ESG and Finance (Corporate Finance)

ESG and Finance Part 1: background and increased interest in ESG ESG: heavily used in the finance industry following a letter sent in 2005 by Kofi Annan (UN secretary general) to leading financial institutions asking them to “better integrate environmental, social, and governance issues” à Common poi...

ESG and Finance Part 1: background and increased interest in ESG ESG: heavily used in the finance industry following a letter sent in 2005 by Kofi Annan (UN secretary general) to leading financial institutions asking them to “better integrate environmental, social, and governance issues” à Common point with CSR and sustainability: broad umbrella that refers to the incorporation of environmental and social considerations into investors’ portfolio decisions or firms’ decisions à +4300 investors managing +120 trillion had signed the Principles for Responsible Investments (PRI) by the end of 2021 à Active mutual funds have increased their ownership in the high-ESG firms relative to low-ESG firms Blackrock: in 2018, Larry Fink, founder and CEO, one of the most influential investors in the world (it managed $6 trillion in investments at the time) sent a letter to the world’s largest companies to tell them that they need to contribute to society to receive his firm’s support. In his 2021 letter to CEOs, Larry Fink stresses that “no issue ranks higher than climate change on our clients’ list of priorities” An increasing number of companies report ESG-related information: à About 90% of S&P500 firms are now publishing detailed sustainability reports (up from 11% in 2011) à Firms allocate significant portions of their expense budgets to ESG initiatives: $28 billion on sustainability (large U.S. firms in 2020) $15 billion on corporate philanthropy (large U.S. firms in 2020) 30% of publicly listed companies designate ESG metrics as key performance indicators for their executive compensation schemes (up from 3% in 2010) The COVID-19 crisis: the greatest recession since World War II, but investors are also calling it the 21st century’s first “sustainability” crisis and one that has renewed the focus on climate change, acting as a wake-up call for decision makers to prioritize a more sustainable approach to investment” Key questions: What are the driving forces behind the growth of interest in ESG investing? What are the eFects of this investment approach? o Performance: Is it possible to do well by doing good? o Impact: Is it possible to have a positive impact on society/environment? Part 2: the motivations for ESG investing and the corporate objectives The consideration of ESG issues is intrinsically linked to the debate regarding what the corporate objective should be. à DiFerentiating the value versus values motivations for ESG is important because it may lead to a change in the corporate objective What is business for? “Maximize shareholder value” à 1970: Milton Friedman (Nobel Prize in Economics 1976) wrote article in NY Times arguing that a company has no social responsibility towards society or stakeholders: its only responsibility is to its shareholders à Friedman doctrine: “The social responsibility of business is to increase its profits” à Money-making activities should be separated from ethical activities Capital budgeting: is the process of analyzing investment opportunities and deciding which ones to accept à Maximization of firm value Portfolio theory: was developed by H. Markowitz and W. Sharpe (Nobel Prize in 1990) à An analytical framework to choose a combination of assets that oFers the highest expected return for a given level of risk, defined as variance à Mean-Variance analysis: Investors like high expected returns but dislike high volatility à The CAPM comes out of mean-variance analysis à Objective: Maximizing expected return for a given level of risk (as northwest as possible) Societal norm against funding operations that promote vice and some investors, particularly institutions subject to norms, Sin stocks pay a financial cost in abstaining from these stocks. Sin stocks are shunned away by numerous investors. Institutional investors implement exclusionary screening based on direct Dirty stocks emission intensity (the ratio of total emissions to sales) in a few salient industries Corporate finance theory and tools rely on the implicit assumption that the corporate objective is to maximize shareholder value. à The Values approach of ESG implies that we need to rethink the corporate objective: Shareholder Welfare Maximization takes into account that investors derive nonpecuniary benefits from ESG considerations Main challenge: how to account for the heterogeneity in investors’ preferences. The Value approach of ESG does not imply a change in the corporate objective ESG considerations are a way to create shareholder value, which remains the ultimate goal The main diFerence with traditional investing is that it does not view ESG considerations as a waste of money that would be costly for shareholders (pie- splitting vs pie-growing) The pie-splitting approach assumes that the size of the pie is fixed (at least in the short- term): The only way to increase profits (i.e., the slice that goes to shareholders) is to reduce the slices taken by other stakeholders Zero-sum game The pie-growing approach: the most successful companies don’t target profit directly but are driven by purpose – the desire to serve a societal need and contribute to human betterment à “Grow the Pie: How Great Companies Deliver Both Purpose Benefit” by Alex Edmans à Companies can grow the pie by investing in stakeholders – improving working conditions, pioneering new products or reducing their environmental footprint. Profits arise as a by-product of growing the pie A company focused on profits may invest in stakeholders. But only if it calculates that such an investment will increase profits by more than the cost of the investment à Textbook computation: NPV (investment in stakeholders) >0 so Invest! à In practice, it is very diFicult to calculate the cashflows associated with an investment in stakeholders. In the past, most investments were in tangible assets à Most of the value of a 21st century firm comes from intangible assets such as