top of page
Anisha Maini

Does ESG Performance Impact The Enterprise's Bottom Line?

Written by Anisha Maini with support from Saurabh Zanwar



Does ESG Performance of the company impact its bottom line?


Conversations around environmental, social, and governance (ESG) considerations have dominated the recent economic climate, with the release of IFRS S2, European Sustainability Reporting Standards (ESRS), RBI’s guidelines on Climate Risk and Sustainable Finance and more, all within the last year or so, firms can no longer ignore the importance of reporting on their ESG performance. 


With regulations tightening and reporting becoming mandatory for large enterprises, investing in an improved understanding of ESG metrics and measures brings with it the question of how ESG impacts the business bottom line in the short and long term. The notion of Triple Bottom Line, coined in the early 1990s, studied the idea of companies optimising across the three Ps: People, Planet, and Prosperity, i.e., being conscious of their operational impact on society and the environment, in addition to their economic performance. The ESG movement today continues to grapple with the same tensions.  


With the current global climate crisis gaining increasing salience socially and politically, ESG considerations are increasingly at the forefront of all business, financial, and investment-related decisions. However, for all the decision-makers and investors, a pertinent question remains - will investing in ESG lead to a better economic performance for the company? 


Impact of Investing in ESG


The short answer is yes, with caveats. Researchers have been looking at the link between ESG and financial performance since the 1970s (Friede et al., 2015). According to numerous empirical studies conducted in recent years, companies that perform better on ESG metrics, see higher returns in the long run. To demystify the discussion on whether ESG is a distraction from the real business of making money, let’s look at the results of a few studies in detail. 


Aydogmus et al. (2022) in their paper “Impact of ESG performance on firm value and profitability” look into whether the postulate of Stakeholder theory or shareholder theory holds true. Stakeholder theory (Freeman, 1984), which many business associations subscribe to, puts forth the idea that a successful business must align the interests of all stakeholders and, if it can do so, it will be more sustainable. On the other hand, in Shareholder theory the primary object of the firm must be to ensure increasing profitability year on year and maximising shareholder value. 


Aydogmus et al. (2022) analysed the data of the 5000 largest publicly listed firms in the world from 2013 to 2021 and found that ESG performance has a positive and highly significant relationship with firm value and profitability with a coefficient of 0.008 and 0.049. Looking at individual E,S and G metrics, Aydogmus et al. (2022) find that Social and Governance have a positive relation with firm value, while Environment has no significant impact. However, in the case of profitability, all three metrics have a highly positive relationship, with Environment performing better than social and Governance. 


While Aydogmus et al. (2022) found a positive correlation, many studies conducted during the same time got results which stated otherwise. Therefore, researchers at NYU Stern Center for Sustainable Business and Rockefeller Asset Management, decided to look at over 1000 research papers published from 2015 to 2020 which examined the relationship between  ESG and the financial performance of a company. Since there are numerous metrics which can be used as North Star when determining financial performance, they decided to divide the research papers into two segments: one, which focuses on corporate financial performance (e.g. operating metrics such as ROE or ROA or stock performance) and the second, those focused on investment performance (i.e. from the perspective of an investor, generally measures of alpha or metrics such as the Sharpe ratio on a portfolio of stocks). 


Whelan et al. (2021) at NYU Stern Center for Sustainable Business and Rockefeller Asset Management, find a positive relationship between ESG and financial performance for 58% of the “corporate” studies focused on operational metrics, with 13% showing neutral impact, 21% mixed results (the same study finding positive, neutral or negative results) and only 8% showing a negative relationship. For the “investment-focussed” studies,  59% showed similar or better performance relative to conventional investment approaches while only 14% found negative results. 


Whelan et al. (2021) also analysed 59 climate change, or low carbon, studies related to financial performance, i.e. only focussed on the ‘E’ (environment) metric and found a positive relationship for 57% of corporate studies and a positive or neutral relationship for 65% of investment studies. 


Interestingly, a 2020 study by Cheema-Fox et al. (2020) at Harvard Business School finds that companies scoring high on a “crisis response” measure (based on Human Capital, Supply Chain, and Products and Services ESG sentiment) were associated with 1.4-2.7% higher stock returns. This is particularly significant since during a market crisis, investors look for resilient companies. 


Lastly, while Whelan et al. (2021) make a strong case for investments in ESG, it’s worth looking at an India-specific study. A 2022 study published by Dr Bala (2022) at the University of Delhi uses the CRISIL ESG Score and financial performance indicators like return of assets and capital employed to understand the relationship between ESG and the bottom line. The results show a positive relationship between ESG and financial performance as a whole for the 200 companies analysed for the year 2020-21. At the level of an individual indicator, governance seemed to have the highest positive impact on financial performance, followed by social and then environment in the Indian subcontinent. 


So should enterprises prioritise ESG? 


The findings of the above-mentioned studies as well as many others make a strong case for the importance of investment in ESG. However, companies might also prioritise investing in ESG and undertake measures to improve their ESG ratings for different reasons. Let’s delve into a few of these: 


  1. Tightening regulations: With numerous ESG reporting frameworks and regulations coming into existence, both from government initiatives and private-public partnerships, rather than remaining a voluntary initiative, investing in ESG becomes increasingly important for many large firms. For instance, any company looking to register on stock exchanges, especially the Shanghai Stock Exchange, Shenzhen Stock Exchange, and Beijing Stock Exchange (BSE), must mandatorily disclose its ESG metrics. Mandatory reporting has a compounding effect, companies don’t wish to report higher emissions and lower investments in communities each year, therefore, they are incentivised to invest in ESG initiatives, once the metrics are revealed to the public eye. 

  2. Public Perception: The effect of climate change is undeniable. Millions of people across the world suffer from excessive heat, heavier rainfall or stronger drought-like conditions every day due to the rising temperatures across the earth. In today’s world, where citizens are more aware than ever of climate change, and follow the discourse around emission monitoring and restrictions, companies which operate without any regard for their impact on the environment are at risk of losing the goodwill to operate. 

  3. Investor Pressure: Governments aren’t the only ones exerting pressure on companies to operate responsibly. Independent investors and venture firms also consider ESG metrics when evaluating investments. One of the best examples of investors coming together to combat climate is Climate Action 100+, an investor-led initiative to ensure that the world’s leading emitters take necessary action on climate change. Currently, approximately 700 investors responsible for $68 trillion in assets under management are a part of this coalition.


In conclusion, an investment in ESG measurement and management will benefit most firms in the long run. As government regulations tighten worldwide, to achieve their Net Zero commitments, all large enterprises will inevitably face the pressure of disclosing their ESG performance in the public domain. The best course of action is to proactively prepare - start collecting relevant data, build capacity internally and externally, engage with stakeholders to determine material topics and conduct business operations in a manner that prioritises environmental and financial sustainability. 


Citations:


bottom of page