An oped in the Financial Times by Bob Monks introduced me to a nice report by Deutsche Bank that examines the entire body of research focusing on the investment performance of ESG, CSR, and SRI policies. It’s worth reading, as it shows which of these tools actually work ... and which don’t. Let’s investigate.
Let me first show you what the authors did:
“We looked at over 100 studies and then we included in our analysis 56 research papers, as well as 2 literature reviews and 4 meta studies. To increase the confidence in the results presented in the reviewed papers we chose to include papers that met a minimum level of academic rigor. Accordingly, we excluded papers that have been working papers and have not been published for more than five years, we only included papers published in well known journals, and excluded papers where we were concerned with methodological problems in terms of selection bias and correlated omitted variables.”
In short, they restricted their lit review to only the best (i.e., peer-reviewed and published) papers. I think that’s wise, as there’s plenty of poor research floating around these days. So, what did they find in these studies?
“100% of the academic studies agree that companies with high ratings for CSR and ESG factors have a lower cost of capital in terms of debt (loans and bonds) and equity. In effect, the market recognizes that these companies are lower risk than other companies and rewards them accordingly. This finding alone should put the issue of Sustainability squarely into the office of the Chief Financial Officer, if not the board, of every company.”
“89% of the studies we examined show that companies with high ratings for ESG factors exhibit market-based outperformance, while 85% of the studies show these types of company’s exhibit accounting-based outperformance. Here again, the market is showing correlation between financial performance of companies and what it perceives as advantageous ESG strategies, at least over the medium (3-5 years) to long term (5-10 years).”
So ESG is legit. Very interesting. But what about SRI?
“At the same time, we are able to show that... SRI adds little upside, although it does not underperform either. Exclusion, in many senses, is essentially a values-based or ethical consideration for investors.”
So let me sum up here: The negative screening that many associate with SRI doesn’t seem to impact returns at all. However (!) the ESG side of the equation does seem to create value: lower cost of capital and financial and accounting outperformance. In short, ESG seems to offer long-term investors a mechanism for generating higher returns than the average players in the marketplace. So this raises an important question: Why has there been so little take-up among institutional investors? After all, even ESG champion, like CalPERS, struggle to convince their own people of the value of ESG (or at least convince their Board). Why is this the case? Here’s the authors’ explanation:
“These conclusions go a long way towards explaining why the concept of sustainable investing has taken so long to gain acceptance and even now inspires indifference and even cynicism among many investors. It has been too closely associated for too long with the SRI fund manager results which are not only an extremely broad category (i.e. in terms of investment mandate), but historically were based more on exclusionary – as opposed to positive or best-in-class – screening. ESG investing, by contrast, takes the best-in-class approach. By analyzing the various categories within the universe of sustainable investing, we can now say confidently that the ESG approach, at an analytical level, works for investors and for companies both in terms of cost of capital and corporate financial performance (on a market and accounting basis). It is now a question of ESG best-in-class funds capturing the available returns.”
I buy that. And I also really like Bob Monk’s explanation; so I’m going to give him the final word:
“The resistance to ESG research also draws strength from the excessive intellectual specialisation endemic in the modern world. Adam Smith and many great thinkers of his time did not restrict their purview to a single field such as economics, politics, or social welfare. Instead they wrote about political economy, a discipline that sought to understand how individuals, companies, markets and governments can best interact for the good of society. We lost this holistic perspective with the development of modern financial theory after the second world war.”
Indeed.
