Benefits & costs of SR

Empirical work discussed here suggests financial benefits of SR generally outweigh financial costs but each business has to consider its own situation, abilities, and strategy. Benefits and costs vary with SR variant since each has its “stakeholders” and expects business intelligence (BI) systems to collect and distill a different set of information. Unfortunately, there is no published cross-walk between any SR variant and any BI system so each business has to devise its own.

The simple solution is to look for the SR variant that minimizes cost of using existing BI systems. The forward looking approach is to see sustainability metrics as R&D: an investment made for a future return. To encourage the latter view, much of the SR literature is about financial benefits and most skepticism is about the vagueness about what, specifically, works. Similar issues arise with business R&D and “new business intangible assets” more generally, which Federal Reserve researchers estimate are worth more than all equipment and software combined. The greatest benefit of sustainability metrics may turn out to be that it provides a more systematic way for businesses to discover their hidden assets—and liabilities.

1. Financial Benefits of SR

Most studies available online suggest SR increases shareholder value. Part (a) gives a subset of studies in favor of SR, with extracts to highlight distinctive features. All studies that suggest no or negative financial benefit are listed in Part (b) because so few were found.

Most of the studies test whether shareholder value, measured by market capitalization, grows more rapidly for companies adopting SR, variously defined. None compare results across SR variants; say distinguishing those built upon corporate governance indicators, now often mandatory (e.g., Sarbanes-Oxley), from those built on EHS (Environment, Health, Safety) metrics that also tend to be compulsory—and reports that go into strictly voluntary reporting on community involvement, human resource policies, etc. There are valid reasons why such differences persist but they leave ample scope for those who want to argue their companies are special cases, absent a coherent model that addresses concerns skeptics raise about direction of causation.

That is why OconEco only views empirical evidence as proof that shareholders see assets (or liabilities) that business accountants don’t; develops a wealth “model” that considers what factors of production business accountants may be missing, including but not limited to SR elements; and recognizes that the materiality of such factors will vary by industry and ultimately by company. It is not a fully quantitative model but, as shown in the SD&A Map it has clear, objective, defaults to qualitative data via SR^Prep where quantitative data, summarized in KSI^b and KSI^c, are inadequate. It is not the model so much as the materiality filter a client selects that determines what reaches SD&A. While it remains to be proven, this approach is expected to yield unique financial benefits by using sustainability metrics to inform strategic planning, and reporting as a networking strategy.

1. Proponents of SR

Corporate Social and Financial Performance: A Meta-analysis (2003; Orlitzky, et al)

“This meta-analysis both rejects and confirms notions developed by neoclassical economists. On the one hand, it rejects the idea that CSP [Corporate Social Performance] is necessarily inconsistent with shareholder wealth maximization (Friedman 1970; Levitt 1958). Instead, organizational effectiveness may be a broad concept encompassing both financial and social performance (Andrews 1987; Judge 1994). It is also worth noting that, according to most credible versions of stakeholder theory, shareholders are legitimate stakeholders. On the other hand, our findings also confirm the notions of libertarians such as Friedman that government regulation in the area of CSP may not be necessary. If the statistical relationship between CSP and CFP [Corporate Financial Performance] were negative, bottom-line considerations might constitute barriers to outcomes desired by the public, which in turn would make government intervention, which serves the ‘public interest’, a necessity. Yet, with CSP, the case for regulation and social control by governments (acting on behalf of ‘society’ or ‘the public’) is relatively weak because organizations and their shareholders tend to benefit from managers’ prudent analysis, evaluation, and balancing of multiple constituents’ preferences. Therefore, these actions are most likely adopted voluntarily, based on managers’ cost-benefit analyses of a firm’s investments. In contrast, ‘socially responsible’ command-and-control regulation may prescribe inflexible means–ends chains that are inappropriate for a particular firm’s non-market and market environments (Majumdar and Marcus 2001).”

