THIS ARTICLE IS WRITTEN BY RUBEN HARDING. RUBEN ([email protected]) IS A SENIOR CONSULTANT FOCUSING ON ESG WITHIN THE BUSINESS CONSULTING SERVICES OF RSM NETHERLANDS.

It is increasingly expected of companies to consider their environmental and societal impact. Sustainable finance refers to any form of financial service that integrates environmental, social and governance (ESG) criteria into business transactions or investment decisions. This concept is becoming ever more important because the lasting benefits for both clients and society as a whole are considered.  

ESG-PERFORMANCE LEADS TO INCREASED FINANCIAL RETURNS

Based on studies conducted in recent years, it can be concluded that investments to ESG also translates into creating financial value. Of the more than 2000 studies compared, a strong ESG-proposition correlates with higher stock returns in 63% of the cases[1]. ESG-performance has shown to lead to better financial performance for different reasons. One reason lies in the fact that growth can be facilitated by attracting customers with sustainable products and services. Also, companies understand the opportunity by contributing to increased employee productivity and making it easier to attract and retain talent because there is a clear (social) purpose. Finally, optimizing investments by allocating them to long-term value creation which avoids investments in traditional industries that do not pay off because society is moving away from industries causing environmental problems and solutions.

THE FINANCIAL, ENVIRONMENTAL AND SOCIETAL PERFORMANCE OF ESG-FUNDS

Most recently it was noted again that the valuation of companies and assets are influenced by the sustainable expectations of consumers, investors and upcoming legislation on ESG, forcing companies to adjust. For example, almost all office buildings in the Netherlands must meet energy label C requirements by January 2023. If buildings do not comply, closure or a penalty can be imposed. All properties that do not comply may reduce in value from that moment on.

ESG-focused investing has grown rapidly. According to a McKinsey[2] study, sustainable investments totaled $ 30 trillion globally in 2019 - a 68% increase since 2014. This trend seems obvious when considering the above-mentioned correlation between ESG-performance and financial returns. More and more, investment funds also focus on sustainable finance. As of December 2021, global exchange-traded funds that publicly set ESG investment objectives amounted to more than $ 2.7 trillion[3]. One would expect that investing in sustainable funds would also lead to better financial returns, but it remains to be seen whether this is the case. A recent study by Columbia University and the London School of Economics[4], compared the financial performance of U.S. companies in 147 ESG fund portfolios and that of U.S. companies in 2,428 non-ESG portfolios. In this case, the ESG-funds appeared to underperform financially compared to other funds within the same asset manager and year.

This seems counterintuitive seeing that companies with high ESG-performance generally also perform better financially, so why do ESG-funds perform so poorly? The exact reason is still to be examined further, but Flugum & Souther (2021) provide a possible explanation. They found that managers that are falling short of earnings expectations are more likely to cite ESG-focused objectives in their public communications around earnings announcements. Shareholder value is objectively measured and expressed in monetary value, but ESG-performance does not have an agreed-upon measurement or definition. Flugum & Souther (2022)[5] claim that this ambiguity opens the door for managers to take advantage by claiming that they have focused on improving ESG-performance to distract from poor financial performance.

Investing in ESG-funds does not seem to lead to better financial returns, but at least companies with a positive environmental and social impact receive funding, right? According to the study by Columbia University and the London School of Economics, there is no evidence to support that ESG-funds select stocks with better “E” and “S” performance compared to non-ESG-funds by the same issuers. In fact, on average, ESG-funds include firms with worse employee treatment and environmental practices than non-ESG-funds.

So, what is going on here? Relative to other funds offered by the same asset managers in the same years, ESG-funds hold stocks that are more likely to voluntarily disclose ESG-performance. Yet, this does not necessarily mean that their ESG-performance is better than companies that do not disclose ESG-information. For example, the researchers found that within the ESG fund portfolio, companies are more likely to voluntarily disclose carbon emissions performance, but also have higher carbon emissions per unit of revenue than companies that do not disclose carbon emissions. Despite lower ESG-performance, ESG-funds do hold portfolio firms with higher average ESG scores.

Therefore, it can be concluded that ESG scores are correlated with the quantity of voluntary ESG-related disclosures but not with firms’ actual ESG-performance. In other words: higher ESG-ratings are linked to disclosing ESG-information and not linked to the actual ESG-performance of a company. Thus, investing in funds that hold portfolios with higher ESG-scores, does not necessarily translate into investing in funds that hold portfolios with high ESG-performance.

A CASE FOR IMPROVED TRANSPARENCY

This evidence suggests that investing in ESG-funds does not yield better financial returns and does not lead to more investments in companies with a positive environmental end societal impact. This is (partly) because voluntary ESG-disclosures do not automatically result in better ESG-performance, seeing that there are no agreed-upon common standards, measurements or definitions. This voluntary nature leaves room for inconsistency in comparisons between companies and greenwashing.

With the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD), the European Union is making strides to foster transparency on ESG and on improving performance. Many companies will view this as an extra compliance burden (which it is), but it is also an opportunity to systematically improve ESG-performance that (in the long run) will lead to improved financial performance.

Therefore, we expect that more companies, investment funds and investment opportunities will (have to) become more transparent on a wider and commonly defined set of ESG topics. This will ring in a new era in which the perception of what constitutes as ‘value’ will change for investors, clients and employees; requiring companies to re-evaluate how they impact the environment and society and how to communicate this in a transparent way.

 

[1] Witold, H., Koller, T., & Nuttall, R., (2019). Five ways that ESG creates value Getting your environmental, social, and governance (ESG) proposition right links to higher value creation. Here’s why. McKinsey Quarterly.

[2] Witold, H., Koller, T., & Nuttall, R., (2019). Five ways that ESG creates value Getting your environmental, social, and governance (ESG) proposition right links to higher value creation. Here’s why. McKinsey Quarterly,

[3] Bhagat, S., (2022), An Inconvenient Truth About ESG Investing. Harvard Business Review,

[4] Raghunandan, A., & Rajgopal, S., (2021). Do ESG funds make stakeholder-friendly investments?

[5] Flugum, R., & Souther, M., Stakeholder Value: A Convenient Excuse for Underperforming Managers?