“Stock price performance of companies is positively influenced by good sustainability practices”
Sustainability is one of the most remarkable trends in financial markets. Together with Gordon L. Clark and Michael Viehs from the University of Oxford, UK, Andreas Feiner, Arabesque Asset Management, London, UK, published a report on how sustainability can drive financial outperformance. FQF talked to him about the key findings.
Mr Feiner, could you explain, which effects do environmental, social and governance (ESG) issues have on the cost of capital?
In 2015, Arabesque produced a joint research report with Oxford University on current findings relating ESG to finance. It represented the most comprehensive knowledge base on sustainability to date and the results were ground breaking. Of all the papers reviewed in the study, 90% found that companies with sound sustainability standards faced a lower cost of capital.
The case studies and academic literature we reviewed found that environmental, social and governance issues can impose reputational, financial, and litigation risks on corporations. Thus, by treating CSR as an ‘insurance’ benefit, corporations can lower their cost of debt. A famous example is the Deepwater Horizon catastrophe in April 2010, which caused BP’s credit spread to increase eight-fold. In addition, a recent academic report collecting data from the Stockholm Stock Exchange between 2006 and 2014 found Swedish equity capital markets did respond to CSR, as firms with higher ratings showed a lower cost of equity.
Do sustainability practices influence the operational performance of companies?
Our research found that 88% of operational performance studies showed that solid ESG practices resulted in better operational performance. This was based on more than 200 academic studies, industry reports, newspaper articles, and books.
Taking social criteria as an example, we found that maintaining positive corporate relations with all three major stakeholder groups (employees, customers and the community) noticeably improves the operational performance of companies. A study by the University of Maryland found that after computing 270 correlations, there was not a single significant negative relationship relating the two.
Good governance through proper executive compensation schemes is also beneficial to operational performance. When the schemes motivate managers to not take excessive risks, the impact on the operational performance is generally positive, whilst poorly-designed executive compensation on schemes can tend to have the opposite effect.
In terms of environmental performance, it has recently been demonstrated that proper corporate environmental policies result in better operational performance in terms of return on assets and Tobin’s Q ratio.
When we look at the relationship between sustainability and financial market performance. Do good sustainability practices boost the stock price?
Sustainability has been one of the most signiﬁcant trends in ﬁnancial markets for decades. Research has shown that more sustainable firms generally outperform their counterparts over the long-term, both in terms of stock market as well as accounting performance. In addition, various studies have found a ‘momentum effect’, where strategies that assign a higher portfolio weight to companies with improving ESG factors have outperformed strategies that focus on static ESG criteria. Overall, 80% of the studies show that stock price performance of companies is positively inﬂuenced by good sustainability practices.
Perhaps the most prominent assessment on the relationship between stock price and the social dimension of sustainability is by Professor Alex Edmansin. In 2012, he demonstrated that a portfolio comprising of the ‘100 Best Companies to Work for in America’ yielded 2.3% above industry benchmarks over the period 1984-2011.
Good governance is also a boon to market performance with stocks of well governed firms significantly surpassing those of poorly governed firms. For example, a study showed that a portfolio that went long in well governed firms and short in poorly governed firms would have created an alpha of 10% to 15% annually over the period 1990 to 2001.
In terms on environmental sustainability, it has been demonstrated that negative environmental news triggers negative stock price movements and vice versa. This is exemplified particularly in the chemical industry, where following environmental disasters, the stock price of the affected firms generally tumble.
Which sustainability parameters are the most relevant ones for operational performance and investment returns?
Our enhanced meta-study shows a remarkable correlation between diligent sustainability business practices and economic performance on all fronts.
To maximize investment returns, our research indicates corporate eco-efficiency and environmentally responsible behavior are the most important sustainability parameters leading to superior stock market performance. Good employee relations and employee satisfaction additionally play an important role in long term returns.
For maximizing operational performance, there is a strong beneficial relationship with all three ESG criteria. Regarding the environment, specific topics of corporate environmental management practices, pollution abatement and resource efficiency are considered the most relevant. Social factors such as employee relationships and good workforce practices also have a significant impact on operational performance. Finally, governance initiatives, such as executive structure and compensation, result in substantial operational improvement.
Lastly, do you expect that investors will treat sustainability criteria on eye level with financial figures in the future?
At Arabesque, we believe the evidence clearly shows that it is in the best financial interest of investors to incorporate sustainability considerations into their decision-making processes. Furthermore, with current industry trends, the inclusion of sustainability parameters into the investment process will become the norm in the years to come.
With the European Union pushing to increase companies’ accountability on ESG matters, there is a need for ongoing research to identify which sustainability parameters are the most relevant for operational performance and investment returns. We believe that investors should be active owners, exerting their influence on the management of their invested companies to improve the sustainability parameters relevant to operational and investment performance.
The most successful investors will likely set up continuous research programs regarding the most relevant sustainability factors to be considered in terms of industry and geography. Similarly, it is in the best interest of asset managers to integrate sustainability parameters into the investment process to deliver competitive risk adjusted performance and to fulfill their fiduciary duty towards their investors.
Interview: Sebastian Kaiser
www.arabesque.com (several research papers are available for download here)
ABOUT ANDREAS FEINER
Andreas Feiner is a founding Partner of Arabesque. He is responsible for Arabesque`s Sustainability Process, which is the basis for all of Arabesque`s flagship products, and Bespoke Solutions, which offers tailor-made products based on investors` individual preferences.
Prior to founding Arabesque he was Head of Distribution for Barclays Saudi Arabia. Previous positions include Structured Product Sales for Germany, Austria, and Switzerland at Barclays, as well as Equity Research and later Portfolio Management at Metzler Asset Management.
Mr. Feiner holds a BS in Business Administration from the Frankfurt School of Business and Finance.