Is sustainability a luxury for listed companies?

What does ESG have to do with stock values?

There are several ways in which corporate sustainability is at odds with the investment markets.

The short-termism of markets is a clear driver of valuations that favor the corporate status quo. Between 1930 and 2020, the average holding period of stocks reduced from years or decades to months and sometimes weeks. Investors have no incentive to care about where a company will be in five years because their focus is much more immediate.

Fixes have been suggested for the short-term focus of markets, such as tackling day trading and short selling or introducing new taxes so that quick ‘in and out trading’ is no longer profitable. However, there is a lack of global agreement on these measures, without which investors can simply move to other markets.

The transition risks that companies face due to having to comply with ESG-related regulations are much higher in Europe than in the US. Consequently, from a risk modeling point of view, analysts in the region may believe that a company such as Shell carries unacceptable risks. As a result, they will conclude that it is necessary to discount whatever cash flows the company has more heavily than those of competitors, leading to a lower valuation.

There is no agreed method of accounting for the externalities associated with companies’ activities when valuing them. Despite strong returns, extractive companies have massive negative impacts on the climate and on society that outweigh the profits. An analysis that counts the true price of unsustainable activities gives a completely different picture to the robust figures achieved by many of the world’s largest polluters and other damaging organizations. Integrated valuation of companies along with their financial, environmental, and social impacts will give investors and stakeholders a much fuller picture of the true value created by companies.

Changing perceptions of sustainability

In the aftermath of the Paris Agreement in 2015, as countries committed to the UN Sustainable Development Goals, there was a ‘golden decade’ of green investing. Seeing bigger risks in companies with poor sustainability records, institutional investors like Swiss Re shifted their portfolios towards companies with greener policies and plans. However, because of COVID-19 and supply chain disruptions triggered by geopolitical developments like the war in Ukraine, these portfolios began underperforming, leading to pressure on corporate boards to rethink their investment criteria. In the US, this has manifested as opposition to green measures, while in Europe there has been a scaling down of ESG ambitions. Companies across sectors are reducing their sustainability targets, partly to become more realistic, but also in response to the polarized sentiment on ESG.

The result of all these pressures has been a revival in the popularity of ‘sin stocks’ such as the oil and defense industry, and a cooling of enthusiasm regarding anything related to ESG (not helped by the fact that for many companies, ESG policies have not moved much beyond talk and marketing).

It is reasonable to question whether companies such as Shell – and their investors – are really worried about the transition model when they seek alternative listing options, or whether they are simply seeking to make as much money as possible, as quickly as possible.

Whatever the corporate motives behind these moves, investors are happy because they get a good return and attractive dividends, leaving the sustainability problem for someone else to solve. In this context, ESG may be regarded as a luxury item that is unaffordable for companies focused primarily on ensuring consistently high returns to their shareholders and competing in markets with different regulatory frameworks.

A better way forward

In the past, the financial and ESG aspects of company strategy were kept separate and regarded as two completely different things. This has made it difficult to see how they could be integrated and affect the overall results of the business. Integrating sustainability in a corporation’s strategy, based on a thorough materiality assessment, allows firms to be a profitable source for responsible production and products.

Sustainability is not just about being green, but it concerns firms’ primary focus on longevity. Corporate sustainability implies long-term viability and the ability to continue to create jobs and opportunities for people long into the future while delivering products and services in support of people’s needs and wellbeing. In this way, sustainability is directly linked to long-term shareholder value creation.

Despite market pressures towards short-termism, investors have a fiduciary duty to create long-term value. In this context, sustainability should be embedded in overall investment strategies. The change needed is impossible to achieve based on share prices alone; rather, it requires an understanding of the full costs and long-term risks of externalities, accompanied by strong incentives to do things differently.

Market actors including governments, investors, and corporate leaders need to work together in the interests of long-term value creation for the wider stakeholder community (including shareholders) in the face of the growing sustainability crises facing the world. However, this collaboration cannot effect real change if stock markets continue to follow a pricing model in which many of the most damaging externalities of companies’ activities are not considered. Until this is acknowledged, there is no way to make renewable energy compete with fossil fuels in the markets or to reward sustainability over the profit-focused ‘business as usual’ approach.

Investors have a crucial role to play in leading the necessary changes. It is up to them to use their knowledge and influence to encourage a more sustainable way of doing business – one in which sustainability is neither a luxury nor an afterthought but embedded at the heart of things.