How can aligning corporate strategy with ESG metrics measurably improve annual stock returns?

Why are purpose-driven companies outperforming competitors in market share and long-term profitability?

Harvard professor George Serafeim presents evidence that companies prioritizing Environmental, Social, and Governance (ESG) goals earn 3% higher annual stock returns. Explore the five-action framework for integrating sustainability into operations and learn how businesses like Dow and JetBlue utilize impact-weighted accounting to drive innovation and secure financial growth.

Dive into the full analysis to master the specific strategies used by global leaders to turn sustainability into a competitive financial advantage.

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Corporate leaders in the mid-1900s thought mandatory financial reporting was “impossible.” Now, those who resist reporting corporate environmental, social, and governance (ESG) data take the same stance, but Harvard professor George Serafeim offers research and examples showing that pursuing ESG goals increases a company’s market share. And reports indicate that as of 2019, about 90% of companies reported ESG data. Serafeim provides steps companies and leaders can take to be more accountable. He also points out that advanced technology and new metrics simplify the process of collecting and reporting valid information. With customers and employees increasingly focused on corporate behavior, companies that achieve meaningful ESG goals can benefit financially while being socially responsible.

Take-Aways

• Businesses and their stakeholders realize the significance of environmental, social, and governance (ESG) issues.
• Corporate success requires ESG participation.
• Workplace transparency and the availability of data impede companies from hiding behind hollow ESG claims.
• When the US government mandated basic financial reporting, corporations claimed such transparency would undermine competition.
• Companies are transforming to become more sustainable.
• Traded companies can achieve ESG-related stock return gains in six ways.

Summary

Businesses and their stakeholders realize the significance of environmental, social and governance (ESG) issues.

In 2011, many finance professionals believed that environmental, social, and governance (ESG) issues had scant relevance. Author and professor George Serafeim researched this issue at Harvard University and created metrics showing that companies with improved ESG performance earn 3% more in annual stock returns.

“The collision of purpose and profit has emerged from larger shifts in the society as well.”

As technology evolves to support better data and metrics collection, stakeholders expect more from companies. Businesses also seek to increase their revenue and profits by performing well on ESG issues. For example, Microsoft’s CEO Satya Nadella reinvigorated his company by putting his belief in business’s social contract into action.

Corporate success requires ESG participation.

Companies are changing how they view themselves in light of ESG issues. One of Serafeim’s former students started Harlem Capital Partners to invest in minority and women-owned businesses. Another created Mogul, an educational platform for women.

The Business Roundtable’s 181 top CEOs published a letter in 2019 supporting diversity and sustainable practices. Though the open letter was monumental at the time, nothing changed immediately. However, participating business leaders realized their corporate survival required acknowledging the importance of generating positive social impacts.

Workplace transparency and the availability of data impede companies from hiding behind hollow ESG claims.

Today’s “Impact Generation” supports ESG improvements in the products they buy and the companies where they decide to work. Younger people seek jobs that offer personal satisfaction and purposeful work based on the values they share. Thanks to increased transparency, job candidates and consumers know more about what companies do, and they can support – or join – corporations that reflect their values.

“Consumers want reality, not just image.”

Companies now publish data that verifies their ESG claims. And, more than 3,500 companies globally are working toward earning B Corp certification, which requires achieving high-level social and environmental goals. New standards also make it easier to gather the necessary metrics on a company’s ESG initiatives. The Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB) have created such benchmarks. In 2011, only 20% of the S&P 500 reported this kind of information. In 2019, about 90% of companies reported ESG data.

Companies that do not want to change structurally can reduce their reliance on short-term, profit-oriented reporting by moving to an “integrated guidance framework” that includes expected ESG results in investor documents. Companies also can share their ESG activities on their corporate websites. Employees, too, demand better corporate behavior. For instance, Amazon employees walked out to secure corporate action against climate change.

“B Corp certification allows a company to signal its commitment to ESG issues.”

Capital markets are waking up to the importance of ESG issues. A company’s value is no longer based only on “physical capital and manufacturing capacity.” The pharmaceutical giant Merck went on an ESG offensive and developed a badly needed Ebola vaccine although it lacked fundamental market value. Now experts base 80% of a company’s valuation on its employees’ abilities and know-how and its social capital. Google’s trillion-dollar value, for example, reflects far more than its servers, network, and locations.

When the US government mandated basic financial reporting, corporations claimed such transparency would undermine competition.

In the mid-20th century, the US government required public companies to report financial information. Business leaders claimed it would curtail competition. Now such reporting is the norm. Similar outcries met the idea of ESG reporting, but today, companies recognize its “value relevance” and the importance of accountability. In 2010, when NYC implemented a health inspection score for restaurants, the number of restaurants that received an “A” increased 35% and incidents of salmonella poisoning fell 5%. However, cleaning up a kitchen is much easier than redesigning a manufacturing process to emit less pollution.

“The mandates do exactly what they are intended to do, leading to no more secrets.”

Value relevance deals with whether ESG performance predicts future performance. But, as the SASB realized, not all metrics are useful for all industries. It mapped out which metrics prove meaningful for different industries. For example, a bank that reduces its carbon emissions has achieved a meaningful goal. However, providing data privacy and ensuring that underserved people have access to financial services matter more.

Investors now see that ESG concerns affect their income. At one investor meeting in 2019, about half of the questions potential funders asked dealt with ESG issues. In studies using SASB standards, Serafeim and his colleagues found that businesses aligned with industry-specific ESG metrics realized greater success. Studies from Credit Suisse, Russell Investments, and Rockefeller Capital Management generated similar findings.