Insurance & Sustainability (2004; WestLB)

“In the last few years the number of empirical studies has increased steeply along with the market volume for SRI [Socially Responsible Investing] and the generally greater public interest in the topic of the social responsibility of companies. Looking at the findings as a whole creates the impression that those investing in companies with social responsibility do not need to fear systematic financial disadvantages compared to ‘normal’ investors. The restriction of the investment universe, which implies a loss in portfolio efficiency, a fact which the SRI philosophy has been widely criticised for, is by no means specific to this approach. In fact, the SRI approach is in no respect different from most other asset management processes which concentrate on specific sectors, investment styles or regions…

In our note ‘More gain than pain – Sustainability pays off’ (November 2002, with an update in October 2003) we examined how the sustainability factor affected share price performance using Jensen’s alpha. The basis for our analysis was a three-factor model (see Fama/French, 1996), which took into account other fundamental risk factors in addition to market risk and enabled the calculation of a multidimensional risk-adjusted excess return. The result is astonishingly robust and confirms the result of our earlier study. Taking the entire observation period (January 1999 to August 2003) as a basis, then the alpha of the DJSI is 0.2572% per month or around 3.1% p.a. which is significantly above our original result of 0.171% per month. In a generally very difficult equity market environment, with very different sub-regimes characterised by the different risk attitudes of market participants, the tested sustainability index was able to achieve a risk-adjusted outperformance. This time the result is statistically highly significant (1% level), of which only a part is attributable to the larger number of observations.”

Does Corporate Governance Matter to Investment Returns? (2005; BNA Inc.)

“As discussed throughout this article, a substantial number of studies support the notions that investing in companies with sound corporate governance programs and practices makes good economic sense and that good corporate governance fosters long-term profitability. Simply put, good corporate governance does, in fact, pay”

Report on Socially Responsible Investing Trends in the United States (2007, Social Investment Forum)

“Socially responsible investing (SRI) is thriving in the United States, growing at a faster pace than the broader universe of all investment assets under professional management. Roughly 11 percent of assets under professional management in the U.S. – nearly one out of every nine dollars – are now involved in SRI…From 2005-2007 alone, SRI assets increased more than 18 percent while the broader universe of professionally managed assets increased less than 3 percent.”

Trends in Corporate Reporting: Testing the Hypotheses (website, PriceWaterhouseCoopers)
OconEco’s summary: Focuses on the perspective of financial analysts

“The message to companies that fail to communicate contextual and non-financial information in a credible and well-structured fashion is that although analytical investment models may be financially driven, confidence in their use increases when there is greater access to more contextual and non-financial information.

The Business Case for Corporate Citizenship (Arthur D. Little & World Economic Forum)

“Various studies have demonstrated a link between reputation and financial performance. A study of companies over an 11-year period by two Harvard professors concluded that “stakeholder-balanced” companies show four times the sales growth and eight times the employment growth of companies that focus solely on shareholders. An analysis of “America’s Most Admired Companies,” as listed in Fortune magazine, found that a good corporate reputation increases the length of time that a firm spends earning above average financial returns and decreases the length of time that a firm spends earning below-average financial returns.”

The Materiality of Social, Environmental and Corporate Governance: Issues to Equity Pricing (2004, UNEP)

“The industry sector reports prepared by brokerage house analysts show that long-term protection of shareholder value rests upon rigorous integration of environmental, social and corporate governance issues in the valuation process. Too many analysts and financial institutions tend to insufficiently acknowledge and appreciate environmental, social and corporate governance issues.”

Beyond the Numbers Corporate Governance: Implication for Investors (2004, Deutsche Bank)

“Corporate governance standards vary widely

We have analyzed corporate governance in different markets, from emerging to developed, and have found that standards vary widely among companies of the same country. None of the analyzed companies, including those in the US and UK markets, were found to have perfect governance and some companies remain far from perfect.

Governance impacts risk, profitability, and price performance

In our research, we have found a clear link between our corporate governance assessment and share price volatility, corporate profitability, and share price performance. Through these relationships, we conclude that the assessment of corporate governance standards is a valid measure of equity risk.

