Using criteria based on environmental, social and governance (ESG) considerations has become an increasingly important aspect of investment decision making, particularly for high profile institutional investors. Investors, including some of the largest institutions, have added social responsibility criteria to their investing screens, and it was estimated that there were approximately $30 trillion invested in “sustainable” assets worldwide in 2019. On the corporate side, there has been a growing awareness of the need to be, or at least appear to be, socially responsible, either to fend off pressure from interest groups and the media, or to market themselves to customers. Both investors and corporate leaders are being told that being environmentally and socially conscious will deliver higher returns (for investors) and higher profits (for companies). In our paper, we take a look at the promises being made by ESG advocates, looking at both the theory and evidence, and argue that most of these promises do not stand up to scrutiny.
Measuring ESG and Corporate Social Responsibility
Much of the debate around ESG and corporate social responsibility starts with the premise that we can differentiate clearly between “good” and “bad” companies, but that is not the case. Unlike profitability and returns, where there are accepted measures of both and numbers to back them up, social responsibility is often in the eye of the beholder. This problem would not be so bad if all the ratings were effectively similar, but this is not the situation. The rating organizations differ not only in how to measure the various ESG criteria, but also with respect to what criteria are deemed worthy of measurement. In some cases, the criteria are so numerous that it is difficult to separate those that are germane from those that are not. While virtually all the raters include the most highly publicized indicators in their ratings, they still fail to agree on how these indicators are to be measured.
We question why governance, a measure that has historically been defined in research in terms of responsiveness of managers at publicly traded companies to their shareholders, is bundled with environmental responsiveness and social consciousness, two concepts that often require managers to put the interests of other stakeholder groups ahead of shareholders. It may be that the governance that is incorporated in the ESG concept is different from the conventional governance measures, but if it is, any references to the payoff to good corporate governance should be not be part of the ESG sales pitch, because it represents a mindset diametrically opposed to the stakeholder value mindset that underlies much of the ESG advocacy.
Value and Social Responsibility
In its simplest form, the value of a business comes from the expected cash flows it can generate over time, discounted back to present value at a “risk adjusted” discount rate.
Note that there is nothing in this structure that tilts a company towards short term profitability, because it allows that the company to trade off lower profits (and cash flows) in the near term for higher profits and cash flows in the future, thus preempting a standard critique of value maximization as myopic. There are four drivers of value: (a) revenue growth, capturing a company’s capacity to scale up; (b) operating margins, measuring the company’s capacity to be profitable; (c) discount rates and failure probabilities, reflecting the risk in the business model; and (d) sales to capital, factoring in the efficiency with which the company delivers growth. These drivers are captured in Figure 1:
Figure 1: The Drivers of Value
If being a “good company” increases value, it will have to show up in these inputs. Using this framework, we can see three possible pathways for ESG to create value.
The Virtuous Cycle
There is a plausible scenario where being good creates a cycle of positive outcomes, thereby making the company more valuable. This scenario is depicted in Figure 2, where being good benefits the company on every dimension, with customers more willing to buy its products, suppliers and lenders offering it better terms because it is a good company, and investors more inclined to invest in it.
For proponents of corporate social responsibility, this is the best-case setting for their cause, because being good and doing well converge. This scenario holds, though, only because customers, employees, investors, and lenders all put their money where their convictions lie and are willing to make sacrifices along the way.
The Punitive Scenario
Even if good companies are not rewarded by customers and investors, the case for ESG can still be made if bad companies get punished by the same groups. This less upbeat scenario is captured in Figure 3.
Here, the punishment for bad companies is meted out from every direction, with customers refusing to buy their products, suppliers and lenders demanding more onerous terms and investors holding back. These companies also risk exposure to grievous, or even catastrophic events, arising from operating with too little consideration of societal costs. With regard to promoting social responsibility, this scenario is not as good as the virtuous cycle, because it will tend to scare companies away from being “bad” rather than induce them to be “good.”
There is a final and darker scenario that is also plausible, where being good does not yield an upside and bad companies are not punished but are rewarded. This creates a perverse outcome where bad companies outperform good ones, not only on operating metrics but also with respect to stock returns. Figure 4 portrays this scenario:
In this scenario, bad companies mouth platitudes about social responsibility and environmental consciousness without taking any real action, but customers buy their products and services (either because they are cheaper or because it is convenient), employees continue to work for them because they can earn more, and investors bid up their stock prices because the expected cash flows are greater and the company is perceived as less risky. As a result, bad companies may score low on corporate responsibility scales, but they will score high on profitability and stock price performance.