“The new analytics of doing good had finally emerged.”

Serafeim and venture capitalist Sir Ronald Cohen created the Impact-Weighted Accounts Initiative (IWAI), which allows analysts to determine a company’s profitability through its fiscal data, including setting a financial value for ESG metrics. These calculations could reduce the profit tallies of companies in certain industries by 25%, but they enable leaders to calculate the effects of their decisions.

More than 100 global companies now employ some “impact-weighted accounting.” The self-proclaimed leader is Danone, the international yogurt and food company, which reports a metric showing carbon-adjusted earnings-per-share, enabling it to confirm that it is profitable even when it factors in any environmental damage for which it is responsible.

When COVID-19 hit, people focused on how companies reacted. An April 2020 study of 3,000 global companies found those that put their employees, suppliers, and customers first significantly outperformed similar organizations with other priorities. For example, Intel provides high-paying jobs and benefits that translate to $4.5 billion in positive impact. If its workforce were more diverse, that number would be even higher.

“Firms accepted the financial hits in the hope that…their good behavior would lead to financial benefit.”

The corporate behavior stakeholders regard as acceptable has changed, and companies are taking note. A 2017 shareholders vote, which went against the board, called for ExxonMobil to report climate change impact metrics. In 2020, 67% of P&G shareholders voted to reduce supply chain-caused deforestation.

Companies are transforming to become more sustainable.

Initially, consumers used ESG data to see if companies were trying to do the right thing. Now, detailed metrics tied to performance have replaced empty marketing language. Most companies have already captured the low-hanging fruit, taking easy actions that make them more efficient. This might provide a short-term advantage, but for lasting benefit, leaders must transform their companies, potentially creating new capabilities.

“Twenty years ago, announcing a goal of carbon neutrality would have been revolutionary. Today, it is pretty standard.”

Use a “five-action framework” to leverage ESG for growth and innovation. First, find strategic ESG actions you can take before shareholders and the market force you to do so. For example, Nike made the upper part of its Flyknit shoe with one strand of yarn, producing zero waste and $1 billion in revenue.

Second, hold your leaders accountable for ESG outcomes by linking executive pay to specific achievements, like improved diversity or pollution reduction. Firms must foster executive and board involvement.

Third, create a culture in which employees support sustainability. For example, Signify changed its focus from “limited life” light bulbs to sustainable lighting and sensor products. Less than 17.5% of its revenue now derives from unsustainable products.

“Trust is at the core of sustainability.”

The fourth element is infusing your operations with sustainability. In 2011, JetBlue hired a sustainability manager, Sophia Mendelsohn, who worked with every department and with the airline’s shareholders. Her first small successes increased ESG visibility across the company. She then signed the biggest long-term deal ever made for renewable jet fuel. The agreement connected JetBlue’s core business to its sustainability goals. Her actions reduced JetBlue’s carbon emissions and protected its future fuel supply from price fluctuations.

As your ESG efforts become part of your central focus, work with individual departments to incorporate those efforts into their operations. Finding a way to move from centralized ESG to decentralized, departmental ESG initiatives is among the hardest problems for most firms to solve, but solutions mesh ESG into the corporate culture.

The fifth step is to focus on long-term goals with your investors. Seek investors who support your ESG initiatives and understand ESG’s competitive advantage, including potential upsides and risks.

Traded companies can achieve ESG-related stock return gains in six ways.

Three types of ESG gains have a higher upside, but they also entail higher risk. The first features companies, usually new ones but including Patagonia and Tesla, that tie their products directly to an ESG impact.

“It is extraordinary to see sustainability outcomes linked so literally to the bottom line.”

Legacy companies often turn to the second way to gain from ESG gain, which involves transforming their business. This process is difficult, but, for example, several legacy car companies are successfully moving to electric cars. This is a high-risk option that can provide a tremendous upside.

The third option, “Pure Play Aligned,” refers to actions companies take purely for ESG-related reasons. For example, the Mexican company Cultivo uses AI and satellite imagery to find farmland that could be more productive. It implements appropriate changes for farmers and sells the resulting carbon offsets to companies seeking to reduce their carbon footprint.

The other three options offer a lower upside along with lower risk.

The fourth option is for companies to identify the sustainable facets of an existing product and highlight how consumers can substitute it instead of using a non-ESG-friendly product.

The fifth option focuses on operational efficiencies. Dow, the global materials company, embraced this method. By investing $1 billion from 1996 to 2005, it generated an overall value of more than $5 billion. Dow’s changes included significantly improving its staff injury rate and reducing leaks, solid waste, and water and energy usage. Dow continues to set similar goals and avoided $500 million in costs as of 2020.

“[Dow] was able to shift its mission…to make related efficiency gains that added up to billions of dollars.”

The sixth method benefits those who invest in companies that are aligned with social or environmental efforts but haven’t yet realized the market-cap benefits. Investors who see the value of such companies prior to broader public recognition can reap rewards. For example, after the Financial Times called NextEra Energy the “world’s largest clean energy group,” the company surpassed ExxonMobil in market capitalization.

As the reliability of data improved, analysts realized the strategic potential of ESG issues. From large ESG private-equity firms to individual investors, everyone can help ensure ESG compliance.

About the Author

George Serafeim is the Charles M. Williams Professor of Business Administration at Harvard Business School. He has presented his research in more than 60 countries. He serves on the board of directors of Liberty Mutual and AEA-Bridges Impact Corporation and co-founded the advisory services firm KKS Advisors and the technology firm Richmond Global Sciences.