ESG investing, or investment strategies that take a company’s environmental, social, and governance (ESG) characteristics into consideration, are gaining popularity amongst investors. Investors are increasingly integrating these non-financial characteristics into their investment analysis processes. Overall, ESG investing now represents approximately one-third of the total global investment assets under management, with ESG assets surpassing $35 trillion in 2020. You may be wondering what has led to the increasing number of investors considering corporate ESG behavior in their investment decisions. Are they motivated by the expectation that firms with strong ESG profiles will generate better financial returns, or are they using ESG information to align their investments with their values and beliefs?
A recent study by Amel-Zadeh and Serafeim (2018) examines the motivation behind investors’ use of ESG information in their investment decisions by analyzing survey data provided by mainstream investment organizations. The results of the study suggest that the use of ESG information is mainly driven by financial rather than nonpecuniary (i.e., ethics-, norms-, or values-related) motives. The majority (63%) of investors who consider ESG information do so because they perceive such information to be financially material (i.e., relevant) to investment performance.
The rationale behind the investors’ responses documented in the study can be best understood through the lens of a discounted cash-flow model framework, in which a firm’s market value is determined by its future cash flows and associated risks. ESG factors can have an impact on the financial performance of a firm by affecting both determinants.
ESG Performance Affects Cash Flows
Firms with better ESG performance are likely to have stronger cash flows due to their efficient resource usage, effective human capital development, and superior innovation management (Gregory et al., 2014). To gain a better understanding of how these ESG characteristics affect cash flows, the UNEP/SETAC Guidelines for Social Life Cycle Assessment of Products provide a useful lens. These guidelines, jointly developed by the United Nations Environment Programme and the Society of Chemical and Environmental Toxicology in 2009, typically consider five stakeholder groups in social life cycle assessment: workers, consumers, the local community, value chain actors (e.g., suppliers), and society. Using the stakeholder group of “consumers” as an example, the Guidelines identify the following ESG characteristics as material:
- Health & safety
- Feedback mechanism
- Consumer privacy
- Transparency
- End-of-life responsibility
It isn’t difficult to see why firms with better performance in the ESG domains mentioned above are likely to have stronger cash flows. For example, firms that prioritize consumer health and safety and feedback mechanisms are more likely to be attractive to consumers and, in turn, have stronger sales.
ESG Performance Affects Firm Risk
Strong ESG performance can increase firm value by reducing risk. Firms with strong ESG characteristics typically have better risk control and compliance standards, both internally and across their supply chains (Giese et al., 2019). Many ESG practices are intentionally designed to protect stakeholders’ interests, with measures like safeguarding customer privacy and implementing employee health and safety programs. These practices can reduce the occurrence of serious incidents and adverse events, thereby lowering the potential for downside and tail risks.
Importance of Research and Due Diligence
In the United States, the majority of ESG funds are self-labeled as such. The responsibility for labeling or categorizing funds as ESG funds lies primarily with the fund managers themselves.
Investors should be mindful that while many funds may label themselves as ESG funds, the specific criteria and approaches for incorporating environmental, social, and governance factors can vary. It is crucial for investors to conduct thorough research and due diligence to understand how each fund defines and implements ESG principles. This includes examining the fund’s investment strategy, holdings, and performance track record, as well as assessing the credibility and transparency of its ESG disclosures. By taking an informed and diligent approach, investors can make more confident decisions aligned with their own sustainability objectives.
While financial motives are the primary drivers behind ESG integration, a significant proportion of investors also use ESG information to align their investments with personal values and beliefs. Amel-Zadeh and Serafeim (2018) found that 32.6% of investors incorporate ESG information as an “ethical responsibility.”
In conclusion, investors are increasingly considering ESG factors in their investment decision-making process. While ESG integration is largely motivated by financial considerations, many investors also consider ESG information in order to invest in companies that align with their values and beliefs. As awareness and understanding of the impact of ESG factors on financial performance continue to grow, it is likely that the trend of ESG integration in investment strategies will continue to accelerate.
Disclaimer: The Content is for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice.
References:
Amel-Zadeh, A., & Serafeim, G. (2018). Why and How Investors Use ESG Information: Evidence from a Global Survey. Financial Analysts Journal, 74(3): 87–103. https://doi.org/10.2469/faj.v74.n3.2
Giese, G, L. Lee, D. Melas, Z. Nagy, and L. Nishikawa (2019). Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance. Journal of Portfolio Management 45 (5): 69-83. https://doi.org/10.3905/jpm.2019.45.5.069
Gregory, A., R. Tharyan, and J. Whittaker (2014). Corporate Social Responsibility and Firm Value: Disaggregating the Effects on Cash Flow, Risk and Growth. Journal of Business Ethics 124 (4): 633–657. https://doi.org/10.1007/s10551-013-1898-5
UNEP/SETAC (2009) Guidelines for social life cycle assessment of products. United Nations Environment Programme, Paris. https://www.lifecycleinitiative.org/wp-content/uploads/2012/12/2009%20-%20Guidelines%20for%20sLCA%20-%20EN.pdf Accessed 07/31/2022
Like (2)