The Evidence on ESG and CSR
Testing whether social responsibility pays off is difficult for two reasons. One is that, as we noted earlier, there is no consensus on what comprises a good company, with different raters using different metrics and measures. The second is that even within the research, there is confusion regarding what is being tested, and what the findings say about the payoff to being socially responsible. As we see it, there are three fundamental questions:
- Do “good” companies create more value than “bad” companies? If good companies grow faster and are more profitable than bad companies, it will lead to good companies being more valuable than bad ones. An alternative possibility is thatif bad companies are viewed as riskier than good companies, that would lead them to have higher costs of equity and capital, and lower values, also supportive of the thesis that it is better to strive for corporate responsibility.
- Do markets price good companies higher than bad companies? If good companies are priced higher by markets, either because they are perceived to be better performers or because investors prefer to hold them as investments, it too would be a powerful incentive for companies to be socially responsible.
- Does investing in good companies earn higher average returns than investing in bad companies? If investments in good companies offer higher expected returns, it would make the push towards socially responsible investing much easier. But as we explain below, if good companies are preferred investments for social responsibility reasons, the result will be lower average returns for investors in the long run.
Figure 5 considers the possible answers to each of the three questions, and how they their interactions make testing the effects of ESG difficult:
The bulk of research to date has focused on answering the last question and the answers are highly ambiguous. A major reason for the ambiguity is the failure to consider sufficiently the impact of market pricing on the observed returns. In this context, Table 1 considers six possible combinations of answers to the first two questions, on operating value and market pricing, and how they relate to excess expected returns for investors:
Table 1: Value Effects, Market Pricing and Excess Returns
|Value Effect||Market Pricing||Investor Returns to ESG|
|ESG increases value||Markets overreact, pushing up prices too much||Negative excess returns for investors in good ESG firms.|
|ESG decreases value||Markets overreact, pushing down prices too much||Positive excess returns for investors in good ESG firms.|
|ESG increases value||Markets underreact, with prices going up too little.||Positive excess returns for investors in good ESG firms.|
|ESG decreases value||Markets underreact, with prices going down too little.||Negative excess returns for investors in good ESG firms.|
|ESG increases value||Markets react correctly, with prices increasing to reflect value.||Zero excess returns for investors in good ESG firms.|
|ESG decreases value||Markets underreact, with prices going down too little.||Zero excess returns for investors in good ESG firms.|
Given the plethora of possibilities, a finding that investments in highly rated ESG stocks provide positive excess returns provides little information about the payoff to companies of being socially responsible, because it is entirely driven by what markets incorporate into stock prices.
ESG and Value
Being socially responsible (or improving your ESG standing) can make a firm more valuable, either by increasing profitability and cash flows or by reducing the discount rate. The argument that socially responsible companies should generate higher profits, either because they have greater revenues or face lower regulatory and legal costs, and that these higher profits lead to more sustainable healthy performance seems to rest largely on faith. Even when the linkage is tested and a positive relationship is found between ESG scores and profitability, causality can run from profitability to a higher ESG score because profitable companies are in a better position to spend money on being socially responsible. If there is a consensus view that emerges from the evidence, it is that the relationship is positive, but the findings are fragile and sensitive to both how ESG and profitability are measured. In a review of the literature, Margolis, Elfenbein and Walsh (2009) examined 251 studies of the linkage between ESG and operating profitability in 214 papers and found only a small positive link between the two, leading them to concluded that “citizens looking for solutions from any quarter to cure society’s pressing ills ought not appeal to financial returns alone to mobilize corporate involvement.”
An alternate reason why companies would want to be “good” is that “bad” companies are exposed to disaster risks, where a combination of missteps by the company, luck, and a failure to build in enough protective controls can not only cause substantial losses for the company, but the collateral reputational damage created can have long term consequences. Glossner (2018) created a value-weighted portfolio of controversial firms that had a history of violating ESG rules and reported negative excess returns of 3.5% on this portfolio, even after controlling for risk, industry, and company characteristics. Glossner views this as evidence that markets don’t fully price in disaster risk. It is worth noting that this argument for ESG is less an argument for companies to be “good” because they will be rewarded, than for companies not to be “bad” because they will be punished.
