Contributing Writer: Peter Flynn | May, 2024
Every company has an impact on the world that isn’t shown in the financials. Environmental, social, and governance (ESG) scores try to quantify this impact. The goal of ESG is to capture all the non-financial risks and opportunities inherent to a company’s day to day activities (What is ESG, 2022). The environmental pillar of an ESG score reflects a company’s environmental impact. This includes factors such as emissions, waste, and impact on land and water use. The social pillar of an ESG score represents a company’s human relations, including the treatment of employees, workplace safety, and product quality. The governance pillar of a score reflects corporate behavior, board diversity, and shareholder rights. ESG scores positively correlate to company profits due to changes in consumer preferences and government policy.
The idea of rating companies based on their ESG performance has been around for a while, but it has only recently gained popularity in the US. Companies are given an ESG score by a variety of different rating agencies. One of the largest rating agencies, Sustainalytics, started assessing firms with ESG scores in 2018. Sustainalytics measures two aspects of a company’s behavior when assigning an ESG score. First, it looks at the actions a company takes that could lead to risks. These risks could include large fines because the company has poor environmental practices, problems with shareholders because of shady corporate practices, or angry customers because of low product quality. Secondly, Sustainalytics looks at industry-specific risks and measures how well a company manages these risks compared to other companies in the industry (ESG Risk Ratings – Methodology Abstract, 2021). For example, a software company faces different risks than a manufacturing company. A software company can reduce risks by investing in the safekeeping of consumer data, reducing the probability of a data breach. A manufacturing company, on the other hand, can lower its risks by ensuring good working conditions in factories, therefore reducing the probability of a labor strike. Sustainalytics combines both metrics to create an ESG risk rating score, reflecting how well a company manages ESG factors compared to industry peers and the market as a whole.
In recent years, a company’s ESG score has become more important than ever to investors. Analysts commonly position investments based on a firm’s ESG score, believing a higher score indicates a thriving company. A 2022 MIT study found a correlation between ESG score changes and stock returns. When a company’s ESG score decreases, on average, its stock returns decrease, reaching a maximum decline of -3.78% about 19 months after the score has changed. Conversely, when the rating increases, on average, stock returns increase a maximum of 2.62% about 22 months after the change (The Economic Impact of ESG Ratings, 2022). As a result, many large investment funds target companies with good ESG scores, which drives stock prices up even more. A 2022 PwC report predicts that by 2026, ESG-focused investment will increase by 84%, and 21.5% of all assets under management will be ESG-centered (PWC, 2022).
These recent studies and conclusions contrast with previous opinions about the correlation of ESG scores to firm profitability. For example, a 2015 study published in Elsevier found no correlation between ESG scores and profitability, “The ESG portfolios do not show significant return differences between companies featuring high and low ESG rating levels”(The wages of social responsibility — where are they? A critical review of ESG investing, 2015). The contrast between conclusions found in the 2015 article, which is representative of the consensus of the findings of the time, and results today can be attributed to changing policy favoring sustainable business practices and shifting consumer preferences. Policies such as the 2022 Inflation Reduction Act offer previously unavailable incentives and tax breaks to companies pushing sustainable and environmentally friendly practices. Additionally, consumers today value ethics more than before, as PDI Technologies data show that 68% of Americans are willing to pay more for sustainable products, up from 64% of consumers in 2021. This increased value of ethical spending is spearheaded by younger generations, with 77% of Gen Z and 72% of Millennial survey respondents indicating they would pay more for sustainable products. These results are considerably higher than the overall average of 68% of consumers who are willing to spend more (Report Finds Americans Willing to Pay More for Sustainable Products, 2023). The increased spending power of the younger, more progressive generations and the sustainability-favorable policy passed in recent years have resulted in ESG scores having a higher correlation with profitability than in the past. Thus, an increasing amount of studies today are finding a positive correlation between ESG scores and profitability compared to more mixed results about a decade ago.
Still, not everyone is a fan of ESG-based investing. Parties deeply involved with the fossil fuel industries and strong conservative values are against ESG-based investing. For instance, the State of Texas’s Comptroller issued a new policy that diverts state funds, such as pension and school funds, away from asset managers and mutual funds that are boycotting the fossil fuel industry. In the State of Florida, Governor Ron DeSantis approved a resolution prohibiting the State of Florida’s Fund Manager from considering ESG factors in investments. The continued relevance of the fossil fuel industry and its supporters leads to a strong anti-ESG sentiment in certain areas of the country. Despite the pushback, many investors continue to pour money into ESG-based funds. Last year, a Russell Investments survey of asset managers found that 82% of U.S.-based asset managers systematically incorporate ESG information into their investment process (The Anti-ESG Rhetoric and Actions of Republican Politicians Are Bad for Investors and Business, 2022).
After taking a close look at all the elements at play, I have come to the hypothesis that a higher ESG score correlates to higher company profits. To test my hypothesis, I conducted a matched pairs T-test in which I analyzed 66 different companies in 33 different industries. I used Morningstar’s Sustainalytics feature, which divides companies by industries and gives each company a score which labels that company as either negligible, low, medium, high, or severe ESG risk. For my comparison, I randomly selected one negligible/low ESG risk company and one medium/high/severe ESG risk company in the same industry and compared their profit margins. I repeated this process for all thirty-three different industries, and twenty-two of the companies with lower ESG risk scores showed higher profits. Based on the results of these tests, I can conclude with 99% confidence that the average net profit is higher for a company with low ESG risk than a company with high ESG risk. My results have shown that, while we cannot prove higher ESG scores will invariably lead to higher profits, we can conclude there is a strong correlation between the two. Thus, it is very likely that companies adhering to better ESG practices will observe increased profits as a result.
One company taking steps that will likely raise its ESG score is United Airlines. In the past few years, United has pushed to lower its carbon emissions and become a more environmentally friendly and transparent company. United has done this by advancing the utilization of sustainable aircraft fuel (SAF) and by ordering over 400 new fuel-efficient planes (United Airlines Corporate Responsibility Report, ND). Additionally, in February 2023, United implemented a new feature that shows customers their estimated carbon footprint per flight (Practicing Good Green Governance Leads to Profits, 2023). These actions have increased the company’s ESG rating, and appreciative customers have proven willing to pay more for airfare. Since February 2023, United Airlines’ profit margin has increased by six percent, two percentage points higher than the airline average. Though the profit increase could be due to other factors, the favorable ESG efforts United made likely positively impacted profitability.
We see a trend with the opposite effect as well. If companies start to participate in poor ESG practices, they will face consequences. In 2022, Tesla began getting called out for engaging in poor ESG practices such as harsh working conditions, racial discrimination, and boardroom issues (Learning from Tesla’s Removal from S&P 500 ESG Index, 2022). The actions and controversy surrounding Tesla likely led to internal issues. They turned away many potential consumers who may have previously felt favorably about the company because of its progressive stance on climate change. During this time, Tesla’s ESG ratings plummeted and so did its profitability (Tesla Stock Sinks To 9-Month Low, 2024).
Changing consumer preferences and favorable government policies have made ESG practices more important. Additionally, there are positive side effects that come from practicing responsible ESG policies. Responsible environmental practices can reduce waste and eliminate potential fines. Treating employees better will result in higher worker productivity. Transparency in the company will lead to higher levels of trust and cooperation. Most importantly, improving ESG practices will generate a positive reputation for the company, leading to increased public support. I believe that the connection between ESG scores and firm profitability will continue to get stronger and more robust as progressive legislation is passed and consumers increasingly value ethical business.
REFERENCE
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