicate and mobilize much faster—for instance, to shame a company for its unsustainable practices. Because of this heightened awareness, Jagannathan predicts that new environmental regulations will follow public protest more quickly than in the past.
“The amount of time it takes for regulation to catch up has actually narrowed,” he says.
A Growing Interest in ESG Criteria
Money managers often base decisions largely on whether a stock seems like a good deal—that is, whether they could buy it for less than it was really worth or might be worth soon. The authors point out that a firm’s worth depends on investors’ perception of its future cash flows, which in turn depend on the rules of the game in the future. And those rules are likely to change significantly given the increased public concern about environmental, governance, and social issues.
ESG criteria encompass three types of measures.
The environmental metrics capture how green a company is—for example, the amount of carbon emitted or acres of forest cut down as part of production. The social criteria cover issues such as whether the firm promotes gender equality. And the governance portion measures whether a company is well-managed. For instance, if a firm’s CEO is also on the board, that might create a conflict of interest and would lower the governance rating.
Companies that do not prepare for ESG-related changes, Jagannathan says, “will lose out in the long run.”
There are currently no standards for companies to report ESG-related information. But investment research companies have come up with ways to calculate these ratings using a variety of resources, such as government data sets, company documents, and media reports.
Why have more investors started watching ESG ratings? The authors believe that there are a few factors at play.
While some money managers may feel an ethical obligation to invest in greener companies or feel pressure from clients to do so, others may care only about their fiduciary obligation to their clients. But even those money managers whose only goal is to maximize returns seem to have realized that sustainable companies are a better bet in the long run.
“ESG criteria can help both types of people,” says coauthor Marco Sammon, a PhD student at Kellogg. “Even money managers who only care about risk and returns could benefit from considering these things.”
The Case for Paying Attention to Environmental-Related Risk
To understand why, consider an important source of risk for companies: new regulations.
For example, let’s say the government places stricter limits on sulfur-dioxide pollution from coal power plants. Heavily polluting firms may need to buy new equipment to reduce emissions or switch to coal with lower sulfur content. If they have trouble making this transition, they may eventually fail.
Companies that pollute more now “will be adversely affected by more stringent environmental laws coming into play and by alternative technologies spurred by environmental concerns,” Jagannathan says.
Consumers can drive unexpected industry changes, too. For example, in 2011 in Boulder, Colorado, some residents thought that the carbon emissions generated by the city’s electricity provider were too high. So people voted to allow the city to create its own utility. The researchers point out that these types of risks have emerged due to the rise in the use of social media for communication among the public.
“You can’t just think about regulation coming from the government,” Sammon says. “Consumer action can have the same effect.”
And calling out bad behavior can happen fast with the help of Facebook and Twitter.
Jagannathan points to the Uber scandal that erupted in 2017: Public outrage spread quickly online after a former employee published a blog post accusing the company of mismanaging sexual-harassment complaints. That uproar was seen as one of the reasons the CEO resigned four months later. Similarly, a widely circulated video of a United Airlines passenger being dragged off a flight prompted the company to pledge within days to reevaluate its procedures.
While those examples don’t relate specifically to environmental issues, similar incidents could happen to unsustainable companies.
“Social media has made it easy to identify violators,” Jagannathan says. If you invest in companies with shady environmental practices, “you may be caught by surprise.”
Why Investors Should Care about ESG Criteria
The team—which also included Ashwin Ravikumar, an expert on environmental issues at Amherst College—examined two specific cases in detail in their study.
The first case study was coal stocks. During his presidential campaign, Donald Trump pledged to help the coal industry by ending the “war on coal.” When he was elected, coal stocks surged—likely because investors thought Trump would weaken environmental regulations. This pattern suggests that even the expectation of changing laws—whether in favor of or against sustainability—can have rapid, dramatic effects on the market, the authors say.
But in the following months, coal stocks sagged again. Investors may have found that deregulation did not happen as quickly or benefit the coal industry as much as expected, Sammon speculates.
In addition, major consumers of coal, like China, reiterated their support for reducing reliance on fossil fuels. And technological innovations have made other sources of energy such as natural gas relatively cheap. Even if environmental laws were relaxed, coal still faced stiff competition.
“What is standing in the way of coal is not regulation,” Jagannathan says. “You need to worry about alternative technologies catching up in response to consumers’ concerns.”
If investors had considered the long-term competitiveness of coal given the increased global concern about pollution and climate change, prices of coal stocks would not have risen sharply immediately following Trump’s election, Sammon suggests.
The second case study was palm oil. Producing this substance, which is ubiquitous in food and beauty products, can wreak environmental damage because rainforests and peatlands are often cleared for farms.
But some firms are yielding to social pressure from consumers to reduce their use of unsustainable palm oil. Companies such as Unilever and McDonald’s have pledged to stop buying palm oil from environmentally unfriendly suppliers. If governments eventually crack down on unsustainable firms, many palm-oil fields could become stranded assets.
Among companies that use palm oil, a firm such as Unilever is a better bet for investors than one that ignores sustainability concerns, Sammon says. If new regulations arise, “Unilever will be well-positioned, and the other firms won’t be,” he says.
The team acknowledges that ESG criteria are not perfect. A firm carrying out unsustainable practices under the radar could still score a high rating. Many ESG scores draw on companies’ self-reported data and may be unreliable.
Research also needs to investigate the link between ESG criteria and stock performance. These ratings have not been around very long, so data are sparse. But as more data accumulate, researchers could test whether the team’s conjectures hold true—for example, whether firms with low ESG scores perform worse when new regulations are passed.
In the meantime, the authors argue that investors should continue to pay attention to environmental metrics. Companies that do not prepare for ESG-related changes, Jagannathan says, “will lose out in the long run.”
Roberta Kwok is a freelance science writer based near Seattle.
Jagannathan, Ravi, Ashwin Ravikumar, and Marco Sammon. 2018. “Environmental, Social, and Governance Criteria: Why Investors Should Care.” Journal of Investment Management. 16(1).
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