Authors: Robert G. Eccles (Harvard Business School), Ioannis Ioannou (London Business School), and George Serafeim (Harvard Business School)
Publisher: Harvard Business School Working Paper No. 12-035
Date Published: November 2011
As the number of companies implementing sustainability and other corporate social responsibility (CSR) policies has grown, an increasingly important question is how embracing these policies affects financial performance. Are environmental and social initiatives essentially efforts in public relations — and costly ones at that? Or does creating a corporate culture that focuses on these issues for employees, customers, the community, and the world at large actually add to the bottom line and the price of a share?
This paper’s analysis of 18 years of data in the United States finds strong evidence that firms emphasizing these practices significantly outperform similar firms that do not, as measured by both financial and stock market returns.
High-sustainability firms — the authors’ term for companies that are deeply committed not only to environmental issues but also to a broad range of CSR initiatives — are different as well in their governance structures, placing responsibility for CSR efforts on the board of directors, rather than the CEO or managers farther down the corporate hierarchy, and tying executive compensation to sustainability and other CSR goals. In addition, they engage more meaningfully with stakeholders, have an investor base that is more focused on the long haul, and are more transparent in their nonfinancial disclosures.
“This is an important finding because it suggests that the adoption of these policies reflects a substantive part of corporate culture rather than purely ‘greenwashing’ and cheap talk,” the authors write. “These policies reflect substantive changes in business processes.”
When companies invest in technologies to reduce greenhouse-gas emissions for their products or customers, for example, they could profit down the line by essentially having wagered that regulators would someday place a tax on emissions. Similarly, companies that underwrite the building of schools or other improvements in underdeveloped communities are betting that in the long run, their philanthropic efforts will make them more attractive to potential employees and will create more loyal customers.
On the other hand, some have argued that tightening restrictions on how a company should behave could lead to lower profits. Managers could lose focus by shifting resources and attention to areas outside the company’s core strategy. These firms could generate higher costs in a number of ways: by paying their employees above-market salaries, reducing their environmental impact beyond what regulations require, passing up potentially lucrative but nonsustainable investments, and driving away customers by charging higher prices to cover sustainability initiatives.
To figure out which perspective is correct, the researchers began by identifying firms that have explicitly emphasized a culture of CSR and sustainability since the early to mid-1990s. Research has shown that media references to corporate social responsibility or sustainability are “nearly non-existent before 1994,” the authors write, and became widespread only in the past five to seven years.
The authors sought firms that were early adopters of these policies because such firms would have had time to integrate the policies into their culture, operations, management, and formal corporate practices. Selecting firms that had a longer association also made it less likely that distortions would be introduced into the data via the inclusion of firms that were “greenwashing,” or adopting short-term efforts mostly for public relations reasons.
From the Thomson Reuters ASSET4 database, which provides annual data on the adoption or non-adoption of sustainability and other CSR policies for 775 large companies, the authors separated firms into those that embraced a culture of sustainability and social issues and those that did not.
For example, environmental policies could include a firm’s seeking to improve energy or water efficiency and the use of ecological criteria in determining how to set up a supply chain. Employee-based efforts included improving work–life balance, favoring internal promotions, and creating policies that encouraged diversity and equal opportunity. Policies related to the community included pledges of corporate citizenship and the strengthening of business ethics. Customer-oriented initiatives might focus on reducing product risk and improving service.
After eliminating 100 financial institutions because their business and regulatory models differ from those of the other firms, the authors analyzed the remaining 675 companies based on their sustainability and other CSR policies as reflected in the database. To further track firms’ history with CSR, the authors incorporated media accounts, companies’ annual reports, and reports on sustainability, and interviews that they conducted with more than 200 executives.
In the end, the authors pinpointed 90 organizations that had enacted a substantial number of social and environmental procedures in the early to mid-1990s. In that early period, this “high sustainability” group had adopted an average of 40 percent of the policies identified in the database, and by the late 2000s had introduced 50 percent. In contrast, low-sustainability firms had implemented only 10 percent, on average, by the end of the 2000s.
To produce a group of control firms as similar as possible to the high-sustainability companies, the researchers matched up firms beginning in 1993, because that was the earliest year that any of the firms in the high-sustainability group adopted CSR policies. The researchers used a series of factors — including total assets as a proxy for size, returns on investment, and market value of equity over book value of equity — to match up similar high-sustainability and low-sustainability firms in the same industries.
On average, high-sustainability firms had total assets of US$8.6 billion and return on assets of 7.9 percent; low-sustainability companies had total assets of $8.2 billion, with a return on assets of 7.5 percent. “The two groups are nearly identical in terms of sector membership, size, operating performance, capital structure, and growth opportunities...and have very similar risk profiles,” the authors write.
The authors examined differences in governance by analyzing proprietary data for fiscal year 2009 from Sustainable Asset Management, a Zurich-based international investment company that performs an independent sustainability assessment of approximately 2,250 of the largest corporations worldwide.
They found that 53 percent of firms with a strong sustainability culture assigned formal CSR responsibility to the board, whereas only 22 percent of the low-sustainability firms did the same. Similarly, 41 percent of companies in the high-sustainability group formed a separate board committee to assist managers with strategy and periodically review CSR performance, but only 15 percent of low-sustainability firms did so. Moreover, companies with a culture of sustainability were more likely to tie executive compensation to meeting metrics related to the environment, community efforts, and customer satisfaction.
Because CSR-related efforts often depend on understanding the needs and expectations of stakeholders, the authors found that high-sustainability firms were more likely to train their local managers in maintaining good relations with customers and subcontractors, particularly with regard to redressing grievances or pursuing targets more in line with their stakeholders’ concerns. The authors also found that roughly a third of high-sustainability firms provided feedback from stakeholders to their board or other key departments, and 20 percent turned the results of the engagement process over to the public, making them “more proactive, more transparent, and more accountable in the way they engage with their stakeholders,” the authors write.
As a result of their vision concerning sustainability and social issues, these firms have a more future-oriented investor base and communicate more long-term information in their conference calls with analysts, the authors found. They are also more inclined to increase the credibility of their corporate sustainability reports by using third-party auditing procedures. These firms also disclose more data on nonfinancial issues: 41 percent of the high-sustainability firms issue a global sustainability report compared with only 8.3 percent of the low-sustainability firms.
Finally, the researchers tracked the financial health of firms in both the high- and low-sustainability groups from 1993 to 2010, examining both stock market performance and general financial performance. They found that a $1 investment at the start of 1993 in a value-weighted portfolio of high-sustainable firms would have swelled to $22.60 by the end of 2010, based on stock market prices. For low-sustainability firms, on the other hand, a $1 investment would have grown to only $15.40. The high-sustainability firms also exhibited lower stock volatility.
The authors used return on assets as one measure of a company’s profitability. They found that $1 in assets at the beginning of 1993 in a portfolio of high-sustainability firms would have grown to $7.10 by the end of 2010; in contrast, $1 of assets in a portfolio of low-sustainability firms would have increased to just $4.40 over the same period.
“This finding suggests that companies can adopt environmentally and socially responsible policies without sacrificing shareholder wealth creation,” the authors conclude. “In fact, the opposite appears to be true: sustainable firms generate significantly higher profits and stock returns, suggesting that developing a corporate culture of sustainability may be a source of competitive advantage for a company in the long-run.”
Firms that embrace corporate social responsibility practices significantly outperform rivals that don’t embrace those practices, as measured by both financial and stock market returns. Firms with a history of commitment to sustainability and social issues also boast more long-term investors and place a greater emphasis on making nonfinancial disclosures.