Does Sustainable Investing Lead to Lower Returns?

Harvard Business School Professor and Palladium Thought Leader George Serafeim argues that sustainable companies outperform over the long term because they are better at adapting to a changing world. 

For skeptics, ESG means excluding “sin” stocks or industries, with little economic rationale. The argument is if enough investors exclude a stock and this is significant enough to increase the company’s cost of capital, without affecting its future earnings, then future expected return should be higher. The argument makes sense and is not new. I made the same argument in a 2014 Harvard Business Review article, in explaining how divesting from oil and coal companies could backfire.

Framing ESG—for environmental, social, and governance factors—solely about exclusionary screens, however, completely misses the point. ESG integration is as much about that as the iPhone is about making phone calls.

Here’s what ESG integration is really about: From an investor’s standpoint, a sustainable company is one positioned for long-term success, one whose management understands and addresses short-term risks and innovates to exploit long-term opportunities. ESG data are a means that can enable an investor to understand a company’s strategy, corporate purpose, and management quality, at scale and in an unbiased, quantifiable way.

ESG is about understanding how companies are adapting to transformational change, such as the shift to a low-carbon economy. European electric utility companies, such as RWE, missed the message that renewables should become an important part of power generation. They lost half a trillion in market capitalization as a result. Automobile manufacturers are in a race to not become the next victims by missing the electrification wave. Consumer packaged-goods companies, such as General Mills, Nestlé, and PepsiCo, are product reformulating as consumer preferences change, taking out sugar and sodium from their products, while repositioning their offerings to compete in healthier food and beverage choices.

It is also about understanding how and which technology companies are best at managing data-privacy issues. In the wake of the Facebook controversy, not only shares of Facebook, but also those of Twitter , which is also highly exposed to data-privacy issues, dropped more than 10% in a day. It is about how retailers are managing a more productive workforce. As Walmart discovered, moving away from its legacy of poor labor relations, improving workplace conditions, and creating economic opportunity for its associates can improve employee engagement, leading to higher customer satisfaction and higher revenue growth.

These aren’t just one-off stories. We have systematic evidence that firms with better ESG performance have better future financial performance. In one study, we found that companies that developed organizational processes to measure, manage, drive, and communicate performance on ESG issues in the early 1990s outperformed, over the next 18 years, a carefully matched control group of firms with very similar profitability, size, capital structure, and market valuation multiples. Companies such as 3M and Clorox not only improved their operating efficiency through ESG activities but also brought innovative products to market with positive ESG profiles.

What is important for a hotel operator, however, is different from what is important for a bank. Taking into account the work that the Sustainability Accounting Standards Board has done in identifying material ESG issues, industry by industry, in another study we analyzed more than 2,000 stocks over 22 years and showed that firms improving their performance on material ESG issues, such as on environmental impact in the power sector, workplace safety in the mining sector, and employee inclusiveness in the information-technology sector, have significantly higher future risk-adjusted returns.

When critics beat up on ESG, they are often right—but the problem is simply bad implementation. Unfortunately, most asset managers that offer ESG products wrap a Blackberry inside an iPhone X. While they talk big game about ESG integration, their products offer some basic tilt away from controversial stocks. A negative screening in the oil-and-gas sector would exclude all companies, while an ESG integration approach would take into account how different firms are investing in renewable-energy generation and electric charging stations, dimensions on which Shell and Exxon Mobil, for instance, look very different. Moreover, we documented that development of ESG funds is driven by marketing goals as opposed to investment logic. There are signs this will change in the next five years, but if it doesn’t, ESG investing could enter a vicious cycle of underperformance and illegitimacy, and fade into history.

To truly move the market toward ESG integration, asset managers need stop “goodwashing”; using ESG only as a marketing tool to attract capital. There are no shortcuts: They need to understand the materiality of ESG issues, identify high-quality data, deeply engage with how ESG issues are reshaping business strategies, and model the impact of ESG catalysts on future revenues, costs, and cost of capital.

We have clear evidence that ESG factors can identify companies that will outperform, and that there is investor demand. For those asset managers who do it right, that combination spells opportunity.

Dr. George Serafeim has won numerous awards for his “Reimagining Capitalism” course at Harvard and recently presented at the World Economic Forum in Davos. Hear him speak in person at the Palladium Positive Impact Summit on June 25, 2019 in New York City.

This article originally appeared in Barron’s and was republished with permission.