How sustainable businesses make above-average returns
How sustainable businesses make above-average returns
Green practices are often great for company coffers, despite their initial cost
TLDR: On a planet with finite material and human resources, only resource-efficient companies will survive in the long term. That being said, for financial markets the short-to-medium term is much more important. Short-term fluctuations are inevitable; mid-term effects, however, are very interesting. Through a variety of methods based on correlations and causal connections we show that sustainable performance can impact financial performance. The approaches vary based on the availability and quality of data, the asset type, and the goals of each investor. We conclude that it is wise to quantify the influence of sustainability on financial models, as this can have a material impact on returns. This piece originally appeared in March 2024.
In the long term, only companies that manage the planet’s resources efficiently can survive. Timber companies that do not treat forests responsibly will otherwise run out of trees. Staffing companies will run out of talent to hire if they do not treat their applicants with respect. Manufacturing companies that pollute the air will run out of workers when too many get sick from the machine exhausts. And so on.
In the short term, things look very differently: Following the outbreak of the Russia-Ukraine war and the ensuing sanctions on Russia, oil prices surged. Energy companies that focused on oil and gas were winners in this context, leaving renewables in the dust.
Short-term fluctuations will always happen. They will randomly benefit more sustainable companies one day, less sustainable companies the next. Such fluctuations can be interesting to play with, but they are notoriously difficult to predict even for experienced traders. On the other hand, many investors are unwilling to bet on the very long term and invest their cash for decades at a time.
The sweet spot is the medium term. If a company adopts sustainable practices today, how will it play out in 3 to 10 years?
How sustainability impacts financials
Everything a company does has financial consequences. This includes but is not limited to sustainability-related actions. What makes sustainability special, however, is that it not only that it is morally imperative, but also that ample information is being published about what corporations are doing about it. This development stems from regulatory pressure and higher internal standards, as well as from pressure exerted by investors, clients, employees, and the public.
Sustainability is therefore a unique window through which one can get a closer look at a company’s operations. This allows analysts not only to track and anticipate financial performance based on traditional methods, but also to anticipate it based on sustainability-related developments in a company.
For example, a company that chooses to decarbonize its operations might face a higher operating cost in the short term as new machines need to be installed. On the other hand, its tax rate might go down if it operates in a jurisdiction where a carbon tax is imposed, such as the EU. A company that fights against deforestation in the vicinity of its factories might see its interest rate on debt fall, because creditors assign a lower risk of the factory falling victim to weather-related hazards such as storms or flash floods, from which the forest protects it. Finally, a company invested into biodiversity might see their total equity swell as climate-conscious retail investors add the stock to their portfolios.
On the social side, there are equally influences. Wage equality might lead to more operating cost in the short term, as previously lower-paid workers receive higher salaries. This might pay out in the mid-to-long term, though, because the company makes itself more attractive on the job market and thus can select more productive candidates, which can serve more customers and hence increase revenues further down the line. Similarly, avoiding human rights violations might have a positive impact on revenues because consumer sentiment improves. Not only do such practices allow the company to sell more items, it also allows it to charge a premium vis à vis its competitors that are not as progressive.
This is, of course, not a comprehensive overview. The size of any such impact generally depends on sector, geographical location, and many other factors that might affect a company. It is therefore important to study each company in detail, where that is possible.
It is worth noting that such findings go well beyond the work of most financial analysts today. Nevertheless, these effects can be sizable, and methodologies such as impact accounting might help quantifying such impacts. Research articles such as the ones below suggest an increasing appetite for studying such effects:
Duc Cuong Pham et al, The impact of sustainability practices on financial performance: empirical evidence from Sweden, 2021
Tensie Whelan et al, ESG and Financial Performance: Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies Published between 2015 – 2020, 2021
A Dewi and L Widyawati, The Relationship between Sustainability Performance and Financial Performance with External Assurance as the Moderating Variable in Indonesian Listed Companies, 2023
Maria-Eleni Agoraki et al, Firms’ sustainability, financial performance, and regulatory dynamics: Evidence from European firms, 2022
ABM Fazle Rahi, Ruzlin Akter, and Jeaneth Johansson, Do sustainability practices influence financial performance? Evidence from the Nordic financial industry, 2022
ABM Fazle Rahi et al, Corporate sustainability and financial performance: A hybrid literature review, 2023
Ebru Aydoğan and Esen Kara, The Analysis of The Dynamic Relationship between Corporate Sustainability and Financial Performance, 2023
This is far from an exhaustive list of such studies. The majority of them shows a light positive correlation between corporate sustainability and financial performance, albeit with a time lag. Most of them do not, however, go into granular detail and investigate sustainability-related and financial variables to find correlations or even causal connections.
Such granular detail is needed for financial analysts. Wangari aims to equip them with such detail.
Data availability
Reliable financial data is ubiquitous; sustainability data is not. The volume of sustainability-related data is increasing, but the data standards and methodologies are still in development. As we have written before, this is not necessarily a problem because messy data, well evaluated, can lead to insights that would have otherwise been overlooked.
Many sources of data are available today. Traditional sources are annual reports and news data, which can be processed using large-language models, sentiment analysis, and more. Such data is also more readily available through Bloomberg terminals and its competitors.