Investors are struggling to anticipate governance problems

Concerning equity valuations among companies in the US and the UK, we have identified a time and information gap, causing most investors to react to bad corporate governance news rather than anticipate potential problems. We also found that investors in emerging market companies tend to be more aware of governance risk, allowing them to discount that risk through equity valuations within the same market.

We believe that as investors improve their ability to measure and integrate corporate governance risk into their investment decision making process in a more systematic way, corporate governance standards will likely play an increasing role in a company’s valuations.”

The Impact of Total Quality Management (TQM) on Financial Performance: Evidence from Quality Award Winners (2000, Hendricks & Singhal)

“The results indicate that award winners significantly outperformed the benchmark portfolios. The stock prices of award winners increased by an average of 114% over the five year period. Over this same time period an alternative strategy of investing a similar amount in S&P 500 Index and holding it over the same time period would have resulted in a 80% return. The difference of 34% is a statistically and economically significant level of outperformance - it translates to an average market value creation of an extra $669 million. The chances of observing the difference of 34% purely by luck is about 1 out of 150.”

The Eco-Efficiency Premium Puzzle (2005, Derwall, Guenster, Bauer, and Koedijk)

“Although conventional investment theory predicts that investors should be cautious about adopting SRI, we presented evidence that a stock portfolio consisting of large-cap companies labeled “most eco-efficient” sizably outperformed a less ecoefficient portfolio over the 1995–2003 period. Using several enhanced performance attribution models to overcome methodological concerns, we showed that the observed performance difference cannot be explained by differences in market sensitivity, investment style, or industry bias. Even in the presence of transaction costs, a simple best-in-class stock selection strategy historically earned a higher market risk–adjusted and style-adjusted return of 6 pps than a worst-in-class portfolio. Overall, our findings suggest that the benefits of considering environmental criteria in the investment process can be substantial.”

Corporate Environmental Governance (2004, Innovest, UK Environment Agency)

“The overall finding from the literature review is that there is strong evidence that where a company has sound environmental governance policies, practices and performance, this is highly likely to result in improved financial performance. The evidence tends to be more compelling when comparative studies are undertaken, with differences in performance between leaders and laggards being quite marked.

The case studies in this report confirm the findings of the literature review, in that changes in financial performance stemming from environmental governance measures can be demonstrated and quantified, although the extent to which these changes is due entirely to environmental governance issues is not always clear.

One area where links can be more clearly established is that of operational impacts. The cost of an eco¬efficiency initiative and its financial outcomes can be measured fairly precisely when a company sets up the appropriate environmental accounting and reporting procedures.”

Risk, Returns and Responsibility (2004, Association of British Insurers)

“The growing body of evidence on the financial impacts of socially responsible investing and corporate responsibility activity suggests several important conclusions:

• the weight of evidence does not support traditional assumptions about the negative impact on risk or returns of introducing social, environmental and ethical investment criteria. On the contrary, incorporating social, ethical and environmental (SEE) criteria can reduce volatility and increase returns

• social and environmental impacts do not fall uniformly across or within sectors – some companies are more or less exposed than others, just as with conventional business drivers

• companies are not equally skilled at managing the impacts, even if they are equally exposed

• investors and lenders, therefore, need detailed information on specific company exposures, but also their strategies and success in managing those exposures.”

Transparency & Disclosure Study: U.S. Results & Methodology (2002, Standard & Poor’s)

“For U.S. companies, there are significant differences in the amount of disclosure provided in annual reports. T&D rankings based on annual reports for the U.S. companies studied are correlated to the determinants of expected returns, such as market risk, size, and the price-to-book ratio. Most telling are the findings that suggest that companies which voluntarily disclose more in their annual reports than is required may command a higher stock price and that such additional disclosure may be a best practice.”

 BUSINESS WEALTH l SR REPORTING VARIANTS