ESG: A Material Information Advantage
Conventional wisdom suggests that sustainable investing doesn’t add alpha, right?
Wrong! Harvard researchers have found new evidence linking performance on sustainability issues to stock performance. Mozaffar Khan, George Serafeim, and Aaron Yoon from Harvard Business School present their findings in “Corporate Sustainability: First Evidence on Materiality (Working Paper 15-0703).” Importantly, this new research differentiates between material and immaterial sustainability factors — addressing a significant gap in prior research.
A major finding is that firms with good performance on material sustainability issues, using the Sustainability Accounting Standards Board (SASB) framework, and concurrently low performance on immaterial issues have the best future stock performance — generating an annualized alpha of 6.01%. In short, these results point to the efficiency of firms’ sustainability investments as highlighted below:
These results illustrate the importance of firms distinguishing among the types of sustainability investments they make. First, the best returns go to firms that only make investments in material sustainability issues while avoiding investments in immaterial issues (6.01% alpha). And, more importantly, firms that make no sustainability investments have the worst performance, with an estimated alpha of -2.90%.
The authors correctly point out that a large number of companies are now identifying sustainability issues as strategically important, and are releasing a wealth of new environmental, social, and governance (ESG) data. Also, investors are increasingly committing to using ESG data within the investment decision-making process. But, as investors, knowing exactly which ESG data to focus on can be difficult.
So what’s the big deal? Access to material sustainability information can help investors and asset managers generate alpha.
Access to Material ESG Information
In the Harvard study, the data collection process was driven based on materiality guidance on sustainability issues from SASB. The SASB website provides a sector-level materiality map that identifies sustainability issues by level of materiality. In short, this map is a great starting point for identifying which issues are likely to be material for more than 50% of the industries in the sector. The Harvard researchers then used MSCI KLD as the source of their sustainability data — which they cite as the most widely used dataset by past studies (7).
SASB sustainability issues are organized under the following five categories: Environmental, Social Capital, Human Capital, Business Model and Innovation, and Leadership and Governance. For example, the Environmental category contains issues such as greenhouse gas (GHG) emissions, air quality, energy management, fuel management, water and wastewater management, waste and hazardous materials management, and biodiversity impact.
After identifying material issues, the SASB Standards Navigator can be used to research specific “evidence-based metrics” that are known to impact business value in the areas of revenue, costs, assets, liabilities, and cost of capital. Each SASB accounting metric has a unique reference number, description, and a clearly defined unit of measurement. Bottom line: it is all about analyzing the right non-financial ESG metrics that have a material impact on financial performance.
It’s my hope that more access to high-quality and material ESG information will improve the investment decision-making process, increase business competition and lead us to a more sustainable future.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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