For sustainability-related information, many different data providers exist. That being said, many financial institutions have expressed their dissatisfaction regarding such data as it is often incomplete, inaccurate, or out of date. Alternative data sources include satellite- and other geospatial data, municipal or regional data, and other direct or indirect indices that could point to a company’s sustainability-related performance.
Collecting such data is more art than science as the landscape is constantly shifting and high-quality datasets can be hard to come by. Wangari is using cutting-edge techniques such as ecosystem accounting to not only collect corporate data but also verify it.
Relevant financial variables depend on asset type
The perhaps easiest use case for sustainability-enhanced financial modeling are public equities. Annual and quarterly reports are reliably published by listed companies, regulatory scrutiny is high — making false or fraudulent claims difficult — and the share price gives a clear indication of current market sentiment. All one needs to do is model how the share price might change based on sustainability-related behavior, and compare it to the market price. One can then speculate whether and when the market might correct for any difference and make investment decisions accordingly.
With bonds of public corporations, the approach changes slightly. Instead of calculating a share price, the relevant variable is the risk premium that investors would want to charge a company. Calculating that risk premium is essentially actuarial work; one can then assess how sustainability-related performance might affect that risk. On the one hand, capital expenditures might go up because of sustainability-related spending, raising the prospect of a default on any debt. On the other hand, increased sustainability typically makes companies more resilient to outside shocks, which should decrease the risk premium in the mid-to-long term.
For privately traded companies, a few approaches are possible. One can use models of similar but public companies as a proxy, then feed them with the data about a specific private company. This comes with obvious shortcomings because private companies are often smaller than public ones, often differ in style and structure, and are not subject to the same regulatory risks. If one has ample data about a specific sector of private companies, one can also establish a proper model on that sector. Either way, one must prioritize financial variables and time horizons on the goals of their investors. They are usually a lot less numerous in private than in public markets, and hence have a lot of say when it comes to corporate strategy. Their management- and exit goals can influence a lot of corporate actions.
Finally, alternative assets such as cryptocurrencies, commodities, real estate, and collectibles are best assessed by evaluating the (public or private) companies that manage or are exposed to them. Evaluating the sustainability-related and financial performance of a non-fungible token (NFT), for example, is very difficult. It makes more sense to investigate the performance of the companies that sell, buy, process, or issue such NFTs in order to understand how NFTs might be affected by this.
How Wangari is developing its methodology
At the time of writing this piece, we are still in the midst of our first case studies on public equities. We plan to publish some of our findings and automate our approach on public equities of various sectors in summer 2024. In autumn and winter 2024, Wangari also plans to cover corporate bonds, before moving on to private markets and alternative assets in late 2024 or early 2025.
We combine the latest and greatest findings from sustainability reporting, impact accounting, and ecosystem accounting with data-driven approaches from corporate finance, data science, and large language models. We hope that we are able to help spot over- and undervalued assets this way, and generate bigger alphas for our clients.
Our client base includes all types of professional investors, from large banks and asset managers, to insurers and pension funds, to family offices and university endowments, to hedge funds.
Discounting future returns a little less
Never do long-termist versus short-termist strategies clash more than in times when interest rates move rapidly. As money gets more expensive, short-term goals become more attractive over long-term ambitions. Once interest rates are cut down, long term goals move front and center again.
When companies perform well on sustainability-related metrics, their cost of capital should in principle go down. Investors should see less risk and more opportunities in a business that has long-term strategies in mind. This can only happen, however, if investors have the necessary tools to understand how sustainability really impacts financials. Once these tools are in place, investors are empowered to make decisions that give them a bigger alpha, and companies have better incentives to act responsibly.
In effect, this amounts to discounting the future a little less. The future is important for us, for our children, and our grandchildren. As investors, we have a duty to keep the future a habitable place for them.
What we’re reading at Wangari
An original thought on a decades-old problem: The meat and dairy industries are starting to look a lot like oil and gas did a decade ago, willfully denying scientific evidence and continuing to fund lobbyism to deny its substantial carbon footprint. As
and find out in an interview with a researcher, however, we might not be discussing our diets if oil and gas hadn’t been so persistent over decades. “Meat and dairy should be suing oil and gas” is an eye-opening piece on how little space we have on our planet for high emitters — and how we might want to pit them against each other.For those of you investing in gold, crypto, NFTs, or junk stocks,
has a word of caution: If history does anything but repeat itself, it is looking like animal spirits are loose on the market. Despite risk-free returns topping 5 percent, non-cash flow generating assets are having a moment. His piece Beware Animal Spirits is a cautionary note for those who are getting too excited about the recent gold- or crypto-rally.- does a great roundup of some new and important climate papers in his piece Climate Policy Rethink. Three key findings are: (1) The Paris Agreement targets are infeasible and need revisiting; (2) Climate equity might be more important than emissions scenarios, i.e., one should pay close attention to effects like the green transition might exacerbate the gap between rich and poor even further; (3) Climate scenarios are based on the expansion of coal, which is extremely misleading. The article is a must-read, and the papers worth a glimpse too.