How ESG Makes Companies Better

New research shows that companies that adhere to positive environmental, social and governance (ESG) principles have lower costs of capital, higher valuations, are less vulnerable to systemic risks and are more profitable. But beware; those higher valuations translate to lower expected returns for investors.

ESG investing covers many different investment approaches addressing three main areas, each with its own main objective:

  1. Values-based investing: Align the portfolio with the investor’s beliefs;
  2. Impact investing: Use capital to trigger change for social or environmental purposes; and
  3. ESG integration: Improve the risk-return characteristics of a portfolio.

The popularity of ESG investing, which now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe, has been accompanied by heightened research into the subject, with more than 1,000 research reports published with mixed results – finding positive, negative and nonexistent correlations between ESG and financial performance. The inconclusive results may stem from the different underlying ESG data used, the varying methodologies applied (especially insofar as they control for common factor exposures), and the fact that the heightened demand for ESG investments has led to rising valuations of stocks with high ESG scores relative to stocks with low ESG scores. Increased cashflows have two effects. First, they lead to short-term capital gains. Ultimately, the higher valuations mean that investors should expect lower future returns over the long term.

Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy and Laura Nishikawa contribute to our understanding of how ESG affects equity valuations, risk and performance with their study “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” which was published in the July 2019 issue of The Journal of Portfolio Management. They noted that one issue with prior research was that it failed to differentiate between correlation and causality: “Often, a correlation between ESG and financial variables is implicitly interpreted to mean that ESG is the cause and financial value the effect, although the transmission easily could also be reversed.” Therefore, they took a different approach: “Instead of simply looking for correlations between ESG characteristics and financial performance in historical data, we first analyze the transmission channels from ESG to financial performance and develop a fundamental understanding of how ESG characteristics affect corporations’ valuations and risk profiles. Afterwards, we verify these transmission mechanisms using empirical analysis.” Their approach provides three benefits:

1. It mitigates the risk of correlation mining between ESG data and financial performance data.

2. It reduces the risk of finding correlations that are caused by unintentional exposures to common factors.

3. It better differentiates between correlation and causality by studying transmission channels.