ESG and Pricing
If being socially good creates a payoff for firms either as higher cash flows or a lower discount rate, their values should increase. But will markets have the foresight to look past what may be near-term lower earnings and reward good companies with higher pricing? The research on this question is sparse, due to two challenges. The first is that it requires a measure of ESG that can be correlated with current pricing, with that pricing measured using multiples such as PE, price to book, or EV to EBITDA. The second is that even if a correlation exists, it is difficult to establish causation. In other words, do companies with high ESG scores get rewarded with higher market pricing or are companies with higher market pricing just more favorably viewed by society? One way to avoid the interlinkages that make it difficult to isolate the effects of ESG on pricing is to focus on ESG events, i.e., events that would lead to market to reassess a firm’s ESG standing. Capelle-Blanchard and Petit (2017) look at 33,000 ESG news stories on one hundred listed companies between 2002 and 2010 and conclude that negative events cause a market drop of 0.1% but that firms gain nothing from positive events. In summary, the evidence that markets reward companies for being “good” is weak to non-existent, which can be taken to mean one of two things: (1) markets are rationally assessing ESG actions and finding that they have little effect on value or (2) markets are short sighted and are not incorporating the long-term value increases associated with being more socially conscious. Neither conclusion is promising for ESG advocates; the first undercuts their central thesis that being good translates into doing well, and the second makes it less likely that managers will invest more in ESG, because they will realize few tangible benefits in the market today.
Investor Returns and Social Responsibility
Fama and French (2007) develop a simple framework for analyzing how investors preferences for good companies affect expected returns. They show that if investors prefer to invest in good companies, the expected return on companies that are socially responsible will be lower. Conversely, bad companies (those that investors shun) will have to offer higher expected returns in equilibrium. As an illustration of this effect, Hong and Kacperczyk (2009) study what they call “sin” stocks, i.e., companies involved in businesses such as producing alcohol, tobacco, and gaming, and find that they offer higher expected returns.
There is a complication to the theory developed by Fama and French that arises when analyzing stock returns relative to ESG ratings. Concern over ESG is a relatively new phenomenon coming to the fore during the past 10 years or so. Therefore, it is possible that during this period market prices have been adjusting to reflect ESG considerations. As the market adjusts, the discount rate for good companies will fall and the discount rate for bad companies will rise. Due to the changes in the discount rates, the relative prices of highly rated ESG stocks will increase and the relative prices of low ESG stocks will fall. Consequently, during the adjustment period the good company stocks will outperform the bad company stocks, but that is a one-time adjustment effect. Once prices reach equilibrium, the value of high ESG stocks will be greater and the expected returns they offer will be less.
The bulk of the empirical research on ESG investing has been directed at answering the question of whether you can have your cake (be socially conscious as an investor) and eat it too (by earning higher returns). For instance, Di Bartolomeo and Kurtz (1999) showed that stocks in the Anno Domini Index outperformed the market, but that the outperformance was more due to factor and industry tilts than to social responsiveness. Derwall, Guenster, Bauer and Koedijk (2005) look at the payoff to socially responsible investing by comparing the returns on two portfolios, created based upon eco-efficiency scores, and conclude that companies that are more eco-efficient generate higher returns. One of the problems with the empirical research is that it often fails to take account of the adjustment effect described above. Furthermore, some of the strongest links between returns and ESG come from the governance portion, which, as we noted earlier, is ironic. The essence of governance, at least as measured in most of these studies, is fealty to shareholder rights, which is at odds with the current ESG framework that pushes for a stakeholder perspective.
In many circles ESG is being marketed as not only good for society, but good for companies and for investors. In our view, the hype regarding ESG has vastly outrun the reality of both what it is and what it can deliver. The potential to make money on ESG for consultants, bankers and investment managers has made them cheerleaders for the concept, with claims of the payoffs based on research that is ambiguous and inconclusive, if not outright inconsistent with their claims. If there is a connection between being socially responsible and value, it is that bad firms get punished, either with higher discount rates or with a greater incidence of disasters, not that good firms get rewarded with higher profits. Furthermore, theory predicts that if investors prefer good ESG firms for social responsibility reasons, the expected returns on the stock of those companies should be less than that for bad companies. The empirical literature finds little evidence of positive excess returns associated with ESG investing.
To conclude, Milton Friedman’s thesis that companies should focus on delivering profits and value to their shareholders, rather than playing the role of social problem solvers, is now largely treated as passé. At the risk of sounding like Neanderthals, we think Friedman’s viewpoint has much to recommend it in the ESG space. Just because the cause is a good one does not mean decisions related to public policy should be turned over to corporate managers who have never stood for election. Instead, corporate managers should focus on what they do best and leave public policy decisions to duly elected officials.