It is not in doubt that businesses that perform well on sustainability also perform well financially and are more resilient. This is a correlation, not a causation. Academics are much more reserved about the degree to which financial performance can be attributed to sustainability practices than those who market ESG portfolios would care to admit.

  • This article describes the evidence for links between business sustainability and financial performance
  • 10 min read
  • Last updated 24 May 2021

Correlation, Not Causation

The recent, rapid global upsurge in sustainable investing is due to a range of motivations, from supporting the transition to a low carbon economy or a fairer society to simply aiming to maximise returns by investing in steadier stocks that outperform the market. By 2018, sustainable, responsible and impact (SRI) investing amounted to more than US$30 trillion globally, an increase of 34% in just two years (GSIA, 2018). It has been found that 45% of institutional investors base their investments in ESG hedge funds, seeking opportunities to generate alpha (KPMG, 2020).

It is not in doubt that businesses that perform well on sustainability also perform well financially and are more resilient, as the evidence set out further below attests. It is important to note, however, that the current body of evidence shows correlation, not causation.

Academics are much more reserved about the degree to which financial performance can be attributed to sustainability practices than many ESG portfolio asset managers would care to admit. Many well-meaning champions of business sustainability also promulgate the myth that sustainable businesses create more value or are less risky, which leads to above market returns. Sustainable businesses do frequently outperform the market, but the reasons for this are complex and have not yet been fully unraveled.

Why It’s Too Early to Call Causation

Ambiguity on Financial Performance

Financial performance is an ambiguous term in the literature. It may refer to return on assets, return on equity, return on capital, profitability, market value, stock price or earnings.

Ambiguity on Sustainability Performance

Business sustainability performance is becoming an increasingly transparent area, with businesses providing more data than ever before across a range of sustainability measures. Data increases certainty, however sustainability data is extremely diverse, which skews academic results.

  • Unlike financial performance, which is measured in monetary units, sustainability metrics use an array of units of measure, including number of people, litres of liquid and tonnes of CO2. How can a business that performs well on socioeconomic factors be compared to a business that is resource efficient – which one is the more sustainable? Assessment of sustainability performance is not formulaic, but interpretive.
  • Of sustainability data that is disclosed, much of it is qualitative in nature as businesses describe outcomes and impacts that they do not have systems in place to measure on a quantitative basis. Qualitative data is harder to assure than quantitative data – how much reliance can an observer place on data that may be over- or under-emphasized.
  • The sustainability topics that businesses chose to report on depend on the outcomes of their materiality assessment, and which topics, thereafter, that the business decides to target. There is a great deal of variation, even among peer businesses, in the topics of the data that are disclosed.
  • Do chosen metrics meaningfully reflect actions that lead to sustainable outcomes? For example, does a diverse board that is not expert lead to better outcomes than an expert board that is not diverse? It may well do, but most businesses will report the diversity of their board as a sustainability performance factor, but not assess the changes in business impact that their diverse board makes compared to a less diverse board. Business change is often used erroneously as a proxy for impact.
Small Pool of Research

The evidence pool is determined by the topics and sample populations that researchers choose (or are funded, or have access) to study – the vast majority of business sustainability research has been on large, listed firms in developed nations.

Evidence of Correlation

Sustainability-Financial Performance Nexus

The correlation between sustainability and financial performance is proven.

  • Businesses that perform well on sustainability also create shareholder value, with higher equity returns and reduced downside risk (McKinsey, 2019).
  • High sustainability companies significantly outperform their counterparts over the long term, both in terms of stock market and accounting performance (Eccles et al, 2014).
  • Morningstar examined 745 sustainable funds and compared them against 4,150 traditional funds, and found they matched or beat returns, whether bonds or shares, UK or abroad (The Guardian, 2020)
  • An analysis of Fortune 100 companies found that sustainability performance shows significant correlation with financial performance (Hussain et al, 2018).
  • In a meta-analysis of more than 200 different sources, 80% of the reviewed studies demonstrate that prudent sustainability practices have a positive influence on investment performance (Clark et al, 2015).
  • Stocks rated high on ESG tend to be in the low volatility group and vice versa (PRI, 2016).
  • A study of 481 firms in the S&P 500 from 2009 to 2016 found that high ESG performance is shared with lower share price volatility (Jacobsson and Lundberg, 2018 (pdf)).
  • A sample of 600 North American firms in the Dow Jones global stock market index found that investors penalize large, profitable firms that have a low level of business sustainability performance (Lourenço et al, 2011).

