Can investors do well while also doing good?
Events like BP’s Gulf of Mexico oil spill are stark reminders of the risks of ignoring environmental, social and governance issues. Even so, many investors are reluctant to embrace “sustainable” investing, fearful of the effect on performance. We highlight recent research that suggests such worries may be misplaced.
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Events like BP’s Gulf of Mexico oil spill, or the discovery that major banks have been manipulating the $5 trillion foreign exchange market, are stark reminders of the risks of ignoring environmental, social and governance (ESG) issues. Losses to a company’s reputation, profits and, increasingly, its share price, can be immediate. In BP’s case, the shares halved in little more than two months following the 2010 disaster, while – to date – the five banks involved in the foreign exchange scandal have been fined a collective £2.6 billion.
Despite these and other high profile disasters, many investors have been reluctant to embrace “sustainable” investing, wary of its possible effect on long-term returns. We understand such concerns, but would point to recent research that suggests that worries about underperformance may be misplaced. Indeed, it may be that investors who incorporate ESG or other sustainable criteria into their investment decisions can actually enjoy better returns than those who only rely on more traditional methods.
One of the more interesting bits of analysis has been a “study of studies” conducted jointly by Oxford University and Arabesque Asset Management1 published towards the end of 2014. This confirmed that companies deemed to be operating sustainably tended to outperform their more traditional rivals. The authors looked at 190 academic analyses to arrive at their conclusions, which were divided up according to various different measures of performance.
Sustainability and the cost of capital
One very telling finding was that an overwhelming 90% of studies confirmed that adopting good ESG standards lowered a company’s cost of capital. Few might be surprised that good governance would reduce the cost of debt, but the research shows that high environmental and social scores have the same effect. Moreover, “according to recent studies, the converse relationship also holds. Firms with significant environmental concerns have to pay significantly higher credit spreads on their loans. For instance within the pulp and paper industry firms that release more toxic chemicals have significantly
higher bond yields than firms that release fewer toxic chemicals.”2
This is confirmed by rating agencies, which tend to give better ratings to issuers with good ESG policies. And, of course, more than four years on from the BP disaster, the 10-year credit spread on the oil company’s debt (as measured by credit default swaps) is, at more than 100 basis points, still about double the level at which it stood before the incident.
It’s a similar story with respect to equity cost. According to one analysis3 , well-governed firms enjoyed an equity cost advantage of anywhere between 0.8% and 1.3%. Another found a reduction of 1.8% in the cost of equity for firms with “good” corporate social responsibility and which were reporting their policies for the first time.
1 From the Stockholder to the Stakeholder, Smith School of Enterprise and the Environment, University of Oxford and Arabesque Asset Management, September 2014.
2 Oxford-Arabesque, as above
3 Corporate Governance and the Cost of Equity Capital, Hollis Ashbaugh, Ryan LaFond, both University of Wisconsin, and
Daniel W. Collins, University of Iowa, October 2004.