Written for ESG Clarity – editorial panel contribution
The jury’s still out on the cost of capital for companies and the change created.
As more and more capital flows into sustainable investing, there are two burning questions: one, does this lower the cost of capital for the underlying companies; and two, do these companies go on to affect the change investors are expecting to see (alongside financial performance)?
With both these questions in mind, is sustainable investing the biggest lever an investor has in creating a better future for people and planet?
In 2020, Alex Edmans, professor of finance at London Business School, stated that the first question’s answer isn’t a simple yes or no. He argued that the relationship between sustainability performance and the cost of capital is complex and depends on several factors. These included the level and nature of systemic risk, the amount of risk aversion in a company, and the cyclical behaviour of public trust in business, notwithstanding the nature of the business itself and the role of other factors in either managing risk or creating risk.
A different paper by the Multidisciplinary Digital Publishing Institute in 2022 found that while better ESG performance is associated with a lower cost of equity, the relationship is positive regarding the cost of debt. In other words, equity investments reward sustainability, fixed income investments don’t. Yet, the authors also found that the channels of a firm’s cost of capital composition also acts differently in response to changes in sustainability performance.
The answer to the first part of the question, therefore, is likely yes in equity markets (subject to the complex factors that can influence this cost) and in debt, no (again, subject to the complex factors that can influence this cost).
Does ESG outperform?
Looking at financial performance through the lens of ESG, are we able to find any evidence of outperformance? Most of the meta studies that carried out an examination of ESG and financial performance, up until recently, looked at studies done prior to 2015.
A recent meta study review by New York University Stern School of Business conducted between 2015 and 2020 found improved financial performance due to ESG becomes more marked over longer time horizons and that ESG investing appears to provide downside protection, especially during a social or economic crisis.
The study found a positive relationship between ESG and financial performance for 58% of the “corporate” studies focused on operational metrics such as return on equity, return on assets, or stock price, with 13% showing neutral impact. 21% returned mixed results (the same study finding a positive, neutral or negative result) and only 8% showed a negative relationship. The study, therefore, showed better sustainability performance drives better financial performance as a result of enhanced risk (and opportunity) management.
Does ESG affect change?
If equity investors, for example, are rewarding better sustainability performance, and sustainability performance is rewarding investors with better financial performance, what is the reward for planet and people?
Some would argue that this ‘gain’ is being privatised, while the risks and losses socialised. However, what’s the enterprise contribution to creating a fairer, more resilient and sustainable world?
The answer to that question is – we don’t know. Yet. It’s too early to know the real-world outcomes of the capital flowing into more sustainable and impactful companies.
We can see some outputs such as reductions in carbon emissions, fewer pollution incidents, more women in leadership, better and fairer pay, more inclusive pricing, displacement of energy intensive processes with greener, cleaner ones, and better product design on a year-by-year basis when capital is invested this way.
But ultimately, what this means in terms of the volume of people lifted out of poverty, and the regeneration of the natural world, will take time to track and measure.
One thing that can be noted is the impact pathways that are being funded and invested in through sustainable investment. For example, investing in a way that supports the deployment of educational resources and empowerment of women in low income and marginalised communities is investing in an impact pathway that will drive long term, positive change – people are lifted out of poverty, there’s decreased social discord and greater and fairer distribution of wealth.
The level and type of change needs to be monitored and measured over time. But investing in enterprises, governments, and charities contributing to the challenges faced as a global community can drive the change we need to see.
Example of progress
A good demonstration of this is to look at the results of decades of investment in Bangladesh. As a nation, they chose three strategic development priorities: investing in people, empowering women, and disaster preparedness and adapting to climate change.
In December 1971, when Bangladesh gained independence, it was among the world’s poorest countries. In 2015, it crossed the threshold to become a lower middle-income country, with gross national income per capita rising to over $2,500 in 2021, a 20-fold leap from its 1971 levels. There’s still a long road ahead for the country, but the results show positive progress.
Caution needs to be taken when using the ebbs and flows of capital markets to shore up any argument for or against sustainable investing. More and more evidence is pointing to the power of patient capital. Sustainable investing provides an opportunity to drive the change required, while providing a new rule book for risk-adjusted investing.
