Sustainability Measures and Financial Performance of Firms
Posted in Finance Articles, Total Reads: 2722
, Published on 19 October 2014
Sustainability measures and investments undertaken to that effect have become increasingly frequent in the corporate sector in the past decade more than ever before. Firms are realizing that green is the way to go as far as the future of the business world is concerned. By being proactive and publishing their activities on the front of environmental and social sustainability, they are lining up to present themselves as good corporate citizens in the eyes of consumers and investors alike.
That however is unlikely to be the only reason why firms are investing heavily in everything green and sustainable. There has to be a hard economic foundation for such behavior on their part - and indeed there is one.
For long businesses have associated significant additional costs with incorporation of environment and society friendly practices, which in turn erode their competitiveness. However, this line of thought has undergone a paradigm shift in the past decade after being challenged by a number of experts (Gore, 1993; Porter, 1991; Porter & van der Linde, 1995). Porter, particularly, argued that pollution is often associated with a waste of resources (material, energy, etc.), and that the innovative technologies that would be employed to comply with the environmental regulations would offset the costs of their installation by saving on the wastage of valuable resources. Believers of this school of thought insisted that there were ways in which increasing the environment friendliness of their enterprises would not adversely impact their financial performance. It does so happen however that the benefits that accrue from such technology are realized at a later point in time; say on a quarterly or yearly basis, while the costs incurred are immediate or on a monthly basis. However there are several kinds of benefits that are not tangible and go neglected in a discourse of this kind.
The Observed Relationship
Several studies have established that there exists a positive link between the sustainability measures that a firm takes up and its financial performance. A study that used extensive data covering a five year period from 1996-2000 and included a large number of the S&P 500 firms substantiates this claim. Other inquiries that reported a positive relationship were: Waddock and Graves, 1997; McGuire, et al., 1988, 1990; Auperle, et al., 1985. Another analysis that studied a huge database of 337 Dutch and Chinese firms suggests a significant positive association between environmental sustainability and firm performance. (Also Graph 1 in Appendix A1)
The Probable Causes
Some reasons as to why such a positive linkage is observed over and over again have been enumerated in the reasons below. A diagrammatic representation of the same can be found in Figure 1 (Appendix A3)
Behavior of Institutional Investors
The current trends of the behavior of institutional investors, as shown in Graph 2 (Appendix A1), make it apparent that in the past decade, they have tended to diversify their asset baskets towards firms that have a formidable reputation as an international benchmark in the realm of corporate sustainability. In 2009 alone, USD 8 billion were invested in financial products associated with firms in the Dow Jones Sustainability Index (DJSI) by institutional investors, as opposed to little under USD 500 million in 1999. Among the several possible reasons behind this behavior could be:
• Non-sustainable firms are likely to have short term prospects and investors are increasingly taking cognizance of the associated risks
• Investors are on the constant lookout for attractive long term investments with high potential returns.
Further, there are several dedicated financial instruments like green (or ethical) mutual funds that make capital a lot more readily available to firms that integrate their businesses with the society and the environment. These funds basically ensure that the investors’ money gets invested only in such firms that meet certain requirements such as a proper environmental management system (EMS) or the absence of environmental litigation etc.
Further, Socially Responsible Investment (SRI) too is an upcoming important phenomenon. Socially screened funds in the US saw an asset increase of 258% between 1995 and 2005, a rate of growth faster than the average of other professionally managed U.S. funds. In France, the increase was 92% between 2002 and 2006. In 2005, nearly one out of every 10 dollars (9.4%) under professional management in the U.S. was involved in SRI (10% to 15% in Europe).
Brand Image and Reputation
Being socially responsible enhances the brand image and reputation of a firm, which often draws consumers to them, along with their CSR records. While reputation is hard to quantify and its impact on a company’s value hard to ascertain, overall image or prestige of a firm may play a part in increasing consumer loyalty or aid sales efforts.
Preferential Treatment by Aware (Institutional) Buyers
Several public and private organizations have procurement policies that favour and reward green suppliers. An environmental performance criterion is becoming increasingly more frequent while choosing suppliers for most big corporations. This phenomenon is known as green public purchasing (GPP). Some firms have had well-documented policies regarding their suppliers’ green performance. For instance, before choosing a supplier, IBM asks potential candidates to do a self-evaluation of their environmental performance, and for those that have a satisfactory score on the self-evaluation, there is an on-site evaluation of practices (Herren et al., 1998).
Less Risk of Negative Rare Events
Firms that adopt sustainable practices are somewhat shielded from such risks by virtue of being more transparent and having a lesser tendency towards bribery and corruption. Further, they may also be implementing costlier yet more effective environment friendly mechanisms, which not only make them less prone to running such risks as recalling defective products or paying huge fines for causing excessive pollution, but also keeps them ahead of the curve as compared to their peers in terms of anticipating the future regulations by the relevant authorities. This also reduces the risk of negative events in the name of the firm which could cause serious damage to their reputation and take millions of dollars of advertisements to correct.
