My primary research area at present is corporate environmental management. In particular, I am interested in the empirical relationship between corporate environmental and financial performance. For if improved environmental performance is associated with improved financial performance, the business sector can be a powerful force for addressing many of our most pressing environmental problems.
Dating back to 1997 in the academic literature, portfolio studies have generally shown a positive relationship between better environmental performance and stock returns. A small new “industry” has been created around the evaluation of firm environmental and social performance and the association of good performance with good returns. In addition, many of the leading mutual fund providers now offer one or more “socially responsible” (SRI) funds and these funds have grown tremendously in number and in assets under management over the course of the last decade in the US, Canada and Europe. Recent studies have shown that the most prominent of the SRI funds have performed at least as well as the S&P 500 on a risk-adjusted basis. Even the venerable Dow-Jones and FTSE have gotten into the business, with the establishment of their DJSustainability and FTSE4Good stock indexes.
Long popular in the academic finance literature, event studies are often a useful approach to analyze the impacts on stock price of announcements or news. Dating back to two 1994 papers that looked at the negative impact of the Exxon Valdez accident in Alaska on Exxon’s stock price and the Bhopal accident on Union Carbide’s, event studies in the environmental arena have also demonstrated the power of information disclosure regulations and “transparency”, especially in conjunction with TRI emissions data and environmental bad news. The most recent studies transform the raw emissions data to make it reflect public health risk prior to analysis, a definite improvement, but even in raw form it is clear that firm behavior is changed as a result of the negative impact on stock returns associated with TRI disclosures for firms with high emissions relative to their industry averages.
Cross-sectional analysis over firms and/or across industries is perhaps the most popular approach to ferreting out the empirical relationship between corporate environmental and financial performance, and dates back to 1996 with the first analysis of the impact on return on equity of reductions in emissions within the early years of TRI. Subsequent work, refining the econometric approach and the measure of financial performance has reinforced the result, namely that there is a positive relationship between TRI reductions and improved financial performance, especially for firms with high initial emissions. The most recent work again focuses on translating the TRI emissions data to reflect public health risk which, among other things, results in the identification of those industries whose emissions are the most lethal. It is worth noting, however, that all of these studies suffer from the fact that the TRI data are the only quantitative information available and that “environmental performance” is inherently multi-faceted and probably best thought of as a latent variable that requires special econometric attention.
Nevertheless, a fairly recent and very comprehensive “meta-analysis” covering 52 studies dating back to 1972, and analyzing 388 separate correlations between financial and social/environmental performance, concludes that the correlation between environmental and financial performance is indeed positive, and that contemporaneous bidirectional causality is indicated. In this work, observed correlations are associated with characteristics of the studies that generated them, such as sampling error (an aspect of which is sample size).
A related study uses longitudinal data from 1990-2003 for the four most polluting industries in the U.S.—Pulp & Paper, Chemicals, Oil & Gas, and Metals & Mining, and shows that firms demonstrating a significant improvement in their relative environmental performance over time have a higher Tobin’s q (the ratio of a firm’s market valuation to the replacement value of its tangible assets), more liquid assets, and more spending on R&D immediately prior to the improvement taking place, and enjoy further improvement in Tobin’s q, profitability, liquidity, and sales growth afterward. The so-called resource-based view of the firm suggests exactly this, that firms with greater financial resources and superior management can indeed benefit from a proactive strategy, while others not so favorable positioned will either fail to achieve lasting results or will not attempt to improve their environmental performance in the first place. This is consistent with the observation that even in industries where stringent environmental regulations have existed for decades there can be wide variation in corporate environmental performance.
Finally, to date the academic finance profession has taken little interest in environmental issues, probably because of the long-standing view that the role of the firm is profit maximization narrowly defined. Institutional investors and mutual fund managers have historically interpreted their fiduciary duties in a similarly narrow way, so there has been no pressure from outside to alter that view. This situation may be changing, however, with the recent publication of a study commissioned by the UN Environment Programme’s Finance Initiative (UNEP FI) by a respected international law firm which concludes that not only is there no legal constraint to the integration of environmental, social, and governance considerations into the decision-making process of a fiduciary, failure to do so may itself amount to a breach of fiduciary duty. One theoretical finance paper that follows along these lines shows that when so-called green and exclusionary investing is a significant factor (with holdings of >20% of a firm’s stock), it will lead to a change in the firm’s behavior toward improved environmental performance. Since SRI funds now comprise upwards of 15% of all mutual fund assets in the U.S. and are growing rapidly, and with UNEP FI pushing its new “Principles of Responsible Investing” on the world’s largest public pension funds, that “tipping point” may be upon us.
Among the largest U.S. and multinational firms, there seems to be considerable momentum behind the notion that improved environmental and social performance is good for business. Dubbed “Corporate Social Responsibility” (CSR) and defined as going beyond what is required by statutes or regulations in the areas of environment, worker health and safety, and community investment, more and more literature is appearing that documents the case for CSR and other things that fall under the rubric of “the business case for sustainability”. New business organizations are popping up around sustainability themes and sets of principles, some of the most visible being the World Business Council for Sustainable Development (WBCSD), the Global Environmental Management Initiative (GEMI), the Coalition for Environmentally Responsible Economies (CERES), and the Global Reporting Initiative (GRI), the latter which aims to establish a common accounting framework for reporting the environmental and social performance of firms. In the past several years individual firms have also adopted leadership positions on many significant environmental issues of the day, the most visible being greenhouse gas emissions reductions.
There are critics of the CSR “movement”, of course. Primarily they rely on predictable lines of argument derived from the initial premise that the only job of business is increasing shareholder value and that considerations of CSR are generally at odds with that premise. A variant is that in pursuing CSR firms are taking on the responsibilities of government, something that is definitely not in the corporate charter. While there is merit to this argument, its main flaw lies in its inability to embrace aspects of business such as long-term reputational effects and reduced future operating risk that are consistent with improved social and environmental performance.
Whatever the basis may be for CSR, one cannot deny the growing number of firms pursuing its tenets and the attention being paid to the environmental and social aspects of firm performance by institutional investors and the purveyors of credit and insurance on whom the firm depends in essential ways to support its business objectives. Can this really amount to a massive attempt to fool the public, as some would have us believe? After all, firms operate not only in the context of governmental laws and regulations but evolving social norms, not all of which have been (or ever will be) codified. The business sector is constantly trying to adapt to those norms as part of its ongoing research into customer wants and expectations, and to anticipate future governmental regulations that may come out of them. The investor community, and the credit and insurance industries, are likewise trying to assess their own opportunities in terms of those firms that are positioned for future success defined by profitability and risk mitigation. Some CSR critics ask the question, if businesses are pursuing CSR initiatives solely because they make good business sense, what’s so “socially responsible” about that? Such a question diverts attention from the key challenge posed by CSR, namely to convey clearly through laws, regulations, and uncodified societal norms, the expectations society has for the business sector, and to hold it accountable through governmental, customer and investor actions. That corporations can exert undue influence on government, can create and mould customer preferences via massive advertising campaigns, and can limit or manipulate information on financial performance and/or risk factors, is a reality that requires constant surveillance on the part of the public. Companies are not moral beings but the people who run them are. We should expect them to manage their firms consistent with society’s prevailing ethical standards. Along these lines, writing in 1946, management guru Peter Drucker said that “the corporation can only function as the representative social institution of our society if it can fulfill its social functions in a manner which strengthens it as an efficient producer, and vice versa.”
