Do firms’ environmental, social and governance performances matter? Jacquelyn Humphrey Darren Lee

Introduction Sustainability investing: recognising firms face environmental, social and governance (ESG) opportunities and risks  requires that ESG factors be incorporated into investment analysis (alongside ‘traditional’ financial analysis)

Why do we care? Starting to see a demand for ESG information Many stock exchanges now have mandatory ESG disclosure requirements e.g Australia, France, India, Malaysia, South Africa, Sweden, Taiwan and Thailand Other countries have voluntary requirements, e.g. stock exchanges in China have issued ESG guidelines for listed companies UN Principles for responsible investment (UN PRI) : 906 signatories (as at 14 September 2011) Majority are investment managers US$21 trillion in assets globally - most from Europe (US$12.5 trillion) North America (US$5.5 trillion) Asia (US$1.96 trillion).

Why do we care? Opening paragraph of the UN Principles for responsible investment (UN PRI) states: “As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognise that applying these Principles may better align investors with broader objectives of society.”

Introduction So the question is, does ESG matter? We look at this question in three ways: does ESG impact performance? are there consequent flow-on effects meaning ESG affects book-to-market ratios? does ESG impact firms’ corporate financing decisions? We investigate the UK market

Why look at the UK? A developed market At the forefront of sustainability investing: Carbon Disclosure Project, Institutional Investors Group on Climate Change and the secretariat of the UN PRI all based in London Large proportion of assets invest according to ESG: 117 UN PRI signatories more than 30% of the Investment Management Association’s recorded funds under management are UN PRI signatories  a natural experiment Also only three studies have looked at the UK market, and all only examine performance (Brammer et al., 2006; Lee et al., 2010; Humphrey et al., 2011)

Literature Does ESG impact performance? We don’t seem to know yet, the literature has found: a positive relation between ESG and performance (e.g. Lo and Sheu, 2007; Filbeck, Gorman and Zhao, 2009) a negative relation between ESG and performance (e.g. Lee et al., 2009 ) no relation between ESG and performance (Galema et al., 2008; Statman, 2006, Lee et al., 2010; Humphrey et al., 2011).

Literature Some studies suggest we should separate the subcomponents: perhaps some factors have a positive effect while others have a negative effect on performance thus cancel each other out (Galema et al., 2008; Statman and Glushkov, 2009) And there is literature that has done this, again with mixed results: E - Derwall et al. (2005), Klassen and McLaughlin (1996), Gilley et al. (2000), Brammer et al. (2006), Galema et al. (2008) S - Lado and Wilson (1994), Turban and Greening (1997), Herremans et al. (1993), Filbeck et al. (2008), Galema et al. (2008) G - Gompers et al. (2003), Cremers and Nair (2005), Statman and Gluskhov (2009)

Literature Does ESG impact btm ratios? Galema et al. (2008) argue that the reason for studies finding no relation between ESG and financial performance is because studies misinterpret models Most studies use Fama and French (1992) market models and interpret insignificant alpha as evidence ESG is not priced But, if ESG pushes prices up, this will increase market value therefore decrease btm ratios  factors impacting btm are independent of risk profiles for these firms If this is really what is going on we should see a relation between ESG and btm

Literature Does ESG impact corporate financing? Opposing theories on whether firms with high ESG will raise relatively more debt or equity: Hong and Kacperczyk (2009)  inflated stock prices for firms with high ESG ratings makes raising equity more attractive than raising debt, similarly Herremans et al. (1993) find firms with low ESG ratings have slightly higher leverage, however Goss and Roberts (2007) find firms with very low ESG ratings face higher yields: debt relatively less attractive for these firms.

Data ESG data from Sustainability Asset Management Group GmbH (SAM) proprietary company which specialises in sustainability research Dow Jones Sustainability Indexes ESG data is mainly from a comprehensive annual survey of over 1000 companies globally We select UK portion – 249 listed firms

Data Total general Total Industry Specific Total Combined

Data FTSE index components directly from FTSE All other data from Datastream and COMPUSTAT Global Sample period is October 2002 to September 2008

Method Performance: BTM: Corporate financing: CorpFin = book leverage, market leverage, cash, overall payout ratio, dividend payout ratio, shares repurchased

Results: performance Little evidence of any relation between ESG and performance All ESG coefficients insignificant Exception is general social score – firms with good social scores appear to have higher returns

Results: BTM Total scores (combined, general and specific) – no relation with BTM Environment: -ve higher demand  inflated prices? Social – not significant Governance – opposing effects: general –ve, industry- specific +ve

Results: Corp financing Total combined scores – no effect except cash – weakly +ve Total general and industry-specific – no effect Environment: +ve relation with leverage Easier for firms with good environment ratings to access debt +ve relation with repurchases

Results: Corp financing Social: General: -ve relation with leverage Lines up with higher returns found earlier – these firms prefer to raise equity Firms with low social scores repurchase more – in line with signalling that market has underpriced their stock Governance: insignificant

Summary and conclusions Little evidence of ESG affecting returns (except for general social) Negative relation between environment scores and BTM ESG does affect corporate financing decisions However, in differing ways across E, S and G Note importance of finer disaggregation: components of ESG have differing impacts on returns, BTM and financing: only looking at highly aggregated ESG scores can lead to erroneous conclusion that ESG has no impact