Financial performance and extra-financial performance are now inseparable
The financial value of extra-financial performance is debatable, but in the long term, one does not go without the other, explain Franck Bancel and Henri Philippe.
Over the past two decades, the pressure on companies in terms of extra-financial performance (or ESG performance) has increased considerably. There are several reasons for this major development. One is the regulatory framework, which has imposed new rules on companies in terms of extra-financial reporting and has reinforced transparency obligations. Another is the financial community, especially large institutional investors, which considers respect for the environment (E), social responsibility (S) and the establishment of effective governance mechanisms (G) to be essential to the long-term business development. Institutional investors are now sensitive to ESG criteria and carefully analyze extra-financial performance before deciding to invest in a company.
However, while ESG performance can be a source of competitive advantage, it also generates additional costs for companies. These costs can be significant and negatively impact the company’s cash flow. This is why it is essential to understand the relationship and interactions between ESG performance and financial performance. For example, do investments that improve ESG performance necessarily translate into better profitability and/or better stock market performance? How to define the level of investment necessary to achieve a “good” level of ESG performance? What does a good level of ESG performance mean? Investors also face similar issues. Does investing in companies that perform well on extra-financial criteria necessarily create value for investors? Will this value be priced into the stock price in the short term, or will investors have to wait a while to benefit from this value creation? Should we consider that companies with mediocre extra-financial performance destroy financial value and that the only option for investors is to sell their shares in these companies?
Researchers have tried to answer these questions and there is now a large academic literature on the relationship between financial and non-financial performance. However, the answers are not always so clear-cut. While the majority of academic studies show that companies that perform well on extra-financial criteria are more profitable, incremental profitability appears limited. Similarly, the majority of academic studies conclude that companies that perform well on extra-financial criteria are more valued, but again, the results are not particularly significant. It also appears that companies with a better ESG score are structurally less risky and have a lower cost of finance, but even this difference is small. In other words, the academic literature does not clearly conclude on the financial value of non-financial performance. The researchers believe that further work needs to be done to try to answer these questions. The fact is that researchers are struggling to solve two major problems: the meaning of causality and the measurement of extra-financial performance. It is unclear whether ESG performance improves financial performance or vice versa. The most profitable companies can more easily invest in ESG; perhaps therefore the direction of the relationship is reversed. The other difficulty is to define what constitutes a “good” company according to extra-financial criteria. For example, extra-financial rating agencies may assign different ESG ratings to the same company because these agencies use different methodologies (they do not assess the same aspects of ESG performance). Beyond that, measuring the externalities that condition a company’s extra-financial performance is a particularly complex exercise.
In view of all this, what would we say to a company that hesitates to invest to improve its extra-financial performance? Paradoxically, we do not believe that our advice would relate directly to financial arguments. We would explain to this company that by not managing its extra-financial performance, it risks being increasingly ostracized by financial investors, more broadly by its customers and even by the future employees it hopes to recruit. Furthermore, regulatory frameworks need to be strengthened; it would be better to prepare for such an evolution, even to contribute to its construction, rather than to suffer from it. This means that extra-financial performance will affect, for example, access to financing, as well as the quality of recruitment and ultimately the company’s ability to be competitive. In this sense, financial and extra-financial performance are intrinsically linked and one does not go without the other over the long term. This is a real paradigm shift for investors and businesses alike.
In this context, the question for companies is no longer whether they should invest in ESG; the answer is positive. But the question now is how to progress in managing extra-financial performance. This will require a better understanding of the level of investment and organizational changes needed to achieve this new goal.
Frank Bancel is professor of corporate finance at ESCP Business School, where he was associate dean for research and director of the doctoral program.
Henri-Philippe is a partner at Accuracy, a corporate finance advisory firm.