brand, reputation or corporate culture Bottom line: many investments in stakeholders that are likely to bear fruit over the long- term are diFicult to justify based on traditional NPV calculations (productivity, loyalty, reputational benefits) Motivation for ESG investments: survey, laboratory experiments Giglio et al. (2023) analyze ten waves of the survey (around 2,000 per survey wave): Fact 1: Between mid-2021 and late-2022, investors expected the 10-year return on ESG investment to underperform the market by about 1.4% per year Fact 2: There is substantial heterogeneity across investors in their ESG return expectations and their motives for ESG investing: o 45% of survey respondents do not see any reason to invest in ESG o 25% are primarily motivated by ethical considerations o 22% are driven by climate hedging motives o 7% are motivated by return expectations Fact 3: There is a link between individuals reported ESG investment motives and their actual investment behavior, with the highest ESG portfolio holdings among individuals who report ethnics-driven investments motives The perceived primary ESG investment motives diFer across demographic groups: Richer, older, and male investors are more likely to see no specific reason to invest in ESG portfolios Ethical motivations are more important for female and younger investors Concerns about climate change are associated with investors being more likely to report ethical or hedging reasons as the primary motives for ESG investing. Bottom-line: ESG investing is driven by values for many investors, but the values motivation diders across investors depending on their age, gender, and level of concerns for climate change Part 3: implementing an ESG investment strategy – ESG measurement and its limitations Implementing an ESG investment strategy: Have a way of measuring ESG performance of companies Able to identify socially or environmentally responsible companies à ESG ratings: not always clear ESG scores from Refinitiv (LSEG): Used in more than 1500 academic papers since 2003 Major assets managers including Blackrock Two types of data points: Boolean data points (1 or 0). For instance, for the data point: does the company has a water eBiciency policy? Equal to 1 if this is the case and 0 if not (or not reported or partial information) Numerical data points as for the percentage of female board members or the level/intensity of GHG emissions. Limitations: Relativity: ESG performance is measured in relative terms within an industry group. This approach does not penalize entire industries or businesses (e.g., cigarettes, weapons, oil) Materiality: Emphasis put on material E&S considerations (hence depends on how materiality is defined). Mostly about financial materiality (how a firm is exposed to E&S risks and having policies about it) rather than impact materiality (the impact on stakeholders of the company’s activities) Readability: Blackbox / discretionary choices and methodology. Big factory that turns mostly binary variables coding for the existence of an information into a score. Hard to understand/interpret what it really means Sticky: Because of the numerous ESG factors considered, ESG scores change very slowly over time for a company. It reflects a lot what has been reported and done up to now (backward-looking measures), poorly captures progress or commitment Aggregation fallacy: The aggregation hides malpractices. Perhaps some issues are so significant, such as extreme human rights violations or massive oil spills, that they should not be compensated by other E&S considerations. More generally, mixing ES and G considerations does not make a lot of sense Important challenges for ESG investing: Divergence of ESG ratings: The Aggregate Confusion à No consensus on the definition of ESG performance across data providers ESG conflicts and lack of hierarchy: ESG comprises diFerent dimensions that may conflict with each other. E versus S (e.g., closing a polluting plant), Climate change versus biodiversity. Hierarchy of ESG dimensions would be important: but it is likely to diFer across values- motivated ESG investors And across value-motivated investors Part 4: ESG investing and performance No evidence that ESG funds outperform compared to other funds! (Matos 2020) Lack of evidence on the outperformance of ESG funds is not surprising: à In practice, there is a wide variety of ESG funds: Green/climate oriented ESG funds, Gender equality, Animal rights, Religious (e.g., investing according to Shariah or Catholics values), Greenwashing: some ESG funds are not investing diFerently from other funds ESG funds have proliferated recently… Morningstar documents a nearly 50% increase in the number of ESG funds available in the US from 2019 to 2020 alone Anecdotal evidence suggests that some funds were misleading investors by marketing funds as ESG-friendly but not making investment decisions consistent with such marketing à Endogeneity concerns: A potential correlation between ESG scores and profits could be driven by reverse causation (i.e., more profitable companies have more financial resources to invest in stakeholder friendly initiatives) The correlation between ESG investments and profits could be spurious if it is driven by a third (didicult-to-observe) variable (e.g., management talent) à ESG stocks outperform if the stock market as a whole overlooks important ESG-related value drivers à ESG stocks outperform when investors’ concerns about ESG issues increase (or when their preferences shift) à ESG stocks outperform during crisis periods: Trust between a firm and both its stakeholders and investor built through ESG investments pays oF when the overall level of trust in corporations and markets suFer from a negative shock The Best Companies list is compiled by the Great Place to Work® Institute and annually published in the January issue of Fortune magazine à less subject to manipulation because independent Over 1984-2009, the “100 Best Companies to Work For in America” have an annual outperformance of: 3.8% (market) 2.4% (industry) 2.9% (peer firms with same characteristics) à Employee satisfaction but takes times to see the implication in value of the firm à Conflict between short term and long term investors. Consistent