The Sobering News for Private ESG Impact Investments

As predicted by theory, increased investor demand has resulted in higher returns for public stocks with good environmental, social and governance (ESG) characteristics. Unfortunately, that means future returns will be lower for those stocks. New research confirms that this is also the case for private “impact” investments.

ESG investing in its various forms (such as SRI, or socially responsible investing, sustainable investing, and impact investing) now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe[1]. The trend is poised to continue.

While economic theory posits that if a large enough proportion of investors chooses to favor companies with high sustainability ratings and avoid those with low sustainability ratings (“sin” businesses), the favored company’s share prices will be elevated, and the sin stock shares will be depressed. Specifically, in equilibrium, the screening out of certain assets based on investors’ taste should lead to a return premium on the screened assets.

The result is that the favored companies will have a lower cost of capital because they will trade at a higher price-to-earnings (P/E) ratio. The flip side of a lower cost of capital is a lower expected return to the providers of that capital (shareholders). Conversely, the sin companies will have a higher cost of capital because they will trade at a lower P/E ratio. The flip side of a company’s higher cost of capital is a higher expected return to the providers of that capital. The hypothesis is that the higher expected returns (a premium above the market’s required return) are required as compensation for the emotional cost of exposure to offensive companies. On the other hand, investors in companies with higher sustainability ratings are willing to accept the lower returns as the “cost” of expressing their values.

There is also a risk-based hypothesis for the “sin” premium. It is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. The stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in high-scoring firms relative to the lowest-scoring firms. The greater tail risk creates the sin premium.