So much of the news today heralds a new path to profits.
“Investing in social good is finally becoming profitable”, reads a recent New York Times headline. The Financial Times reported on February 6 that “ESG funds defy havoc to ratchet huge inflows”, while Bloomberg News wrote on February 10 that “the boom in ESG shows no signs of slowing”.
Environmental, social and governance (ESG) factors have clearly garnered the attention of companies and their investors and stakeholders. Amid the global crises of the pandemic and climate change, there is a special allure to business strategies that can deliver profits and societal value, especially if those results are mutually reinforcing.
Yet some studies have questioned whether integrating ESG factors into corporate decision-making necessarily leads to improved profitability. One study looking at 2,396 enterprises found that those with high ESG scores in general did not outperform the market in a statistically significant way1. Another study found that the average socially responsible investment fund in the US and the UK, and in certain European and Asian-Pacific countries, underperforms relative to benchmarks2.
Establishing purpose is critical to expanding the total value of the enterprise, so that both investor and stakeholder value increases in the long term.
However, there is more to the story. Companies which score highly in ESG factors that are material to their industry, yet poorly in immaterial factors, have been found to outperform their peers by a statistically significant percentage3. Investments in ESG often require trade-offs, and the most productive investments appear calibrated to ESG factors that are highly relevant to the business in question, such as environmental protection for a natural resources company, or customer privacy and data security factors for a technology company.
A purposive approach to defining material ESG factors
Assessing the materiality of ESG factors is not always easy, if for no other reason than the number of factors from which to choose. For example, the Sustainability Accounting Standards Board (SASB) has published a Materiality Map highlighting 26 sustainability issues that are reasonably likely to have a material impact for different businesses in different sectors. Furthermore, the evaluation of ESG risks, opportunities and priorities crosses a wide range of disciplines and expertise and requires collaboration among many different functional groups within an organization.
What can help a company prioritize investments in ESG? Drawing on extensive evidence, Professor Alex Edmans of the London Business School makes the case for defining an organization’s purpose in society: why the enterprise exists, and who it serves. In his view, establishing purpose is critical to expanding the total value of the enterprise, so that both investor and stakeholder value increases in the long term. For example, an energy company’s purpose could be “creating automotive fuel that results in a net reduction of global greenhouse gas emissions”, whereas a pharmaceutical company could be “creating innovative medicine that is accessible to the broadest possible population”. Even these simple examples show how a purpose can act as a signpost, implicitly setting priorities and engendering tradeoffs. In this way, says Edmans, a purpose can help organizations answer questions such as: which stakeholders are material to the business? Which stakeholders should the organization be especially concerned about? Answering these questions can guide decisions about which ESG factors are material, and in turn shed light on the ESG investments that are most likely to increase value.
A focus on an organization’s social value, Edmas posits, “is neither defensive nor simply ‘worthy’—it’s good business.” He adds, “The highest-quality evidence, not wishful thinking, supports this conclusion: to reach the land of profit, follow the road of purpose”4. Or, as BlackRock CEO Larry Fink stated, “purpose is not the sole pursuit of profits but the animating force for achieving them”5.
Effective ESG integration and communication
Of course, once established, a purpose must be integrated and communicated well to be effective. According to one study, those companies found to have a strong and clearly communicated purpose beat the market by 5.9% to 7.6% per year, controlling for risk6. This finding is at the heart of the ESG project. When embedding a purpose with a business, and communicating it both internally and externally, companies can use a wide array of ESG standards.
Today, although there is no single universally accepted standard for evaluating and disclosing ESG factors, there are nonetheless several well recognized standards and bodies, such as SASB, the Global Reporting Initiative, CDP Global, Task Force on Climate-Related Financial Disclosures, Climate Disclosure Standards Board and the International Integrated Reporting Council (IIRC). There has been significant pressure from companies, investors, regulators and the accounting firms to harmonize the complicated maze of standards, and we expect this progress to continue following recent announcements by several organizations to create a comprehensive reporting system, and following the announced merger of SASB and IIRC to form the Value Reporting Foundation.
These are becoming legal considerations as well, with ESG considerations increasingly embedded in financing agreements and transaction documents, board decision-making and public disclosure requirements, which are being strengthened in many jurisdictions. Companies are being held to higher standards of accountability and subject to increasing criticism and activism where they have failed to deliver on their ESG promises.
Ultimately, the evidence suggests that a clear purpose—one that defines an organization’s role in society—can guide the integration of ESG factors into corporate decision-making in a way that increases both investor and stakeholder value.
1 M. Khan, G. Serafeim and A. Yoon, “Corporate Sustainability: First Evidence on Materiality”, The Accounting Review (2016).
2 L. Renneboog, J. Ter Horst and C. Zhang, “The price of ethics and stakeholder governance: The performance of socially responsible mutual funds”, Journal of Corporate Finance (2008).
3 See footnote 1.
4 A. Edmans, Grow the Pie: How Great Companies Deliver Both Purpose and Profit, Cambridge University Press (2020), p. 304.
5 Larry Fink’s Letter to CEOs, 2019.
6 C. Gartenberg, A. Prat and G. Serafeim, “Corporate Purpose and Financial Performance” (2019) 30 Organization Science 1-18.