Company value

A company’s value is a function of its expected future cash flows and its cost of capital. It therefore follows that ESG needs to impact either or both if it is to influence firm value.

There is growing evidence that firm ESG does influence cash flows. For instance, Fombrun, Gardberg, and Barnett (2000) suggest that ESG helps enhance firm reputation and allows it to charge premium prices for its products.

Share returns

On balance, theory suggests that the existence of strong investor preferences favouring positive ESG companies and avoiding negative ESG companies would imply that shares with unfavourable ESG characteristics should have higher expected returns to attract investors.

There is some important early work that provides evidence of this. Hong and Kacperczyk (2009) considered companies involved in the production of alcohol, gaming, and tobacco or what they referred to as “sin stocks”. They found that these companies were less owned by pension funds and were also less followed by analysts, which would naturally follow from less institutional demand for information about these companies. They found that sin stocks outperform other companies from a returns perspective, even after controlling for known risk factors.

However, the evidence is not universally consistent with positive ESG companies underperforming their negative ESG counterparts. Edmans (2011) shows that a value-weighted portfolio of the “100 Best Companies to Work for in America” generated an alpha of 3.5% p.a. after controlling for the market, size, value, and momentum factors. The outperformance persisted even when comparing with firms in the same industry. These results suggest that employee satisfaction is correlated to share returns.

However, the observation that ESG can enhance value in a firm does not necessarily imply that investors will receive superior returns from investing in that firm. As noted earlier, investment returns are influenced by the degree to which ESG benefits are already factored into current share prices.

It also implies the market doesn’t fully and accurately value these intangible factors because, if it did, prices would adjust immediately, and future return outperformance would not persist.

More recently, In, Park, and Monk (2019) considered the relationship between CO2 emissions and US share returns over the 2005–2015 period. Their results indicate that a portfolio that takes a long position in the most CO2-efficient firms and a short position in the least CO2-efficient firms earns abnormal returns of 3.5–5.4% per year. This result is consistent with investors earning superior returns by investing in positive ESG companies with low CO2 emissions. This is also consistent with the Edmans (2011) finding that alpha can be earned by investing in positive ESG companies. However, the weight of evidence supports the position that larger returns are generated from investing in companies that emit more CO2 and have lower ESG ratings.

For instance, Bolton and Kacperczyk (2021a) find there is evidence that the prices of US companies that are high CO2 emitters have been marked down in recent periods such that these companies generate higher returns to compensate investors for the risks involved in holding them.

While investors did not include CO2 emissions in share pricing back in the 1990s, they do now.