Where’s the evidence...?

Environmental, Social and Governance (ESG) characteristics and investment returns

The likely effect of a company’s Environmental, Social and Governance (ESG) characteristics on its investment returns is the subject of considerable debate.

For instance, Dillian (2020, p.1) suggests that “ESG investing looks just like another stock bubble”, while Kynge (2017, p.2) states, “The outperformance of ESG strategies is beyond doubt”.

They can’t both be right.

Unfortunately, like the seemingly endless ‘passive versus active’ debate, there are entrenched views on both sides.

Investment theory (incorporating ESG preferences)

Investment theory implies that shares are priced according to their risk and return characteristics as well as investors’ preferences for these characteristics.

This suggests that if –

1. there was certainty regarding the extent to which good ESG improves company value (or bad ESG harms company value), and

2. the market was perfectly efficient at reflecting this information, and

3. investor views about the impact of ESG on company value did not change, then Company returns should not vary based on their ESG characteristics.

Rather, the price of good ESG companies would instantly rise and the price of bad ESG companies would instantly fall such that company ESG performance would be correctly reflected in the current share price and have no impact on its future price.

Proponents of the theory of completely efficient markets would assert there is no relation between company ESG and investment returns.

Under this scenario, investors would be worse off, in terms of risk-adjusted returns, by incorporating ESG criteria into their portfolios as ESG acts as a constraint on the optimal portfolio, but with no incremental benefit.

However, in the real world it seems that –

1. the exact impact of ESG on company value is not perfectly known,

2. there is evidence that investors do not always instantly incorporate known value-relevant information into price (e.g. Cohen and Frazinni, 2008), and

3. views towards ESG change through time

Therefore, forming an expectation regarding the returns of companies with different approaches to ESG becomes an exercise in estimating the extent to which ESG exposure is reflected in current prices, and anticipated changes in this level of compensation in the future.

Investor awareness matters

Pedersen, Fitzgibbons, and Pomorski (2021) suggest that investors can be classified into three categories - ESG unaware, ESG aware, and ESG motivated.

ESG unaware

The first group is unaware of ESG information.

ESG aware

The second group is aware of ESG scores and incorporates this information into their expectations of company risk and return.

ESG motivated

The third group has a preference for companies with high ESG scores beyond the implications of these on risk and return.

This work, together with that of Pastor, Stambaugh, and Taylor (2021), has important implications for the long run relationship between ESG characteristics and a company’s share returns.

If investors are ESG unaware or if they under-price the benefits of positive ESG and the costs of negative ESG, then positive ESG companies will be under-priced and negative ESG companies will be over-priced.

Under this scenario, the realisation of the impact of ESG on share prices will lead to the prices of positive ESG companies increasing more than expected and the prices of negative ESG companies decreasing more than expected. This implies that there are risk-adjusted returns or “alpha” on offer for investing based on ESG. However, if investors are aware of the benefits to companies of positive ESG and the risks of negative ESG, they can be expected to pay more for positive ESG companies (and less for negative ESG companies) than they would for equivalent firms.

This implies that negative ESG companies will have higher expected returns as investors require additional compensation for the risk of holding them, while positive ESG companies will have lower expected returns.

The relationship documented for ESG aware investors is in the same direction but even stronger for ESG motivated investors.

As authors such as Hong and Kacperczyk (2009) point out, if investors prefer to avoid certain companies (such as those with poor ESG characteristics) for reasons other than their risk and return characteristics, the prices of these shares will be lower, and the expected returns will be higher.

If ESG preferences are strong enough, there will be risk-adjusted returns on offer for investors willing to invest in bad ESG companies, against the prevailing view of most investors.

While the studies discussed so far have focused on share prices, the same line of reasoning applies equally to bonds. If investors are ESG unaware or underreact to issuer ESG characteristics, the yields of positive ESG companies will be too high and the yields of negative ESG companies will be too low.

However, with ESG aware investors and/or ESG motivated investors, the yields of negative ESG companies will be higher than those of their positive ESG company counterparts. This risk premium is required to entice investors to invest in them.

Based on the above, the long run pricing of, and returns from, ESG companies will depend on whether ESG unaware, ESG aware, or ESG motivated investors are the predominant investor type.

It seems reasonable to assume that the predominant investor type will increasingly comprise at least ESG aware, if not ESG motivated, investors and, as noted, these can both be expected to lead to the same long run relationship between ESG and share returns.