Finding the Value in Environmental, Social and Governance Performance

Abstract

We’d all like to find the pot of gold at the end of the rainbow. This is no less true in the world of sustainable investing, which seeks to leverage a company’s environmental, social and governance (ESG) performance to identify winning stocks. To date, managers of approximately $30 trillion in financial assets – all signatories to the United Nations Principles for Responsible Investment (UN PRI) – are trying to identify companies with higher levels of ESG performance and strong returns. For nearly all of the world’s largest publicly traded companies, reporting on ESG performance is table stakes. ESG management is on the agenda of more CFOs. Yet when questioned, many investors doubt whether that pot of gold exists, and companies are having a hard time convincing them.

These doubts have been detrimental to how much companies invest in ESG management, and make it more difficult to argue for mandating disclosure of ESG metrics because they are financially material. Integration of ESG criteria into investment strategy has reached an estimated $10.7 trillion in assets under management, only about seven percent of the total global market. How companies approach ESG and report their performance varies greatly, and this idiosyncratic behavior only further clouds the issue. Mixed messages from the academic community do not help.

At the heart of the matter is the kind of information investors pay attention to. Our review of the empirical research on investor behavior confirms that ESG issues can trigger a crisis, which often leads to fundamental changes in a company’s management, culture and financial well-being. A growing class of risks, they can be financially material and increasingly a concern in today’s growth-challenged and volatile environment, where even small shocks from the outside world can impact whether a company sinks or swims.

Those companies that are demonstrably prepared for ESG shocks can better mitigate the downside risks, both short and long-term. This makes disclosure on how companies manage their ESG risks all the more critical, because it can help capture investor interest and establish the long-term value of ESG management.

Keywords: Environmental, social, governance, performance, market value, event risk