One of the questions we keep asking is if sustainability is so great for companies why we don’t see more investors paying attention to it. After all, socially responsible investing (SRI) still represents only 11.3 percent of the U.S. financial market. Is it that the business case for sustainability is not as strong as we tend to think or that most investors just don’t get it yet?
The answer is probably more the latter than the former, claims Eric Hespenheide and Dinah Koehler of Deloitte in a paper they published last month. In Finding the Value in Environmental, Social, And Governance Performance, they explain that the problem actually starts with the companies, which need first to do a better job in identifying the issues where sustainability makes a difference for investors, such as risk management strategies. Then, they should build a disclosure narrative focusing on these issues to help capture investor interest.
This excellent paper adds a fresh perspective on how to connect the dots between what companies do to become more resilient and “ESG-proof” and what matters to investors when they pinpoint winning stocks. Here are the main lessons:
1. When ESG management makes a difference – The paper points out that environmental, social and governance (ESG) management (or the lack of it) makes a difference mainly when companies face a crisis. “ESG events can occur at any time as a short-term shock, which, if repeated, can chip away at a company’s performance or be large-scale catastrophes of the black swan variety; especially for companies already facing a tough business environment,” the authors explain.
In general, the authors write, the average investor (not only the ones involved already in SRI) is paying attention to ESG when things go wrong. They quote an MIT study showing that investors’ response to negative environmental news rose in 2000-2009 to equate a 1.12 percent drop in the stock returns.
So what can companies do? Dan Hanson, managing director at BlackRock, recommends stakeholder engagement as a preventive strategy to mitigate ESG shocks when they occur. The authors also add a recommendation for companies to demonstrate to their investors how “they are getting ahead of ESG risks in their day-to-day management and building resilience before the next ESG shock.” This means not just changing the way companies manage their ESG risks, but also the way they disclose it (see point 4).
2. ESG Halo – The authors show that strong ESG management can also be valuable on the upside and not just in crisis events. A positive ESG reputation, they claim, adds an extra layer of protection, which they call ESG halo. This is basically about brand reputation management, which can help companies gain during good times and mitigate negative publicity during crisis events.
In all, it looks like the ESG halo mainly makes a difference in protecting the stock price during ESG events, although the authors seem to suggest that it will have a growing impact as investors are learning to better appreciate companies that manage their exposure to ESG risks.
3. Focus on the short term – One assumption that many have is that one of the main reasons many investors tend to ignore companies’ ESG performance is that they are more focused on the short term while ESG benefits companies mostly in the long term. According to this paper, this is actually not accurate.
“The strongest evidence that ESG performance impacts financial performance is found in short-term event studies, which put the spotlight on the link between ESG information and investor interest and decisions,” the authors write.
And what about the long-term? The authors are much more cautious here. They acknowledge that “those companies that are demonstrably prepared for ESG shocks can better mitigate the downside risks, both short- and long-term.” Yet, they suggest that “it would be easier to draw a firm conclusion on the effect of strong ESG management as a driver of long-term returns if the evidence were clearer,” which is not the case at the moment.
4. The importance of disclosure – The authors explain that ESG disclosure is valuable because it “helps a company demonstrate that it is managing its risks and has a track record of paying attention to its ESG performance. Those that disclose more ESG information are more likely to enjoy a lower cost of capital according to academic research.”
In other words, it is not enough for companies to be prepared for ESG shocks – to capture investor interest they need to demonstrate it and be open and transparent about the way they manage ESG risks.
5. Investors need ESG-standardized tools – One clear conclusion from this paper is that no matter how well companies disclose their ESG management practices, investors need more standardized tools to work with to make a better use of this data.
While some investors like Parnassus Investments create their own ESG evaluation frameworks, most investors still don’t do it, and listening to them, it is clear that this is because they still don’t know how to translate ESG into the language they work with, which is the language of revenues, risks and growth. So what they need is a good translator, like a rating agency that will grade companies’ ESG management. Until we have this sort of development, we will probably see only incremental steps forward in the attention investors pay to ESG.
Raz Godelnik is the co-founder of Eco-Libris and an adjunct faculty at the University of Delaware’s Business School, CUNY SPS and Parsons the New School for Design, teaching courses in green business, sustainable design and new product development. You can follow Raz on Twitter.