Increasing Body of Evidence Bolsters Case for ESG Investing

Harvard professor finds they outperform over the long haul, as well as during a market downturn.

A mounting body of research is making the case that the financial benefits of environmental, social, and governance (ESG) investing are as strong as the approach’s societal benefits.

For example, last year, Japan’s $1.53 trillion Government Pension Investment Fund (GPIF) reported that its ESG portfolio outperformed the market, and, earlier this year, a study from the Intentional Endowments Network (IEN) found that responsible investing strategies among university endowments performed as well or better than traditional approaches. And recent research from BlackRock and Bank of America shows that ESG investments outperformed their non-sustainable counterparts during the first quarter market meltdown.

The latest research comes from Harvard Business School professor George Serafeim, who found that ESG not only outperforms over the long term, it also outperforms during market downturns.

Serafeim, with Northwestern University’s Aaron Yoon and Mozaffar Khan, a former colleague of Serafeim’s at Harvard, analyzed the performance of more than 2,000 US companies over 21 years. They found that the companies that improved on material ESG issues “significantly outperformed” their competitors. Serafeim emphasized that this is regarding material ESG issues, as he found that companies that outperformed on immaterial ESG issues actually underperformed their competitors, albeit slightly.

“This suggests that investors are becoming sophisticated enough to tell the difference between greenwashing and value creation,” Serafeim wrote in the Harvard Business Review.

Serafeim says the strategic challenge for CEOs is to identify the ESG themes that are emerging as industry drivers ahead of their competitors. Research he conducted with Jean Rogers, founder and former CEO of the Sustainability Accounting Standards Board (SASB), found that an ESG issue is likely to become financially material under certain conditions, such as when:

  • It becomes easier for management and external stakeholders to gain insight into a company’s environmental or social impact;
  • The media and nongovernmental organizations (NGOs) have more power, and politicians are more responsive to it, such as the enactment and enforcement of anticorruption laws and new regulations;
  • Companies lack the ability to effectively self-regulate, such as with the palm oil industry, where a misalignment of incentives for farmers leads to deforestation; and
  • A company develops a differentiated service or product that replaces an unsustainable way of doing business, such as electric vehicle maker Tesla.

Serafeim also identified five actions companies can take to get ahead of the trends and realize tangible financial benefits from their ESG programs: Adopt strategic ESG practices; create accountability structures for ESG integration; identify a corporate purpose and build a culture around it; make operational changes to ensure the ESG strategy is successfully executed; and commit to transparency and building relationships with investors.

In addition to studying the performance of ESG companies over the long term, Serafeim and his colleagues wanted to see how well ESG companies performed during times of market turmoil. They analyzed data for more than 3,000 firms between late February and late March, when global financial markets were tumbling, and found that the ones the public perceived as behaving more responsibly had less-negative stock returns than their competitors. They also found that during the early part of the global market downturn, most ESG funds outperformed their benchmarks.

Serafeim said he expects that, over the longer term, awareness will increase that companies must consider societal needs, not just short-term profits. He added that the recent prominence of the Black Lives Matter movement is “creating a groundswell of support” that will put pressure on companies to enact strong diversity policies and fair employment practices.

Serafeim said most companies consider ESG the same way people look at a cellphone case—as something added for protection. But in this case, what is being protected is a company’s reputation. He said corporate leaders need to shake this mentality and replace it with an “ambitious and differentiated” ESG strategy if they want to see real financial gains.

“The most fundamental reason to try to raise your company’s ESG performance is that all human beings—in and out of corporate settings—have an obligation to behave in prosocial ways,” Serafeim wrote. “But apart from the moral case, there are very real payoffs for focusing on ESG issues.”

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