Dr. Svetlana Borovkova: ESG versus financial performance: is there a trade-off?

Dr. Svetlana Borovkova: ESG versus financial performance: is there a trade-off?

Svetlanan Borovkova

Door Dr. Svetlana Borovkova, Probability & Partners

Sustainable investing is the buzzword in the modern investment management. Tomorrow’s investors – millennials - are more committed to sustainability than any of the previous generations. So it is clear that sustainability issues – usually measured by the so-called ESG (Environmental, Social and Governance) metrics – need to be incorporated into the portfolio construction. But does a good ESG performance of a firm come at a cost of its financial performance? In other words, do firms that score highly in terms of ESG deliver lower returns than their peers? 

This question has been the topic of numerous academic studies and attracted attention of investment professionals, but no consensus has been reached so far. So we performed our own extensive study, to see how well-performing (in terms of ESG) large cap firms around the world compare, in terms of financial performance, to their peers. We collected 10 years of ESG and financial data for over 2000 large cap firms from USA, EU, Australia and South East Asia and related ESG to the financial performance of these firms. Getting a bit ahead: our findings show that, to a large extent,  ESG-conscious investors do not have to sacrifice their portfolio returns.

One of the obstacles for ESG integration is the perceived lack of and alleged low reliability of ESG data. However, ESG data of high quality are becoming increasingly available from data providers such as Refinitiv. For example, in EU, the number of large cap companies for which no ESG scores were available decreased from 25% in 2010 to 7% in 2019. For US firms, the ESG disclosure is even better: for 20% of firms no ESG data were available in 2010 , while now this percentage is only 2%. For Chinese firms, there is an explosion of ESG reporting:  in the last two years, three times more Chinese firms have ESG scores available than before 2017.

So equipped with these vast amounts of data, we are able to trace the relationships between ESG performance and various financial indicators of firms, such as market capitalization, return and volatility.

For all regions, we see that larger firms perform better on average in terms of ESG metrics, and this relationship is robust and persistent through time. Better ESG performance of larger firms can be explained by the fact that they have more means to invest in sustainability and hence improve their ESG scores. For investors this means that investing preferentially in highly ESG scoring firms will introduce size bias into their portfolios, and asset managers should be aware of this.

Also for firms in all regions, we observe that stocks of firms with higher ESG scores have lower volatility of returns, indicating that more sustainable firms tend to have more consistent and less volatile financial performance. We have seen the confirmation of this during the COVID-19 pandemic, during which more sustainable firms have shown less dramatic stock price swings than others.

Investigating the relationship between ESG performance and stock returns is more complicated: we need to take into account other determinants of the returns, such as financial ratios of firms. When we do that, we see that firms in EU (and similarly in Australia and South Korea) that score highly on ESG issues do not compromise on returns, but, in EU case, improve them, even when other return determinants are accounted for. This is possibly the consequence of the fact that sustainability issues are high on investors’ agenda in these regions and hence, the firms with higher ESG scores are in high investor demand. In US, the situation is different: there we observe a negative relationship between ESG performance and returns. The situation is similar for Japanese and Chinese firms, but the positive dynamics for Chinese firms can be observed, indicating the well-known positive trend in sustainability awareness of Chinese firms.

So good ESG performance of a portfolio does not have to come at cost of the financial performance. In my next ESG-related column, I will talk about how sustainable firms have weathered COVID-19 epidemic and what lessons can we learn from that.

Probability & Partners is a Risk Advisory Firm offering integrated risk management and quantitative modelling solutions to the financial sector and data-driven companies.