Environmental, social and governance (ESG) considerations are becoming increasingly more important in company and investor decision making, but do these considerations influence a company’s value? The authors propose that the value of social responsibility can be established by using the traditional valuation concept that the value of a business comes from future expected cashflows discounted back at a risk-adjusted discount rate. The paper outlines four drivers for this value equation: growth, profitability, investment efficiency and risk.

If ESG is a source of value, it will be found in one or all of the above factors. The report outlines two possible scenarios of how ESG influences value:

• The virtuous cycle: ‘good’ companies are rewarded with increased demand as investors seek ESG investments, increasing revenue growth. Although this might drive operating costs in the short-term, the company’s cost structure adjusts long-term for higher margins, allowing efficient investment. Lenders are willing to provide lower costs of debt. The risk of catastrophic events or scandals which may harm the business is minimised.
• The punitive scenario: demand for ‘bad’ companies decreases, lowering revenue growth. Operative costs may be low in the short-term but rise over the longer-term, resulting in a shift to inefficient investment. Lender’s deb costs increase. The risk of catastrophic events or scandals increases, risking the business model.

A third, ‘dystopian vision’ scenario is outlined where neither ‘bad’ companies are punished, nor ‘good’ companies are rewarded. ‘Bad’ companies outperform ‘good’ ones, as, while they score low on corporate responsibility scales, they score high on profitability and stock price performance. There is no disadvantage for being ‘bad’.

Key areas are reviewed in terms of value:

• Excess returns: the paper concludes, following a literature review, that the hypothesis that ESG is a source of excess returns is highly ambiguous. It argues that markets are not yet at equilibrium as ESG is a relatively new phenomenon. Therefore, the results regarding return will depend on the sample period as the efficient market adjusts to new information. If the sample period includes the market adjustment period, higher rated ESG stocks will outperform, but this may not be reflective of a longer-term ESG result.
• Profitability: the belief that ESG firms generate higher profitability appears to be reliant on faith. It is proposed that an element of causality may apply, as firms with higher profit margins may be able to afford to pursue social responsibility more than firms with lower profit margins, rather than sourcing their profitability from ESG endeavours.
• Risk: if markets incorporate bad behaviour, then the return discount should become a premium. However, research has found these losses are limited to the legal penalties imposed and did not find evidence of additional losses due to reputational damage.
• Pricing: research has found that negative events have caused market drops, but firms gain nothing from positive ESG news events. This suggests the punitive scenario is stronger than the virtuous cycle.

The paper concludes with the observation that a constrained optimum can, at best, match an unconstrained one. It argues that to have both ESG and higher returns is unlikely and requires market mispricing. It frames social change as being the responsibility of elected officials and corporations should instead maximise shareholder wealth.

1. ESG is difficult to define. The authors stipulate that there is no clear way to differentiate between ‘good’ and ‘bad’ companies, as ESG is in the eye of the beholder. However, there are common elements in the definition such as carbon emissions, climate change, pollution, waste disposal, renewable energy, discrimination, community relations, human rights, and independent directors.
2. ESG is difficult to measure. There is no common measurement for ESG indicators, with variables determining what criteria should be measured and changing how to measure the criteria. The paper highlights the literature documenting this divergence of ESG ratings for the same firms.
3. ESG companies who are to be rewarded in value for ‘doing good’ are more likely to meet the following criteria: be smaller in size; be a niche business with a more socially conscious customer base; and be either a privately owned company, or a public company with an investor base that values corporate goodness.
4. Companies who face concerns regarding social responsibility pay higher interest rates on their loans relative to companies without such concerns.
5. The evidence that socially responsible firms have lower discount rates, and thereby investors have lower expected returns but valuation is higher, is stronger than the evidence that socially responsible firms deliver higher profits or growth. There are clearly firms that benefit from being socially responsible, but there are just as clearly firms where being socially responsible creates costs with no offsetting benefits.
6. The evidence is stronger that bad firms get punished, either with higher discount rates or with a greater incidence of disasters and shocks.
7. The evidence that markets incorporate social responsibility into pricing is weak, except for companies that are labeled as bad firms.
8. The evidence that investors can generate positive excess returns with ESG-focused investing is weak, and there is no evidence that active ESG investing does any better than passive ESG investing, echoing a finding in much of active investing literature.
9. It appears just as likely that successful firms adopt the ESG mantle as adopting the ESG mantle makes firms successful.