Two Factors that Determine When ESG

Creates Shareholder Value

by
•Aaron Yoon
February 07, 2024

EschCollection/Getty Images
Summary. The paper “Corporate Sustainability: First Evidence on Materiality,” published in
2016, marked a significant shift in perceptions of corporate sustainability. It demonstrated that
focusing on financially material ESG (environmental, social, and governance) factors...more

A main criticism of corporate sustainability has long been that it results in firms not
putting shareholders first, thus contradicting managers’ fiduciary duty. In 2016,
however, I published a paper, “Corporate Sustainability: First Evidence on
Materiality,” with George Serafeim and Mo Khan, that began to overturn that
narrative. We documented that considering financially material ESG factors (i.e.,
those sustainability activities that are related to the core sector practices of the firm)
improve portfolio returns, which is consistent with financially material sustainability
activities creating shareholder value.

Some attributed the paper to ESG investing taking off. The Financial Times called
the paper a turning point on how investors viewed and integrated ESG information.
Yet despite its popularity among investors and managers, sustainability remains a
contentious topic; academic consensus about whether it creates shareholder value
has remained elusive, and ESG investing has become caught up in a political war in
the U.S., with some conservative critics claiming it’s a fig leaf for promoting a liberal
agenda, and some liberal critics criticizing it for not going far enough in addressing
planetary challenges. According to The Conference Board, a survey of more than 100

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large U.S. companies revealed that nearly half have experienced ESG backlash, and
61% expect this pushback to persist or intensify in the next two years.

Yet ESG investing is not going away; almost all companies still claim to engage in
some form of ESG. So understanding the link between ESG efforts and shareholder
value remains as important as ever. Since my paper in 2016, I have been uncovering
the link between ESG and shareholder value creation. I describe two examples
below.

The importance of high-ability managers in

choosing ESG projects
The quality of management may impact whether ESG activities enhance shareholder
value. In my research with Kyle Welch, we studied the stock returns of U.S. firms
between 2012 to 2020 and found that high-ability managers allocate resources to
ESG efforts in a way that enhances shareholder value.

We identified high-ability managers using Glassdoor employee ratings of senior

managers. We found that the portfolio of firms with high-ability CEOs as well as ESG
investments outperformed the portfolio of firms with low-ability CEOs as well as
ESG investments by 6.64% per year. In addition, the portfolio of firms with high-
ability CEOs as well as ESG investments outperformed the group of companies with
just high ESG investments but low managerial ability, as well as firms with low
investments in ESG and high managerial ability.

What this shows is that both high-ability leadership and high ESG investment are
needed to maximize shareholder value. This makes sense: When pressured to engage
in ESG, CEOs would likely pick ESG projects that generate shareholder value
because their compensation is typically tied to stock price.

The importance of supply chain ESG activities

In 2023, I also examined the long-term value implications of supply chain ESG and
the usefulness of this information to investors. Although a well-known concept,
supply chain risk has been difficult to quantify because of two important hurdles: 1)
Suppliers’ identities are often hidden, and 2) there’s a lack of a credible measure of
supplier ESG practices, especially when suppliers are private. I along with Xuanpu
Lin, Guoman She, and Haoran Zhu created a measure that overcame these problems.

Our research looked at U.S. listed companies and their supply chains, composed of
both private and public suppliers in the U.S. and abroad, from 2009 to 2020. We
obtained information about companies’ suppliers and data on negative ESG news
events and used negative ESG news events that occur at a firm’s suppliers as a proxy
for the firm’s supply chain ESG risk.

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We found a link between the ESG risk in a company’s supply chain and its future
stock returns. Specifically, the portfolio of firms with the fewest supplier ESG
incidents exhibited excess return of 6.77% annually relative to the portfolio of firms
with the most incidents.

The returns we observed were generated largely in three ways. The first is supply
chain stability. With fewer shocks and disruptions, companies can fulfill customer
orders, optimize inventory, and operate more efficiently. The second is that
responsible sourcing policies attract socially conscious customers and investors, and
help companies avoid supply chain problems that can damage their brand and
reputation. Third, ethical sourcing can hedge regulatory risk and reduce legal
liabilities.

...

Why should ESG efforts be related to shareholder value? Simply stated, it is because
ESG activities are investment activities that consume the resources of the firm. As
such, investors, who should be making bets on how effective different firms are in
generating returns on their respective investments, must exercise due diligence to
uncover the link between firm ESG efforts and shareholder value. Several key issues
remain and will likely dominate the ESG discussion in the years ahead: how ESG
information is disclosed; how it is processed by data vendors; how it is used by
investors; and how regulators oversee and regulate ESG.

Moving forward, there will likely be tremendous opportunity in the investment and
accounting industry for greater disclosure and transparency. For companies and
their management, the more they prioritize ESG investment and quantify how these
activities contribute to shareholder value, the more they will likely attract savvy
investors who want to reap that potential return.

Editor’s Note, February, 15, 2024: This piece has been updated from its original
version to clarify details about the author’s 2016 research paper.