By Dr Tom Gosling, Executive Fellow of Finance, London Business School
Oct. 23, 2024
A recent study, co-authored by Alex Edmans (London Business School), Dirk Jenter (London School of Economics) and me, asked over 500 portfolio managers how they take environmental and social (ES) performance into account in their investment decision-making; we wanted to get the views of people that actually manage money on a day-to-day basis, rather than the opinions of their sustainability teams.
We focussed on how investors think about the ES performance of firms they invest in as opposed to ES risks, so, for example, the carbon emissions of a real estate company instead of the risks it faces to its portfolio from rising sea levels. Of course, a portfolio manager may care about ES performance because it leads to an ES risk – higher carbon emissions may lead to higher costs in the future if a carbon tax is imposed. But it’s the ES performance that affects society.
The portfolio managers were either “sustainable investors” (who managed a fund marketed as sustainable, ESG or similar) or “traditional investors” (whose funds had no such marketing). The findings are nuanced and support neither of the extremes in the ESG debate.
For the ESG sceptics
Portfolio managers ranked ES performance as least important in a list of six factors that affect value creation in companies they invest in. It was ranked well below Governance (which is often lumped in with ES to form ESG) and even below capital structure, which, in an idealised world, should have little impact on firm value at all. This was true of sustainable investors and traditional investors.
Unsurprisingly, we also found that investors are in the business of maximising returns. Only 23% of investors would sacrifice even 1 basis point of returns in exchange for improved ES performance and only 27% had ever voted for a shareholder resolution that was even slightly negative for shareholder value. The differences between sustainable and traditional investors were small. They view their fiduciary duty as simply not allowing it. At the same time, investors think that companies are, overall, already investing in ES performance to roughly the right degree to optimise shareholder value, so seem to have little incentive to ask companies to do more.
For the ESG advocates
But, although ES is relatively unimportant, 85% of investors, including 78% of sustainable investors, consider at least one dimension of ES performance to be material in absolute terms. Unsurprisingly, the dimensions that score highest are those most closely related to value, such as employees and consumers. But other environmental and social topics are also considered material by many investors.
73% of sustainable investors and 45% of traditional investors expect good ES performers to produce higher total shareholder returns, which is surprising given that academic studies find no such consistent relationship. The most popular explanation is not that ES performance is directly beneficial to companies in and of itself, but that good ES performance is correlated with other factors that drive returns. For example, a company that takes care of its ES business is probably a well-run company overall.
Good ES performance is considered particularly important for protecting against downside risks: 67% of traditional and 61% of sustainable investors believe that poor ES performers will deliver worse returns.
Mandates versus beliefs
What determines whether investors take account ES performance of the companies they invest in?
We identified two channels.
One is the constraints, such as mandates and firmwide policies, that limit investors’ freedom. 85% of sustainable investors have changed their behaviour because of such constraints and, in around half or more of such cases, this led to lower returns.
The other channel is investor beliefs. Investors who believe good ES performance leads to stock price outperformance are more likely to factor it into the investment process: 73% allocated stocks based on ES performance to increase returns or reduce risk and 87% engage with companies to improve ES performance.
Given constraints (from mandates, firmwide policies etc) and, in particular, beliefs, do not split neatly across traditional and sustainable lines, investors choosing a fund manager need to look under the bonnet to understand what type of ES performance they are really getting, rather than just relying on a label.
What can we conclude overall?
ES performance matters to investors, but it’s not the most important driver of value.
We can’t expect investors to lead the charge in solving society’s problems. But, despite the ESG backlash, most portfolio managers, whether of traditional or sustainable funds, are continuing to factor ES performance into stock selection and engagement activity, where they think it’s financially material.
Dr Tom Gosling is an Executive Fellow in the Department of Finance at London Business School, where he contributes to the evidence-based practice of responsible business by connecting academic research, public policy, and corporate action. He is also the inaugural Executive Fellow at the European Corporate Governance Institute and sits on the ESG Advisory Board of the Financial Conduct Authority. He is on the Advisory Panel and on the Stakeholder Insights Group at the Financial Reporting Council.
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