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«Sustainable Investment Amsterdam, 31 August 2010 Commissioned by Duisenberg School of Finance and Holland Financial Centre Sustainable Investment ...»

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Hamilton (1995) documented a (statistically) significant negative impact of the announcements of the release of information on the use of toxic chemicals on stock prices in the US. Ten years later, Gupta & Goldar (2005) studied the impact of public disclosure of environmental performance on the financial performance of firms, i.e. the impact of environmental rating of large pulp and paper, auto, and chlor-alkali firms in India on their stock prices. They also find that the market generally penalizes environmentally unfriendly behavior: the announcement of weak environmental performance by firms leads to negative abnormal returns of up to 30%.8 Hong & Kacperczyk (2009) elaborate the concept of ‘sin stocks’ – publicly traded companies involved in e.g. producing alcohol, tobacco, and gaming. They find that these sin stocks have less institutional ownership, i.e. they are less held by norm-constrained institutions (such as pension plans) compared with mutual or hedge funds that are natural arbitrageurs. They also received less coverage from analysts during the researched period (1976-2003) than stocks of otherwise comparable characteristics. Furthermore, they are cheaper than otherwise comparable stocks (i.e., have a higher book-to-market ratio), which indicates they are “neglected by norm-constrained investors and facing greater litigation risk heightened by social norms” (Hong & Kacperczyk, 2009, p. 1). In other words, according to their research social norms affect stock prices and returns. This implies that ‘sinful’ companies are punished by the financial markets by lowering their value.9 Halkos & Sepetis (2007) show that improved environmental management system and environmental performance result in reductions in firms’ beta.10 Firms making reference to their environmental policy in annual financial reports and firms publishing an annual social report, see a beta reduction in the period 2001-2004 compared to the period 1998-2001.

Nakao et al. (2007) claim that Japanese firm data show a two-way positive interaction between environmental performance and financial performance: a firm’s environmental performance has a positive impact on its financial performance and vice versa. They used five years’ financial data from approximately 300 listed firms as well as the results of the Nikkei environmental management surveys.

Other studies finding similar correlation/causality between financial and environmental performance, include Annandale et al. (2001) and Dasgupta et al. (2002).

Stakeholder Relations Empirical studies on the relationship between corporate performance and corporate stakeholder relations are scarce. Hillmann & Keim (2001) show that management focusing on stakeholder value (improving the relationships with primary stakeholders like employees, customers, suppliers and communities) also creates shareholder value, while social issue participation (e.g., a ban on nuclear energy and avoidance of ‘sin’ industries) often destroys shareholder value. Goergen & Renneboog (2002) analysed the relationship between control concentration (e.g., the existence of a major shareholder) and CSR (stakeholder management and social issue participation) but failed to find (statistically) significant results. Orlitzky et al. (2003), conducting a meta-analysis of 52 See Guenster et al. (2010) for a similar study.

See Statman & Glushkov (2008) for more research on sin stocks.

The beta is a measure of the volatility of a firm’s stock compared to the overall market (the market’s beta is 1). The higher a firm’s beta, the greater its systematic risk (Halkos & Sepetis, 2007).

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studies (yielding a total sample size of 33,878 observations), find that CSR is positively related to financial performance, although more with retrospective financial measures (accounting returns) than with forward-looking financial indicators (e.g., shareholder returns).

Box 2 CSR-Corporate Financial Performance (CFP) studies at sristudies.org The website sristudies.org is an initiative of the Moskowitz Research Program, affiliated with the Center for Responsible Business at Haas School of Business (UC Berkeley). It provides an overview of ‘key studies’ “that every practitioner of SRI should know about”. The more recent of these studies, ones that concern the relationship between CSR and company performance, have already been discussed above. However, for further reading this website provides an excellent starting point. The bibliography covers over 300 articles and books on CSR and SRI.

2.3.2 Implications for Investment and Investors The cost of capital for any company is related to the perceived risk associated with investing in that company. This implies a direct correlation between the risk involved in an investment and the rewards which are expected to accrue from a successful investment. Companies with positive environmental records are (at least in theory) rewarded with a lower cost of capital, since they are less risky to investors (Harold et al., 2007). Some empirical evidence is found that the sustainability a firm demonstrates indeed influences its creditworthiness as part of its financial performance (Weber, Scholz, & Michalik, 2010).

Some authors also suggest that CSR is sometimes used to ‘mislead’ investors. Aras & Crowther (2009, p. 279) argue that the (future) effects of corporate activity upon its external environment can be obscured/clouded by environmental statements (e.g., an annual sustainability report) so that “the cost of capital for the firm is reduced as investors are misled into thinking that the level of risk involved in their investment is lower than it actually is”. This obfuscation could be fuelled by a lack of a full understanding of what is meant by ‘sustainability’ and the fact that risk evaluation methodologies often are deficient in their evaluation of environmental risk (Aras & Crowther, 2009).

CSR and sustainable investment opportunities (SRI) are closely related. At the stock/company level, CSR influences profitability, thereby enhancing or reducing the company’s share price. At the fund/portfolio level, combined individual share performance influences the risk-return characteristics of the portfolio, either positively (well-performing CSR shares) or negatively (illperforming CSR shares). Also, sustainability screening could influence the ‘investment universe’, as non-sustainable (or ‘sin’) stocks are unavailable (Plinke, 2008). These topics are further discussed in Chapter 3.

2.4 Reporting Requirements CSR can also be driven (or ‘imposed’) by reporting requirements, either on a regulatory or voluntary basis. CSR-related legislation, however, is not widespread. In fact, Renneboog et al.