High sustainability businesses are also more resilient, better positioned to weather bad times, such as Covid-19 lockdowns.

  • The Dow Jones Industrial Average shed 34% during Q1 2020 as Covid-19 spread. Morningstar reported that 51 out of 57 of their sustainable indices outperformed their broad market counterparts, and MSCI reported 15 of 17 of their sustainable indices outperformed their broad market counterparts (Hedgeweek, 2020).
  • Businesses in WBCSD membership who demonstrate taking ESG factors into account, beat the major stock exchange benchmarks for year to date ending on 18 August 2020 (WBCSD, 2020)
  • A study of China’s CSI300 benchmark index shows that ESG performance mitigates financial risk during financial crisis (Broadstock et al, 2020).
  • From January to August 2020, India’s Nifty 100 ESG Index dropped only 2.8%, while the NSE Nifty 50 Index dropped by 8% (The Economic Times, 2020).
Macro Patterns

The sustainability-financial performance nexus has been observed to be U-shaped. Firms with low sustainability or high sustainability financially outperform firms with moderate sustainability. Therefore, companies that aim to become more sustainable should aim for high performance (Nuber et al, 2019; Barnett and Salomon, 2012).

Time Lag

There is a time lag of 12-24 months between implementing a sustainability plan and demonstrating improved financial performance (Lu et al, 2018). Companies transitioning into sustainability should communicate to their investors that gaining financial results may take several reporting cycles.

Environmental-Financial Performance Nexus

Environmental efficiency correlates with financial performance. Efficiency is the ability to do something without wasting time, energy and materials. Businesses are always inefficient to some extent, so operational efficiency improvements are seen as the ‘low hanging fruit’ of business sustainability, resulting in reductions in energy use, water use, raw materials, waste-to-landfill, GHG emissions and air and water pollution. This can be extended all along the value chain, from raw materials extraction to disposal, providing many opportunities for cost reduction.

General Environmental Performance
  • A study of firms’ eco-efficiency and financial performances from 1996 to 2004 shows that eco-efficient companies initially did not trade at a premium relative to eco-inefficient companies, but, over time, the valuation differential increased substantially. This is thought to have been due to initial undervaluation of eco-efficiency that the market has now corrected (Guenster et al, 2011).
  • A meta‐analysis of 142 studies found that increasing environmental performance creates significant financial benefits after one year. This effect is significantly smaller for reactive environmental investments (eg legal compliance) (Hang et al, 2018).
  • A meta-analysis of 198 studies finds that environmental sustainability contributes more to financial performance than social sustainability (Lu and Taylor, 2015).
  • A study of 2,361 firm-years from 2008 to 2012 shows that, for manufacturing industries, profitability is affected by carbon performance and waste intensity, while stock market performance is influenced solely by carbon performance. For service industries, carbon performance and waste intensity influence only profitability, not stock performance. Companies with low environmental performance tend to have a negative link to financial performance, whereas companies with superior environmental performance tend to have a positive link to financial performance (Trumpp and Guenther, 2015).
  • A study on the energy efficiency and financial performance of a sample of firms in China for the period 2010–2014 found that energy efficiency is positively related to return on equity, return on assets, return on investment, return on invested capital and return on sales (Fan et al, 2017).
  • According to a meta-analysis of more than 200 sources, 88% of reviewed sources find that companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into cashflows (Clark et al, 2015).

