My recent post about a Connecticut legislature doing a bit of grandstanding got me thinking a bit – who is the primary beneficiary of a corporate ESG program? This will be the first in a series looking at groups generally thought to benefit from corporate ESG programs. We aren’t going to make conclusions about the matter; we simply intend to offer food for thought – some point/counterpoint if you will.
Many experts agree that the current ESG frenzy was catalyzed by the investment community, which is a diverse group with different goals and expectations. We look at three broad categories.
Numerous credible studies, experts and academics claim that higher ESG performance means better stock price. World renowned Harvard Business professor George Serafeim has extensively studied and written on the positive correlation between equities pricing and ESG performance. His recent paper continues to support his past conclusion. At face value, this makes sense – companies with forward-thinking management and progressive cultures seem inherently more prepared for meeting future challenges. Given that stock prices theoretically reflect investor views of future cash flows, a linkage between ESG performance and future business performance seems plausible.
Yet ESG equity investors are not monolithic. They differ in themes, engagement v. exclusion strategies, screening & ratings methods used and ultimate investment goals. Companies may have a difficult time determining whom they appeal to or how to improve their standing. For example, one common question is how to apply ESG evaluations to sectors like weapons and tobacco products: can they be considered ESG performers in the first place, or is the better approach to evaluate company-specific ESG performance in relation to their industry peers? Confusion and inconsistency in market obfuscate the ultimate success of linking ESG performance to equity performance.
However, the matter isn’t fully settled. A range of other credible studies, experts and academics claim that, at best, strong ESG performance “doesn’t hurt stock performance.” Not a ringing endorsement. Admittedly, there is also a history of less credible studies with fantastical claims of the value ESG brings to companies and their stock price. I won’t delve into those here, but they have provided fodder for opposing views.
Is ESG outperformance for equities real? A study released last week from Scientific Beta (a Singapore-based ESG investment research provider) called “Honey I Shrunk the Alpha:Risk Adjusting ESG Portfolio Returns” argues:
While many of the ESG strategies have positive returns, adjusting these returns for risk shrinks “alpha” (or excess risk-adjusted return) to zero. Sector biases and exposures to equity style factors capture the returns of ESG strategies. In addition, the analysis suggests that returns are inflated when investor attention to ESG rises. The findings do not question that ESG strategies can offer substantial value to investors. Instead, they suggest that investors who look for added value through out-performance are looking in the wrong place.
Not surprisingly, debate is swirling about this report. Among the criticisms is that the study was not peer-reviewed or published with the same level of rigor as academic analyses.
Way back in 2011 (wow, where’d those ten years go?) I put forth the idea that bonds are a better – albeit less flashy – way to reflect financial value of the inherently long-term nature of corporate ESG initiatives. I reiterated the idea in a 2015 post that ended up being the foundation of a book I wrote three years later.
Debt financing is in some ways better aligned with ESG:
- Bonds are not generally subject to the wild valuation swings of equities
- Short term corporate performance pressures are far less meaningful in the debt context
- Debt investment strategies prioritize stability over time rather than big, quick performance spikes
- The interest rate is known and agreed to in advance, and specifically established in the contract/covenants
At the same time, I wonder about the seeming conflict between long term stability that ESG leadership offers bond investors (recovering their principal at the bond maturity date) versus the lower cost of capital (interest on debt financing being a key part of that) that many observers/academics claims as being a benefit of better ESG performance. In other words, better ESG performance may mean more certainty in getting your money back, but it also may reduce the risk-adjusted premium of the yield (i.e., lower interest rate).
We can’t talk about ESG in the bond context without mentioning the new categories of bonds created as a result of ESG. The International Capital Market Association (ICMA) established principles for a range of “green bonds” that cover various ESG topics. Market interest in ESG investment opportunities creates these categories, and green bond issuance has exploded in recent years.
Investing Against the Flow
All is not lost for companies that don’t quickly adapt to ESG mandates, as there remains meaningful investor interest for companies all along the spectrum. Financial Times reported that investors are rather inconsistent in following their ESG guidance, so there is variability in how hard a line some funds and advisors take. Observers and regulators have raised concern about the potential overuse of the “ESG” tag on investment strategies as an attempt to cash in on the current trend, even where consideration of ESG performance is only nominal.
Moving further along the spectrum, contrarian investors bet against ESG-forward companies. High frequency traders probably don’t give ESG matters any particular weight or consideration. Private equity may take advantage of opportunities that others leave behind (i.e., companies others may consider ESG neutral or “laggards”). Clearly, there are still investors who receive investment returns they seek even when putting ESG performance aside.
In the end, investors are undoubtedly a major beneficiary of corporate ESG initiatives, but are they the primary beneficiary? The next part of this series will examine ESG value from the perspective of customers.