(2008b, p. 1728) mention that “France is the first and so far the only country making social, environmental and ethical reporting mandatory for all listed companies”. Since 2009, Denmark

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has been added to this short list.11 Similarly the Swedish government decided to statutory sustainability reporting for all public companies. This law took effect on January 1st 2009 (Nilsson & Nilsson, 2010).

The reason for the lack of CSR-regulation could lie in the general consideration that “CSR initiatives are voluntary and go beyond what is required by law” (van Dijken, 2007, p. 142), although whether self-regulation is sufficient to guarantee corporate social responsibility, is still a matter of debate.12 In general, many companies voluntarily report on the corporation principles, ethics, rules of conduct and philosophical value as they relate to employees, shareholders, the environment and stakeholders. According to Andrew (2008), there has been an increase in the number of companies trying to show their ethical credentials. They realize that stakeholders demand more information and accountability for actions undertaken by the company. Furthermore, socially responsible activity enhances economic performance (section 2.2). Hence, companies realize that sustainability is important and often voluntarily include it in their reporting.13

2.5 Conclusion This paper is a literature overview and covers the most current research on CSR. A few of many interesting financial aspects of CSR have been discussed. Based on the literature discussed in this chapter, no unequivocal conclusion on the financial implications of corporate social responsibility can be drawn. Nevertheless, the theoretic papers addressed in this report point at numerous channels through which CSR creates financial value for companies, and the empirical studies under review generally indicate that CSR enhances corporate financial performance. There seems consensus amongst these authors that the relationship between a company’s performance and its level of sustainability is a positive one, although further research is advised by nearly all.

See the website of the Danish Government Centre for CSR: www.csrgov.dk. CSR is not obligatory as such, but if a company has no policy, it must state its positioning on CSR in their annual financial report.

This is similar to the comply-or-explain axiom underlying several corporate governance codes, inter alia the ‘Tabaksblat Code’ in The Netherlands (Akkermans et al., 2007).

For further discussion see for instance UNRISD (Utting, 2004).

However, the increase of reporting sustainability by companies will not necessarily mean there is an increasing concern with this subject. It might be the case that companies include sustainability in their reporting for benefits such as tax breaks (Gil-Bazo, Ruiz-Verdú, & Santos, 2010).

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3 Socially Responsible Investment

3.1 Introduction In line with the increased attention on climate change, corporate governance and community investing, Socially Responsible Investment (SRI) has shown rapid growth. SRI is an investment process that does not only look at the financial analysis but also takes into account the environmental, social and governance consequences of investments.14 These consequences can be both positive or negative. Funds, (investment) banks, pension funds and other financial institutions (FI) and investors, use a set of screens to select investments. These screens might be based on social, environmental or ethical (SEE) criteria (Renneboog et al., 2007), sometimes also referred to as environmental, social and governance (ESG) criteria (Eurosif, 2008; Reichelt, 2010).

More specifically, financial institutions and investors use sustainability information to screen investment opportunities and/or to influence management of the companies they fund (Mulder, 2007):

1. Positive selection (screening) of corporations: The selection of stocks of companies that perform best against a defined set of sustainability criteria (best-of-class approach);

2. Engagement with management: Influencing corporate policy through associated rights of being an investor;

3. Voting power at Annual General Meetings (proxy voting);

4. Negative screening or exclusion. For example the exclusion of the weapons or tobacco industry.15

3.2 Reasons for SRI 3.2.1 Financial Attractiveness From a finance perspective, there are principally three reasons why investors incorporate sustainability information in their investment decisions. The first is the (relative) financial attractiveness of sustainable investments (compared to ‘conventional’ investments), usually measured in terms of returns. The bulk of SRI literature focuses on the question whether SRI funds perform better or worse than conventional funds. This empirical body will be discussed in section 3.3.

This picture of financial attractiveness of SRI seems, however, not complete. A point not often cited is that financial institutions, notably banks, can distinguish between sustainable and nonsustainable companies when offering/granting them financial products, e.g., project finance, and Sometimes the distinction is made between Responsible Investment/RI (related to institutional investors and mainstream financial community), Socially Responsible Investment/SRI (related to the retail financial sector) and Sustainable Investment/SI (alignment between financial institutions committed to sustainability and investors).

See also Table 4 in Appendix A.

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asset based finance, reflecting investment decisions by the FI.16 These decisions will be based, at least partly, on financial attractiveness as well (i.e., expected returns). Since this type of information generally is not public, studies on the attractiveness of these financial products are sparse. Mulder (2007, p. xi) is an exception. He points out that FI are exposed to sustainability risks both directly and indirectly. Direct risks include reputational risks, liability risk and regulatory scrutiny. Indirect risks refer to the financial products they provide (e.g., loans and investment portfolios): if FIs are unable to identify which companies are most at risk, they can be exposed to increased risk for default (credit activities), lower investment returns (investment portfolios) or an increase in insurance claims (insurance activities). Coulson (2009, p. 154), Hansen (2006) and Papadopoulos (2009, pp. 13-14) offer similar liability and (credit and reputational) risk argumentation for FIs incorporating sustainability information in their business operations.

Despite the scarce amount of research on the link between FI incorporating sustainability information and their (relative) financial performance, it could be argued that SRI fund performance offers a potential proxy for the financial attractiveness of using SEE criteria when deciding on other financial products, in particular for the attractiveness of ‘sustainable’ project finance.17 3.2.2 Compliance The second major reason for incorporating sustainability information in investment decisions is compliance, either to legislation or to voluntary standards. They latter are often the result of ‘public pressure’, e.g., bad publicity and pressure from non-governmental organizations (NGOs).

This motive is closely related to reporting requirements (resulting either from regulation or selfregulation).

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