Note that some environmental factors have become threshold factors and do not confer a competitive advantage.

  • Improving energy efficiency and using renewable energy sources produces a short term positive financial effect but does not affect financial performance in the long term (Martí-Ballester, 2017).
Carbon Emissions

‘Once climate change becomes a defining issue for financial stability, it may already be too late.’
(Mark Carney, 2015 (pdf))

  • A study of 63 South African companies found overwhelming evidence of a negative correlation between carbon emissions (scopes 1 and 2) and corporate financial performance (Ganda and Milondzo, 2018).
  • Analysis by BCG focusing on carbon emissions in chemicals, energy and mining found that companies with the lowest carbon emissions had valuations 12% to 13% higher than those with average emissions, and 22% to 25% higher than those with the highest emissions (WEF, 2020).
  • In Europe and the US, where awareness of sustainability issues is high, market cap rises by 10% for every 500 tCO2e reduction per $1 million of revenue (BCG, 2019).
Green Supply Chain
  • A study of 238 textile firms in Pakistan found that green supply chain management practices (green manufacturing, green purchasing, eco-design, cooperation with customers and green information systems) have a significant direct impact on firms’ financial performance (Kalyar et al, 2019).
  • A study of 3,490 publicly-traded companies from 58 countries over 13 years shows that pollution prevention and green supply chain management are the major environmental drivers of financial performance (Miroshnychenko et al, 2017).
  • Supplier integration and green sustainability programmes significantly improve the financial performance of fashion enterprises and helped mitigate the adverse effects of the global financial crisis on enterprise financial performance (Li et al, 2016).

Social-Financial Performance Nexus

Social Impact
  • Companies on Fortune’s annual Change the World list (which ranks companies for successful integration of social impact into business strategy) from 2015 to 2017 outperformed the MSCI World Index by an average of 3.9% in the year following publication (Institutional Investor, 2019).
  • Investors will pay $0.7 more for a share in a company giving one more dollar per share to charity, while companies with a negative social impact were valued at $0.9 less per share than those whose social impact was considered neutral (HEC, 2020).
  • For large US corporations belonging to the S&P 500 Index, the stocks of companies in the top corporate social performance (CSP) quantile outperform the bottom CSP quantile up to 6.24% annually, 1991 to 2006, after adjusting for market risk, size, book to market ratio and stock momentum. For a company in the S&P 500 Index with average market capitalization, this translates to US$1.28 billion in additional shareholder wealth (Park and Moon, 2011).
  • Trust between a firm and both its stakeholders and investors built through investments in social capital pays off when the overall level of trust in corporations and markets suffers a negative shock (such as the GFC) (Lins at al, 2017).
  • 33% of consumers choose to buy from brands they believe are doing social or environmental good, and 21% said they would actively choose brands if they made their sustainability credentials clearer on their packaging and in their marketing (Unilever, 2017).
  • Willingness to pay (WTP) is greater for products where the socially responsible element benefits humans (eg labour practices) compared to those that benefit the environment. People are willing to pay a mean premium of 16.8%, and on average 60% of respondents are willing to pay a premium (Tully and Winer, 2014).
  • Unilever’s purpose-led Sustainable Living Brands are growing 69% faster than the rest of the business and delivering 75% of the company’s growth (Unilever, 2019).
  • 47% of online purchasers have switched to a different product or service because a company violated their personal values, citing issues such as environmental concerns, lack of transparency, climate change and discrimination on ethnic and LGBTQ grounds (eMarketer, 2019).
  • 50% of people who are willing to pay more for additional features are influenced by sustainability factors – including fresh, natural and/or organic ingredients (69%), and a company being environmentally friendly (58%) or socially impactful (56%) (Nielsen, 2015).
  • 67% of millennials expect the companies they work for to be purpose-driven and their jobs to have societal impact (BCG, 2020).
  • A study comparing the effectiveness of a social incentive (a donation to a charity of the subject’s choice) to a financial incentive found that social incentives lead to a 13% rise in employee productivity (Tonin & Vlassopoulous, 2015).
  • Charitable contributions are significantly associated with future revenue (Lev et al, 2010).
Advocacy
  • 87% of Americans surveyed would purchase a product because a company advocated for an issue they cared about, while 76% would refuse to purchase a company’s products or services upon learning it supported an issue contrary to their beliefs. Hot button issues include racial equality, women’s rights, climate control, gun control and LGBTQ rights (Cone Communications, 2017).
Responsible Sourcing
  • Responsible supply chain practices can enhance reputation and thereby create competitive benefits (Hoejmose et al, 2014)
  • Integrated sustainable supply chain management (social and environmental) is positively associated with corporate financial performance (measured by return on assets and return on equity). The positive effects can have a time lag of at least two years (Wang and Sarkis, 2013).

