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The Economics of sustainability

Published: 8 August 2021 (5 minutes reading)

Executive Summary

•In financial aspect, sustainability can positively impact the bottom line in two ways: cost of capital, and performance.

•Companies that have strong ESG metrics are getting lower cost of capital both in terms of debt and equity, as ESG helps reducing company risks perceived by investors, especially governance (G).

•Companies that pursue sustainability are expected to offer larger return potential for investor, because there is an unlimited growth for companies to move toward innovative product and new market.

The purpose of this article is to show some researches supporting the idea of how sustainability and profitability can coexist and work together. There are many different studies in this area in the last few years, but we’ll be going through few of them in this article.

When it comes to profitability, we normally consider it in two aspects: cost and performance.


Cost of Capital

The cost of capital of a company reflects the perception of risk by investors. For example, if a company is considered to be risky, investors will demand a higher return on their investment, resulted in the higher cost which a company has to bear. So how sustainability helps with the cost of capital? here is a simple explanation. One of the key values that sustainability brings in is “reducing risks”. When investors evaluate the risks of a company, the factor they often consider is a company’s supply chain. Sustainable supply chain can mitigate risks from external parties such as manufacturers, suppliers, transporters, or even unforeseen events like pandemics, natural disasters, or other global events. Another factor is a corporate governance. The more transparent a company is, the lower risk investors perceive. Employing good corporate governance helps a company to reduce the opportunity for corruption. Often, scandals and fraud within a company are more likely to occur when management team do not have to comply with  governance guidelines.

Deutsche Bank, a global leading bank, has conducted a research1 looking at more than 100 academic studies and papers of sustainable investing around the world. Part of the  research summarized that 100% of the academic studies agree that companies with high ratings for CSR and ESG factors have a lower cost of capital both in terms of debt and equity. The governance (G) factor has been the single most important factor among ESG, while Environment (E) is the next most important, followed by Social (S) factor.

Financial Performance

Companies that pursue sustainability are gaining competitive advantage. Sustainability is an approach that enables a company to adapt to new economic and environmental challenges, generates high growth, helps it move toward innovative products and new markets. For example, automotive industry, which traditionally focused on development of internal combustion engine models, has begun to explore EV and hydrogen-based technology. This is expected to offer even larger return potential for investors as a company gaining “first mover advantage”, like how Tesla become world’s most valuable carmaker company in just 17 years. We can see how sustainable products and services helped to acquire huge benefits for shareholders.

The research2 by economists from Harvard and London Business School shown that sustainability initiatives can actually help to improve financial performance. They examined two matched groups of 90 companies. These companies were in the same industry, had similar scales, and had similar capital structures, operating performance, and growth opportunities. The only significant difference was that one group made a substantive long-term investment on sustainability, while the other group did not. According to the researchers’ calculations, the $1 investment in the value-weighted portfolio of highly sustainable companies at the beginning of 1993 will grow to $22.60 by the end of 2010, while the portfolio of low-sustainability companies will be $15.40. Highly sustainable companies also perform better in terms of return on assets and return on equity.

To sum up, we can see how sustainability and profitability can complement each other. Sustainability can help companies to reduce their cost of capital by mitigate risks, improve financial performance by growing the new market and developing innovative products and services, which in the end will increase the overall value of a company.


Source

1  Mark Fulton, “Sustainable Investing: Establishing Long-Term Value and Performance”, June 2012, Deutsche Bank Group

2 Robert G. Eccles, Ioannis Ioannou, and George Serafeim, “The impact of a corporate culture of sustainability on corporate behavior and performance,” Harvard Business School working paper, HBS Working Knowledge, Number 12-035, November 2011, hbs.edu.