COMMENTARY: The Economic Principles of ESG

Katherine McIntire, Princeton University

Over the past decade, there has been “exponential growth” in the popularity of Environmental, Social, and Governance (ESG) priorities. ESG factors are commonly evaluated to determine the sustainability of a business’ practices. For instance, the environmental factor may focus on how a company is oriented with regard to climate change, the social factor may consider how a company supports human rights in the community and equity in its workforce, and the governance factor may evaluate shareholder rights, management structure, or compensation. ESG has become salient in recent years; it is a frequent theme in corporate strategies, political commentaries, and sustainable investing. Nonetheless, the rise of ESG has not been without controversy. Efforts to adopt ESG principles often reach relatively uncharted territory, and some of these enterprises have been met with significant dissent. Thus, it is worthwhile to examine the underlying motive and goals of ESG objectives in order to consider how corporate responsibility and sustainable investing principles may take form in the long term. 

In 1970, Milton Friedman famously wrote that “the social responsibility of business is to increase its profits.” Friedman objects to executives undertaking corporate responsibility initiatives that do not strictly serve to improve profitability for the firm. Working within this ideological framework, scholars in the field have sought to determine the impact of corporate responsibility on corporate financial performance. If evidence suggests that ESG can lead to increased profits, then perhaps companies that adhere to Friedman’s tenets would adapt accordingly.

Indeed, empirical research supports the notion that ESG may be associated with enhanced financial performance. For instance, a 2016 study found that ESG disclosure score has a positive association in the long run with corporate financial performance across the S&P 500. Furthermore, a meta-analysis of 251 studies from 1972 to 2007 determined “a mildly positive relationship between corporate social performance and corporate financial performance.” Nonetheless, as with any relatively new concept, more research is needed. Thus, although it cannot necessarily be concluded that there is a strong causal effect of ESG improvements on financial performance, encouraging evidence of this nature has been a factor in the emergence and popularity of ESG. 

These empirical results have coincided with an increased fervor to achieve many of the objectives that ESG parallels. Calls for more ethical corporate practices and workplace equality between gender and racial groups have grown stronger. Simultaneously, the increasingly dire threat posed by climate change has led consumers and employees alike to advocate for more environmentally conscious business practices. Nevertheless, as Friedman articulated, profit maximization is often viewed as the dominant responsibility of business practice. Thus, if ESG initiatives are undertaken for the social good but at the expense of profitability, such ESG efforts could be seen as an unjustified cost. 

Therefore, given the potential tradeoff between ESG and efficiency, I conducted an empirical study to investigate the relationship between ESG and financial performance. If responsible corporate practices are demonstrated to increase profits, then perhaps companies that adhere to Friedman’s tenets would adapt accordingly. A broader acceptance of ESG priorities as core to a robust and sustainable business model would thereby lead to improved firm performance in addition to societal benefits.

In my study, I examined the effect of ESG outcomes on the financial performance of the S&P 500 companies from 2007 to 2020. Among my results, I found a statistically significant and positive relationship between ESG and both return on assets and return on capital, which was consistent with the existing literature. Of course, there are notable limitations of the findings of my study and others in this area of research. In particular, a singular way to compute ESG has not been established. For instance, I sourced ESG scores from Refinitiv, a data provider from the London Stock Exchange Group, whereas other studies use Bloomberg’s ESG Disclosure score. Although the various ESG score providers may utilize similar approaches, there can be significant differences in the underlying metrics that determine each score. The general concept of environmental, social, and governance principles is relatively broad, and each scoring provider must decide how to conceptualize these factors as numbers. Therefore, when working with ESG scores, it is important to consider the fundamentals of what each score actually represents. 

Overall, it remains difficult to ascertain the true relationship between ESG and economic performance. The statistical nuances render it a complex issue, and political sensitivities surrounding ESG may distort the pursuit of objective inquiry. In general, further research is needed. As we work to integrate ESG principles in corporate strategy and investing, further change is likely yet to occur. Still, given the merit of the underlying principles of ESG, it remains crucial to determine the optimal role ESG should play in the economy.

Note: This commentary draws from and covers the same topic/content as my research paper titled, “The Effects of ESG and Environmental Practices on Corporate Financial Performance: An Analysis of S&P 500 Companies from 2007 to 2020” (2022).

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