Reduction in Operating and Labor Costs
Certain activities driving the sustainability agenda also end up as cost saving mechanisms for the firm. For instance, a reduction in the amount of packaging material used, or charting out optimal routes for vehicular transport of goods and people can have significant impacts on the operating cost of the firm.
Socially responsible firms with strong track records for meaningful CSR activities are also more likely to attract and retain the best talents in their respective fields (Turban & Greening 1997) which in turn reduces their recruitment, training and employee turnover costs.
Products having green origins have a different level of appeal to them, at least for a (growing) spectrum of consumers. This allows firms that perform better on the environmental front a unique opportunity in terms of leveraging their dedication to the cause of sustainability by exploiting the environmentally conscious market segments who are willing to pay a premium for the same. This premium takes care of the extra costs that might have been incurred in production or delivery of the said goods and services. As far as information about environmentally conscious products is concerned, methods such as Eco-Labelling can be used to make and distinguish credible claims about the origins of the product.
Cost Saving Innovations: The Porter Hypothesis
Michael Porter argued that the excessive costs that the governments impose on businesses in the form of taxes and stringent technical requirements can actually be beneficial for the businesses as it drives them to create waste saving technologies that offset the costs of compliance for businesses. This is also known as the Porter Hypothesis, which categorizes pollution as a waste.
Impact of Sustainability Reporting
Several studies have also reported that firms that engage in some sort of reporting of numbers with respect to their environmental and sustainability initiatives under some framework such as the Global Reporting Initiative (GRI) did indeed perform better in those fields.
Thus in summary, it can be said with certainty that being sustainable pays for a firm, not just in the long term in terms of continued availability of natural raw materials or controlling the rate of climate change but also by providing new sources of revenue and avenues for cutting costs all the same. It therefore establishes the business case for sustainability with a strong empirical base; something that firms need to pay heed to – sooner rather than later.
A1. Relationships between Environmental-Social Performance and Financial Performance
Table 1: Typologies for ESP-FP Relationship—Based on Preston and O’Bannon (1997, p. 422)
Direction of the relationship
ESP leads to FP
Social impact hypothesis
Supply and demand theory of the firm
FP leads to ESP
Available funds hypothesis or slack resources theory
Managerial opportunism hypothesis
ESP and FP are synergistic
Table 2: Frameworks Suggesting a Negative Link between FP and ESP
Reflects Friedman’s neoclassical argument that firms have only one social responsibility, which is to increase profits. By increasing ESP, they unnecessarily incur costs and reduce their profitability.
Managerial opportunism hypothesis ( Preston and O’Bannon, 1997): Higher FP leads to lower ESP
Managers will reduce expenditure on ESP when FP is strong to maximize personal compensation (which is tied to short-term FP).
Posner and Schmidt (1992) and Alkhafaji (1989)
Negative synergy ( Preston and O’Bannon, 1997)
Simultaneous relationship combining trade-off and managerial opportunism hypothesis.
Table 3: Frameworks Suggesting a Neutral Link between FP and ESP
Supply and demand theory of the firm (McWilliams and Siegel, 2001): No link between SP and FP
Companies supply a demanded and unique level of ESP to maximize their profits
Some studies found no or inconclusive correlations ( Anderson and Frankle, 1980; Aupperle et al., 1985; Freedman and Jaggi, 1982)
Table 4: Frameworks Suggesting a Positive Link between FP and ESP
Social impact hypothesis ( Cornell and Shapiro, 1987) Higher ESP leads to higher FP
Meeting the needs of various non-owner stakeholders increases FP. Failure to meet less explicit needs of stakeholders generates market fears (i.e. affects company reputation), thus increasing a company’s risk premium and affecting FP. Actual ESP costs are minimal compared to the potential benefits.
Pava and Krausz (1996) and Preston and O’Bannon (1997)
Available funds hypothesis or slack resources theory ( Waddock and Graves, 1997b) Higher FP leads to higher ESP
Superior FP enables companies to devote more resources to ESP.
McGuire et al. (1988), Kraft and Hage (1990) partially Moore (2001),
Positive synergy: ‘‘Virtuous circle’’ ( Waddock and Graves, 1997a)
Simultaneous relationship combining slack resources and good management Good management does most things well, including both ESP and FP. Good management and good ESP are synonymous when ESP is defined in terms of the stakeholder relationships considered important to the firm’s performance and not in terms of discretionary activities, e.g. philanthropy.
Empirically supported by Preston and O’Bannon (1997), Pava and Krausz (1996) and Stanwick and Stanwick (1998)
A2. Graph 1: Sustainability and financial performance
Graph 2: Financial assets associated with companies in the DJSI9
A3. Positive Links between Environmental and Economic Performance
This article has been authored by Aditi Khanna & Animesh Srivastava from XLRI Jamshedpur
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