The Case for Investing in Green Companies
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Operations Social Impact May 2, 2018

The Case for Invest­ing in Green Companies

Sus­tain­ably mind­ed firms are more like­ly to with­stand indus­try shake-ups.

Investors examine a company's sustainable initiatives.

Lisa Röper

Based on the research of

Ravi Jagannathan

Ashwin Ravikumar

Marco Sammon

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. 

And investors are tak­ing note. In 2012, pro­fes­sion­al mon­ey man­agers con­sid­ered ESG cri­te­ria in their invest­ment strate­gies for 22 per­cent of glob­al assets. By 2016, that fig­ure rose to 26 per­cent.

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.”

Featured Faculty

Ravi Jagannathan

Chicago Mercantile Exchange/John F. Sandner Professor of Finance and Co-Director, Financial Institutions and Markets Research

About the Writer

Roberta Kwok is a freelance science writer based near Seattle.

About the Research

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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