with this idea, long- term investor ownership is a key driver of employee satisfaction (Garel and Romec 2021) à Firms with more long-term investors invest more in employee satisfaction and are more likely to be part of the “Best Companies to Work For” list The COVID-19 crisis: Firms with greater social responsibility had better stock returns (Albuquerque et al. 2020). Bottom line: during the 3 worst financial crisis since the great depression, firms with greater responsibility fared much better Part 5: climate finance Climate change is one of the greatest challenges of our time and may impact the health and well-being of virtually every person on the planet. It poses important risks for the economy and stability of financial systems Institutional investors increasingly care about climate change and its consequences: Most believe that climate risks have financial implications for their portfolio firms and that these risks, particularly regulatory risks, already have begun to materialize. Most also believe that climate risk reporting to be at least as important as financial reporting Key questions: How to measure the extent to which firms are exposed to climate change and its consequences? Is climate risk priced by investors? The energy transition away from fossil fuels exposes companies to carbon-transition risk. Firms with greater carbon emissions are therefore more risky Carbon premium: Stocks of firms with greater carbon emissions earn higher returns. Carbon premium is stronger after the Paris Agreement and is stronger in firms with more stringent environmental regulation à Investors have started to price the carbon-transition risk and now require a higher return for investing in carbon-intensive firms. à Only 16% of publicly listed companies voluntarily disclose their carbon emissions in 2018 (up from 7% in 2015)  3 types of climate risk Transition or regulatory risks Reputational risks, stranded assets, litigation Physical risks Heat, natural disasters Opportunity or technological risks Electric cars Key question: How to measure and quantify firms’ exposure to these diFerent climate risks? Sautner et al. (2023) oFer a method for measuring firm-level climate-change exposure which: Identifies the attention paid by earnings call participants to firms' climate change exposures Adapts a machine learning keyword discovery algorithm and captures exposures related to opportunity, physical, and regulatory shocks associated with climate change This method has been used to capture firms’ exposure to other type of risks: political, Brexit, covid Part 6: biodiversity finance Biodiversity: the variety of living organisms in all habitats. à Biodiversity is deteriorating at an unprecedented and alarming speed à Between 1970 and 2018: 69% loss of monitored wildlife (WWF 2022) Biodiversity loss jeopardizes ecosystem services (i.e., the goods and services that humans obtain from the nature): Food provisioning (e.g., plants, animal proteins, pollinator) Air and water quality Medicine (e.g., penicillin, aspirin) Landscape Half of the world’s GDP stems from industries that depend on nature and ecosystem services (WEF 2022) Biodiversity finance is centered on similar issues we have seen for climate finance: How to measure the extent to which companies contribute to biodiversity destruction? How to measure the extent to which companies depend on biodiversity? Whether biodiversity-related risks are priced by investors? Data on firms’ impact on biodiversity (Corporate Biodiversity Footprint) are from Iceberg Data Lab (IDL) CBF metric (km^2.MSA) aggregates the biodiversity loss caused by annual firm activities resulting from environmental pressures (e.g., land use, nitrogen deposition, emissions, and release of toxic compounds). à Mean Species Abundance: 0% = lost everything, 100% = level of original/undisturbed ecosystem à CBF quantifies impact of company in terms of MSA à firms with greater CBF = more risky Garel et al. (2023) examine whether CBF adects the cross-section of stock returns: à Biodiversity-footprint premium: Stocks of firms with greater CBF earn higher returns à Following major agreements to protect biodiversity, investors have started to price the biodiversity-transition risk and now require a higher return from investing in large CBF firms Corporate biodiversity footprint captures biodiversity-related transition risk As climate risk, biodiversity risk is complex and multi-faceted. At least, three types of climate risk could be considered The understanding of biodiversity-related risks is still limited among investors and academics Nature Action 100 (NA100) is an institutional investor initiative that engages with companies in order to tackle biodiversity and nature loss. à NA100 target companies operating in eight sectors deemed to be systematically important to reversing nature loss biotechnology and pharmaceuticals chemicals household and personal goods consumer goods retail, including e-commerce and specialty retailers and distributors food food and beverage retail forestry and packaging metals and mining NA100 was launched at COP15 and is supported by 200 institutions, representing $27 trillion in assets under management or advice as of 2023 Biodiversity risks are diFicult to measure properly but the NA100 initiative is likely to have targeted firms with greater impact on biodiversity Conclusion: The last years have witnessed a growing interest for ESG investing that evolved from a niche market to a mainstream practice. à To understand the increased interest for ESG investing, it is key to understand investors’ motivations for ESG investing: Values versus Value à Significant challenges remain for the incorporation of ESG considerations in investors’ and firm’s decisions: Divergence of ESG ratings, Lack of hierarchy in ESG considerations à Empirical evidence on the performance of ESG investing is nuanced: No evidence that ESG funds have better performance, Some evidence that firms with better ESG characteristics outperform à Climate finance and biodiversity finance have become or are becoming central issues and raises important questions: How to measure firms’ exposure to climate and biodiversity-related risks?, Are these risks priced by investors?