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ESG and financial performance

ESG and financial performance

The identification of concrete links between ESG and financial performance will accelerate the uptake of ESG criteria as a prime driver in investment strategies, and their influence on corporate decision-making. We look at the current evidence connecting environmental social and governance credentials with the bottom line

The evidence linking ESG and financial performance

Academic studies into the link between environmental social and governance (ESG) criteria and financial performance show, on the whole, a positive correlation. From the Stockholder to the Stakeholder, a 2015 study by the Smith School of Enterprise and the Environment at the University of Oxford and Arabesque Asset Management, looked into 200 reports on the relationship between ESG and financial performance. In 88% of reviewed sources, better operational performance was shown among companies with robust sustainability practices. Strategic ESG management eventually translated into cashflow. The review also revealed that in 80% of studies, prudent sustainability practices had a positive impact on investment performance. 

In the same year, research by Deutsche Bank’s Asset and Wealth Management division with the University of Hamburg investigated 2,250 academic studies published on the subject spanning 45 years. It discovered a 62.5% rate of positive contribution by ESG to corporate financial performance. Negative results were noted in just 10% of cases.

The research suggests that the business case for ESG investing is empirically well-founded. But these studies do not tell the whole story. When they were completed, measuring ESG factors was not an exact science, and it continues to face issues with data availability and interpretation. An additional challenge is the temptation to generalise based on specific findings. Each study uses different methodologies, and places greater or lesser emphasis on the various elements of the ESG framework. Sustainable and ethical investing strategies and ratings of companies’ ESG performance vary wildly. Market, sector, and geography also have an impact. 

Compounding these vagaries, the studies have largely been based on historical data, discounting the expectation of future performance. ESG issues are by their nature volatile, with demographic shifts and megatrends such as climate change affecting emphasis. In a remodelled business landscape, where ESG factors are entrenched, these studies cannot accurately reflect the current and future link between financial and ESG performance. 

Stakeholder influence and impacts

While most studies have been aimed at ESG investing with financial motives, ESG materiality can affect financial performance in myriad ways. Better management of environmental and social factors can generate new opportunities, minimise ESG risk and decrease costs, for example. And different ESG-led actions will resonate with different stakeholder groups. The growth in sustainable investing has made the appeal of ethical funds to shareholders apparent. But there are other stakeholder groups with different priorities, which have significant, if sometimes less direct, impacts on corporate finances. 

Consumers who want to make sustainable choices will purchase goods and services from companies they believe are environmentally and socially responsible, making an immediate contribution to the bottom line. Less immediate, but with considerable long-term consequences, are the campaigns of NGOs which are less likely to target businesses with strong ESG credentials – reducing reputation risk which might curb profitability. 

In the value chain, good governance could mean stronger relationships with suppliers, leading to reliable goods provision, increased efficiency and attractive credit terms. Digging deeper, environmental policies could protect natural resources, safeguarding raw materials feeding into the supply chain. Relocating production facilities could reduce both pollution and transport costs. Guaranteed resource supply cuts exposure to volatility in those markets. All of these factors promote long-term corporate profitability.

Staffing is another area where ESG can have a financial impact. Fair pay, employee perks, receptive management, and clear corporate purpose will ensure a satisfied workforce. This means greater productivity, and the attraction and retention of talent, reducing the costs associated with staff turnover. A 2016 study by Aon Hewitt found that a 5% increase in employees’ commitment to their employer led to a 3% increase in revenue the following year.

The regulators also have a role to play in linking ESG and financial performance. In the last three years, ESG regulation grew by 158% in the UK, and by 145% in the US and Canada. As ESG disclosure becomes government-mandated around the world, the companies that can demonstrate a strong ESG position will be the most robust. They will avoid the fines and reputation risks associated with unregulated markets. Both risk and cost will also be mitigated by the avoidance of litigation related to ESG court cases, which could potentially encompass data breaches, discrimination, harassment, pollution, modern slavery, and even local planning violations.

ESG objectives affect outcomes

Where the objectives for employing ESG criteria differ, there will be different outcomes. Not all ESG factors are created equal, and a focus on the various elements of ESG criteria will have a greater or lesser impact on financial performance over the short and long term. Motivation can vary significantly – whether corporations are keen to avoid association with contentious issues, proactively pursuing long-term goals, appeasing specific stakeholder groups, spearheading change as a market leader, or are intent on being at the forefront of creating global solutions.

Industry and geography are also determining factors when it comes to corporate concern with specific elements of ESG. A palm oil producer in the rainforest will have a very different ESG profile to a financial services provider in the City – for the first, environmental considerations will be paramount, while for the latter, governance, such as executive remuneration, will be key. While no less important, the former’s environmental policies may have a slower, and less direct, impact on the bottom line. 

A study by Harvard Business School found that, over a 20-year period, firms that did well on material sustainability factors, as defined by the SASB, outperformed those that did poorly, on both stock returns and corporate profits. Meanwhile, those that outperformed on immaterial sustainability issues did not necessarily do so financially, suggesting that only businesses with financial motives for good ESG performance see a resulting financial performance. 

But as with previous research, this study relies on historic data. As the business world remoulds itself around a stakeholder rather than shareholder model, a wider spectrum of priorities needs to be addressed, and as future projections of ESG performance are taken into account, the ties between that ESG performance and financial performance will become ever more apparent. 

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