Two weeks ago we reviewed a new report from Deloitte focusing on how to connect the dots between investors and companies when it comes to ESG (environmental, social and governance). The report provided some interesting insights on the value of ESG, including the notion that “the strongest evidence that ESG performance impacts financial performance is found in short-term event studies.”
I thought it would be interesting to discuss this with Ioannis Ioannou, Assistant Professor of Strategy and Entrepreneurship at the London Business School, whose research focuses on sustainability and CSR, and hear his perspective on some of the issues mentioned in the report.
Here is an edited version of the interview I conducted with Prof. Ioannou.
TriplePundit: Why do you think the majority of investors have hard time recognizing the value of ESG?
Ioannis Ioannou: I think there are a couple of reasons why the communication channel between companies and investors on ESG issues has been problematic. First, CSR (and the corresponding metrics in the form of ESG) came with historical “baggage”; CSR used to be confined to a set of corporate activities, like corporate philanthropy, that were not explicitly linked to competitive advantage but rather, they were justified in terms of normative or moralistic arguments.
Second, there exists excessive information out there today in terms of ESG data, and it is not clear that all of it is useful or relevant. Therefore, investors can be either overwhelmed with all this information, or be inclined to completely ignore it simply because it is so difficult to characterize what is material and what is not.
Third, related to the previous point, often enough ESG information is presented in a language or in metrics (e.g. units) that do not directly lend themselves to be included in traditional valuation models. For example, how can an investor incorporate in her valuation the fact that, say, one thousand new engineers have graduated from company-sponsored schools in a given year (a metric that is often reported by companies that provide scholarships or that fund schools)?
Fourth, one needs to account for the fact that valuation models take time to adjust. Accounting for ESG information in an investment decision constitutes quite a radical change.
3p: The Deloitte report focuses on the short-term benefits of ESG, mentioning that “the strongest evidence that ESG performance impacts financial performance is found in short-term event studies.” Do you agree with this finding?
II: I think that when one interprets results from event studies, one needs to be aware of their strong underlying assumptions. In particular, such studies try to capture value creation by measuring the “abnormal” fluctuations in share price, typically within very short time frames (e.g. 3-4 days). Their most fundamental underlying assumption is that within this time frame, the market can accurately assess the value created by a focal policy. As you can imagine this is quite a strong assumption, that may or may not apply, especially for issues that are complex. However, the fact that even with such strong assumptions we are able to trace ESG benefits in the short run is very encouraging.
I do not agree, however, that the benefits are predominantly short term. Quite the reverse, a coherent and successful sustainability strategy can generate significant outperformance in the long run, both in stock market returns as well as operational performance. These are the main findings of a study that R. Eccles, G. Serafeim and myself have co-authored recently. In this study, to capture long-run value creation, we focused on about 20 years worth of data, not just a couple of days. Moreover, other work in the field has shown that high ESG scores, indicative of superior stakeholder relations, are associated with a more persistent competitive advantage or, for poorly performing firms, a quicker recovery.
3p: If most ESG benefits are realized in the long term, don’t you see here an inherent problem with investor short-termism?
II: Most definitely. Short-termism constitutes one of the major impediments for the adoption and implementation of sustainability policies by corporations. However, in our work with George and Bob, we did find that to a certain degree there is a matching that takes place between investors and companies. In particular, we find that sustainable companies tend to have a more dedicated investor base (investors that trade less often, and have more focused portfolios) compared to less sustainable companies that attract more transient investors (investors that trade more often, and have more diversified portfolios).
Nevertheless, there is no doubt that short-termism poses a significant challenge that needs to be addressed either by policy makers in the form of laws and regulations and/or by novel incentive schemes that may, for example, provide additional rewards to shareholders for holding a given stock longer.
3p: Should companies address sustainability only in terms of ESG or is this framework too narrow?
II: It depends on how you define ESG; there are multiple definitions out there. In my definition, ESG is a means to an end. It is the way through which a company discloses to its stakeholders how sustainability issues are embedded within its strategy and business model. Thus, a sustainability report, or importantly, an integrated report, would be ESG according to such a definition.
Leaving semantics aside though, what a company should be focusing on in order to become truly sustainable, is to institute and reinforce a positive feedback loop between the generation of economic value on the one hand, and the generation of environmental and social value on the other.
What would also be critical in the future is to come up with those metrics that provide an accurate reflection of this synergistic relationship and metrics that are expressed in terms of value creation. These metrics would be extremely useful for facilitating the communication and the coordination within the firm (think between CSO and CFO) and critically, they will significantly improve the communication between companies and investors.
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.