Governance-Financial Performance Nexus

  • A U-shaped relationship exists between sustainability governance and financial performance, and pays off only after a threshold of sustainability performance has been reached. To serve the interests of shareholders, long term planning and considerable resources should be dedicated to governance as the key driver affecting the sustainability-financial performance relationship (Nollet et al, 2016).
Reputation
  • According to research by Société Générale, two thirds of the time following high ESG controversy events shares underperformed the MSCI World Index by an average of 12% over the subsequent 2 years, and it is best for the investor to sell the stock immediately (CNBC, 2020).
  • Sustainability is an antecedent of corporate reputation (Gomez-Trujillo et al, 2020).
  • Companies in Fortune magazine’s 100 Best Companies to Work For in America annual lists beat their peers on stock returns by, on average, 2% to 3% per year over the period 1984 to 2009. Companies that treat their workers better, do better (Alex Edmans, 2015).
  • Using data derived from natural language processing applied to news coverage of corporate responses to the coronavirus crisis for 3,023 companies around the world, it was found that more positive sentiment around a company’s response to Covid-19 is associated with less negative returns (Cheema-Fox et al, 2020).
  • The value of corporate social performance as insurance against litigation risk is financially significant, adding 2% to 4% to firm value (Koh and Qian, 2103).
Resilience
  • In a study of 77 firms, all three dimensions of supply chain resilience (preparedness, alertness and agility) significantly impact financial performance, but preparedness, as a proactive capability, has a greater influence on financial performance than alertness and agility, both of which are reactive capabilities (Qun Wu et al, 2017).
  • A study of the relationship between organizational resilience and financial performance of 84 tourism firms in New Zealand found that planned resilience had no statistically significant influence on financial performance, however adaptive resilience had a positive and significant influence on financial performance (Prayag et al, 2018).
Materiality
  • There is growing consensus that integrating material ESG factors correlates to long-term financial returns and can help generate alpha (Goldman Sachs, 2018 (pdf)).
  • Companies with good ratings on material sustainability issues outperform those with poor ratings on these issues by 3% to 6% per year. In contrast, companies with good ratings on immaterial sustainability issues do not significantly outperform those with poor ratings on the same issues (Khan, Serafeim and Yoon, 2015).

Disclosure-Financial Performance Nexus

  • A study of 235 European banks from 2007 to 2016 found that ESG disclosures have a significant positive impact on financial performance (Buallay, 2019).
  • A study of 103 Indian listed firms from 2009 to 2104 found that sustainability reporting practices have a significant impact on the profitability (Motwani and Pandya, 2016).
  • A study of 502 companies listed on the Singapore Stock Exchange found that that sustainability disclosure is positively related to the market value of a firm, and the better the quality of sustainability reporting, the stronger the linkage (Loh et al, 2017).
  • A study of 116 public companies drawn from the top 40 firms (based on market capitalisation) on the ASX, the Hong Kong Stock Exchange (HKSE) and the London Financial Times Stock Exchange found a significant relationship between sustainability engagement and financial performance, even after controlling for sustainability performance, firm size, industry, financial risk and type of assurer (Beck et al, 2018).