Companies that show real results in environmental performance – such as lower carbon emissions – receive a premium from investors.
For decades, researchers have tried to answer the question “Does it pay for companies to be green?” and the studies have provided conflicting results. Some studies show strong environmental performance leads to strong financial performance; other studies, however, suggest environmental performance has no effect – or sometimes even a negative effect – on financial performance.
Timo Busch and Volker Hoffman of Swiss university ETH Zurich were intrigued by these conflicting results. The researchers conducted a nuanced study of the relationship between environmental and financial performance, examining 174 energy-intensive companies with large market capitalization in the Dow Jones Global Index.
First, the researchers distinguished between two kinds of environmental issues that matter to investors: issues that have a material effect on the company (such as air pollution in regions where pollution is taxed) and issues that do not have a material effect (such as assessing eco-efficiency, without actively managing it). In particular, they focused on carbon emissions as a material issue to study.
“... lowering carbon emissions did not directly affect a company’s value on paper, but it did affect how much investors were willing to pay for the company’s stock.”
Results versus Targets
Next, the researchers defined environmental performance two ways: one way based on outcomes, or results, and the other based on process. Outcome-based performance refers to reductions in energy consumed, raw materials used or emissions generated. Process-based environmental performance describes the firm’s internal efforts to anticipate, manage or respond to environmental concerns, such as setting targets or announcing an environmental strategy.
Investors Pay for Environmental Results
When the researchers measured return on equity (shareholder return) and return on assets (how efficiently the assets produce income) they found no correlation between a firm’s financial performance and environmental performance. They did find, however, that firms with lower carbon emissions had higher Tobin’s q than their more carbon-intensive peers. Tobin’s q is a ratio that captures the difference between a public company’s market and book values. In other words, lowering carbon emissions did not directly affect a company’s value on paper, but it did affect how much investors were willing to pay for the company’s stock.
The researchers theorize that, as companies improve their operational efficiency and satisfy concerns about environmental impact, investor satisfaction increases. In the current business climate, investors are anxious to see companies reduce the likelihood of environmental risks and sanctions and increase their attractiveness to environmentally conscious consumers and investors. When a firm satisfies these concerns its perceived value increases and demand for its stock goes up.
“... not only did activities such as setting emissions targets fail to generate good returns for investors – they also failed to drive investor demand.”
The study found companies with process-based outcomes such as emissions targets had significantly lower return on equity and Tobin’s q. In other words, not only did activities such as setting emissions targets fail to generate good returns for investors – they also failed to drive investor demand. This is likely because process-based activities often add immediate costs without providing evidence for shareholders that costs will eventually decrease and environmental results will improve. This result is in keeping with standard economic theory that stresses cost minimization as a key to financial performance.
The researchers conclude that investors evaluate different forms of environmental performance in different ways. When firms focus on improving actual outcomes, investors respond by awarding the firm with a “premium” in the form of increased demand. When firms focus on process where the actual outcomes remain uncertain—the anticipation and management of environmental issues—investors do not reward them.
If you want your environmental efforts to positively affect your company’s financial standing:
- Choose an environmental issue that has a material effect on your business;
- Focus on attaining real improvements in the chosen area (e.g. reduce carbon emissions).
When you do these two things, investor satisfaction increases. Your company’s “intangible value” increases as investors award you with an environmental premium, and demand increases for opportunity to invest in your company.
The researchers do not suggest, however, that companies abandon process-based activities such as target-setting and environmental planning: these activities are crucial to achieving the real results investors value. Their findings just reveal that a splashy public announcement about your plans to become carbon neutral, for example, won’t send investors flocking to buy your stock. The researchers note that, as environmental issues become more acute, this may change and, in the future, investors may start awarding premiums for both environmental results and targets.
Busch, T. and Hoffmann V. “How Hot is Your Bottom Line? Linking Carbon and Financial Performance.” Business & Society 50(2) 233-265.
Lisa Richmond and the NBS team