The Financial and Societal Benefits of ESG Integration: Focus on Materiality

January 03, 2017

We examine the alpha-generating potential of material environmental, social and governance (ESG) data.

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Highlights

  • Material environmental, social and governance (ESG) issues impact a company's financials in terms of revenues, costs, and the cost of capital.
  • Because ESG data is slow to be incorporated into stock prices, investors who accurately understand ESG implications typically have time to take advantage of opportunities and generate alpha.
  • A study from George Serafeim and colleagues at the Harvard Business School indicates that firms making investment in material ESG issues outperformed peers in terms of profit margin growth.
  • Firms making investments based on immaterial ESG issues demonstrated very similar performance to peers, suggesting that immaterial ESG investments are not, on average, value-relevant.

The Alpha1-Generating Potential of ESG Data

In the first paper in the Calvert-Serafeim Series, The Role of the Corporation in Society: Implications for Investors, we showed that non-financial but material environmental, social and governance (ESG) issues impact a company's financials in three key areas: (1) revenues, (2) costs, and (3) the cost of capital.

One implication of those effects is the potential for alpha generation -- that is, positive stock returns compared to a benchmark rate or index after adjusting for risk. That's because ESG data is slow to be incorporated into stock prices. Investors who accurately understand ESG implications typically have time to take advantage of opportunities.

Opportunities for Alpha

Further promoting those opportunities is the relative opacity of non-financial disclosures, which are inconsistent, noisy, and selective. That's in sharp contrast to financial disclosures - where the quality, consistency and availability of data has greatly increased in recent decades, to the extent that far fewer stock pickers are able to beat the market as a whole. 

So having established that (a) ESG issues materially affect a company's financials, and (b) ESG issues are not widely understood nor quickly incorporated into stock prices, we see a clear potential for alpha generation, if investors can effectively identify ESG factors that are materially important for a company and make investment decisions accordingly. The research presented here further addresses the necessity of focusing on materially impactful ESG factors and how to go about putting that analysis to work in investment decision-making.

Note that while our primary focus here is on investment returns, it's important to recognize the potential for positive social and environmental benefits stemming from application of these ideas. As more securities are priced in reference to ESG data, companies with strong ESG performance will benefit from lower cost of capital -- and experience opportunities to expand, thus multiplying their ESG practices and, as a result, their environmental and social impacts. In contrast, companies with poorer ESG performance will tend to contract.

Why Focus on Materiality of ESG Data?

The following chart illustrates the potential for material ESG data to separate out stocks likely to perform better.

Material ESG chart

Here's another angle from the same study, by George Serafeim and colleagues at the Harvard Business School -- in this case, focusing on how material ESG factors can affect companies' profit margin growth. Better insight into companies' future profitability can help investors improve stock selection.

The authors hand-mapped SASB's recommended non-financial reporting topics to data points that reflected company investments in material sustainability areas. For instance:

  • Managing environmental impact is a very important element of business strategy for firms in the fossil fuel and transportation industries.
  • Environmental impact is less important for financial institutions and healthcare companies. In contrast, fair marketing and advertising of products are very important for companies in these sectors.

Noting these differences in the materiality of ESG concerns across sectors, the authors constructed one index that ranked companies based on investments in material issues and a second index that ranked companies based on investments in immaterial issues. The materiality and immateriality indices were constructed to be uncorrelated with firm profitability, valuation, size, investments in R&D or capital expenditures, institutional ownership and financial leverage, as well as sector membership.

The authors then constructed portfolios of companies based on the materiality or the immateriality index, controlling for other systematic risk factors, including market, size, value, momentum, and liquidity. Portfolio and index analysis showed very consistent results:

  • Firms making investment in material ESG issues outperformed peers in terms of profit margin growth.
  • In contrast, firms making investments based on immaterial ESG issues demonstrated very similar performance to peers, suggesting that immaterial ESG investments are not, on average, value-relevant.

1 Alpha measures risk-adjusted performance, showing excess return delivered at the same risk level as the benchmark.

All views and opinions expressed are being presented for informational and educational purposes only, represent the views and opinions of the authors(s) as of the date of the presentation and are subject to change without notice. The views and opinions expressed are not intended to forecast future events or guarantee future results and do not constitute a recommendation or a solicitation to buy or sell any security. This information does not take into account the specific investment objective, financial situation, or specific needs of any individual, does not provide information reasonably sufficient upon which to base an investment decision and should not be relied upon as investment advice. This information has been obtained from sources believed to be reliable, but Calvert makes no representation as to its accuracy or completeness.