The debate about whether companies can do well financially by doing good things for the world is settled. The answer is “Yes, in certain circumstances.”

This obviously begs the question of what those circumstances are. In a seminal article “Corporate Sustainability: First Evidence of Materiality” Mozaffar N. Khan, George Serafeim, and Aaron Yoon showed that companies performing well on the material environmental, social, and governance (ESG) issues for their sector had superior financial performance compared to those performing poorly. Those performing well on immaterial issues had slightly worse financial performance although it wasn’t statistically significant. The firms with the best financial performance were the ones performing well on the material issues and actually performing poorly on the immaterial ones. In other words, good performance on some ESG issues contributes to financial performance, as does poor performance on immaterial issues.

The expanded answer to the question is “Yes, in certain circumstances; no in others; and sometimes a focus on sustainability can hurt financial performance”—which was the prevailing “Milton Friedman” view for many decades.

This raises the question of which ESG issues are material and which ones aren’t. The Sustainability Accounting Standards Board’s definition of materiality conforms to the guidance of the U.S. Securities and Exchange Commission: a piece of information is material if it would influence an investor’s decision, i.e., a company’s performance on these issues will affect its financial performance. Defined in this way, material sustainability issues vary by industry.

Access and affordability and product quality and safety are material in the pharmaceutical industry, whereas data privacy and security and systemic risk management are material in the commercial banking industry. Through a rigorous process based on rules of procedure, Industry Working Groups that include companies, investors, NGOs, and other industry experts then determine the material issues—in terms of environment, social capital, human capital, business model and innovation, and leadership and governance—for each industry, along with recommendations on the best way to report on them in quantitative and qualitative terms.

SASB’s determination of the material ESG issues was also very useful input to a major research project conducted by The Boston Consulting Group on total societal impact (TSI). TSI is not a single metric; it is a collection of measures and assessments that capture the economic, social, and environmental impact (both positive and negative) of a company’s products, services, operations, core capabilities, and activities. We found that adding the TSI lens to strategy naturally leads companies to leverage their core business to contribute to society in a way that enhances total shareholder return (TSR) over the long term.

The proof is always in the numbers, so we also conducted a rigorous quantitative analysis in four industries: banking, biopharmaceuticals, consumer goods, and oil and gas. We found that in each sector, the top performers (90th percentile) for combined performance for the material issues—most of which were related to downside and risk—had higher valuation multiples (when all other measures were equal) than the median performers (50th percentile). The valuation multiple premium was 3% for banking; 12% for biopharmaceuticals; 11% for consumer packaged goods; 12% for biopharmaceuticals; and 19% for oil and gas. In general, we found that adding ESG factors to BCG’s SmartMultiple®Fit valuation model added an additional 9% in predictive power to the 74% for financials of a company’s stock price.

Let’s discuss the results which that financial variables can explain 74% of a company’s stock price and ESG variables 9%. How should we think about the latter number? Is it rather low compared to the 74% or is it surprising that it exists at all? Given the plethora of high quality financial information—thanks to accounting and auditing standards and reporting requirements monitored and enforced by regulators—it not surprising that 90% of the explained variance in the SmartMultiple®Fit model should come from financial information. I would argue that with higher quality ESG data, something SASB is trying to accomplish, some of the remaining unexplained variance of 17% could be reduced by ESG factors. Even though ESG can contribute to financial performance, financial metrics based on past performance (by definition any metric is based on something that has already happened) do not completely capture the value from ESG.

This has very important implications for companies in terms of their reporting practices. Today there is a finger-pointing exercise between companies saying, “Investors don’t give us credit for the great sustainability things we’re doing.” Meanwhile, investors are saying, “Companies do a lousy job of identifying and reporting on the material sustainability issues and showing how they are related to financial performance.” In a paper I wrote with Mirtha Kastrapeli, head of State Street’s Center for Applied Research, we report that based on a global survey of 582 institutional investors a remarkable 92% of them want companies to identify and report on what they think are their material ESG issues. At the same time, they are dissatisfied with the amount and quality of ESG performance information they’re getting from companies, with 53% citing poor company reporting as a barrier to ESG integration in the investment process and 60% citing lack of standards for ESG information.

Building on the research of Khan, Serafeim, and Yoon, the BCG report dug further and looked at it in terms of specific ESG issues in each of these sectors. This deeper level of granularity enabled us to quantify the contribution ESG performance makes to financial performance in terms of profitability. For example:

·     In banking, promoting financial inclusion accounts for an additional 0.5% in net income margin, all else equal.

·     In biopharmaceuticals, expanding access to drugs accounts for an additional 8.2% in EBITDA margin.

·     In consumer goods, socially responsible sourcing accounts for an additional 4.8% in gross margin.

·     In oil and gas, maintaining process-oriented health and safety programs accounts for an additional 3.4% in EBITDA margin.

While the material ESG issues affecting financial performance make intuitive sense, we have been able to quantify their impact. This is useful to both companies in making investment decisions and explaining the financial importance of ESG issues to their investors. It is also useful to investors in analyzing the companies in their portfolios and engaging with them on how ESG can contribute to financial performance.

Now that I’ve discussed how your company can benefit from addressing societal challenges, in my next blog, I’ll cover how to integrate a TSI lens into your corporate strategy. 

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