Investors are valuing ESG and corporate sustainability wrong. That’s according to the academics behind two separate papers published in journals last month.
The first explores how ESG factors influence company valuations. Researchers at French business schools ESSCA and ESCP, and New York’s Cornell University, asked more than 300 financial professionals for their perspectives on the issue, including how they integrated ESG into their Discounted Cash Flow (DCF) calculations.
“We were expecting most of them to say they don’t care about ESG when they’re doing their DCF,” admits Dejan Glavas, an associate professor of finance at ESSCA and one of the paper’s authors.
But the results show they do – especially investors and their advisors (the emphasis on ESG was lower among finance experts within the companies themselves).
“More and more valuation experts are factoring in ESG, but the calculations are still quite unsophisticated,” explains Glavas.
Investors that believe issuers with low ESG scores carry greater long-term risks will often apply heftier discount rates to those firms, the research found.
“But that’s the easy option,” says Glavas. “Technically, it is more accurate to account for specific risks by adjusting the projected cash flows.”
That’s because ESG factors are likely to show up through lower sales or higher costs.
Many of the participants in the study acknowledged that applying an arbitrarily higher discount rate to account for ESG is a blunt instrument, but adjusting cash flows instead requires a level of granularity that quickly becomes unwieldy for big portfolios, and requires in-house ESG analysts.
Amundi is one of the few investors to take the plunge already. Frédéric Le Meaux, a senior listed equities portfolio manager at the French investment giant, wrote in detail about it in 2023, arguing that “each ESG issue could be financially linked with one or many items of the DCF”.
“With a deep knowledge of the company, the analyst is best placed to decide on the proposed adjustment line,” Le Meaux continued.
To avoid making things too complex, he recommends focusing on four main financial impacts: growth, costs (opex or capex), liabilities and WACC.
“Valuation techniques are evolving and starting to integrate more information than they did in the past,” said Glavas. “And those who are now including ESG are still looking for the best way to do it.”
ESG and performance
Other analysis shows investors are willing to pay a premium for shares in listed companies perceived to have lower ESG risks.
Research by Morningstar found that, during the 14 trading days beginning April 2nd (when US tariffs were introduced, prompting chaos in the markets), stocks with low ESG-risk scores outperformed those with high scores on 10 days.
Discussing the findings on LinkedIn last month, the study’s author, Bin Fumitake Dong, suggested investors saw ESG attributes as “a form of financial insurance” and were willing to pay up for them during times of economic stability, in return for greater downside protection when things got turbulent.
The findings build on existing literature, including a seminal 2014 paper from Harvard professors Robert Eccles and George Serafeim, and Ioannis Ioannou, at the time an assistant professor at the London Business School. They analysed how 90 companies with sustainability-related policies performed financially over a decade, compared to firms without.
The conclusion: “High Sustainability companies significantly outperform their counterparts over the long term, both in terms of stock market as well as accounting performance.”
The paper has become one of the most influential ESG studies in history, and has been cited thousands of times as evidence that sustainability factors are important financial indicators – by everyone from former Securities and Exchange Commission commissioner Allison Herron Lee, to Generation Investment founders Al Gore and David Blood.
But its findings have been brought into question in new analysis published in the Journal of Management Scientific Reports, which concludes that “the original analysis fails to reveal evidence that corporate sustainability influences either stock-market or accounting returns”.
Andrew King, a professor of strategy and innovation at Boston University’s Questrom School of Business, claims that when he replicated the study, he discovered “hidden problems or uncertainties in the original empirical design”.
In response to his findings, the authors of the original paper issued two corrections last year.
First, they said the word ‘not’ had been omitted from one of their conclusions, which should have stated that, for some portfolios in the analysis, the difference in performance was “not significant”.
The second update related to a coding error that, when corrected, showed the high-sustainability portfolio outperformed the low by 4.4%, not 4.8% as originally claimed.
But King says there are other major errors. He claims, for example, to have found it impossible to match the 90 ‘sustainable’ companies with credible ‘non-sustainable’ counterparts (something the original study claims to have done) in order to prove sustainability factors were driving the outperformance.
Eccles, Serafeim and Ioannou have all either declined to comment or haven’t responded to IPE’s questions.
“My intention isn’t to make a point about sustainability,” insists King. “It’s to bring more scrutiny to academic research, especially influential research.”
However, many of the other studies he’s chosen to replicate recently are also focused on sustainable finance.
“That’s because there’s such a big appetite for research that proves sustainability is good for business,” he says. “So there is a tendency to oversell things in ESG.”
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