Do Environmentally Friendly Companies Outperform the Market?

Do Environmentally Friendly Companies Outperform the Market?

Charles McPeak, Jaclyn Devirian, Samuel Seaman. Journal of Global Business Issues. Burbank: Spring 2010. Vol. 4, Iss. 1; pg. 61, 8 pgs

There has recently been an increased emphasis on corporate social responsibility and environmental friendliness for businesses worldwide. This paper set out to determine if environmentally friendly companies are rewarded in the financial markets for their efforts. There has been some research investigating the relationship between environmental friendliness and overall financial performance, but that research has not been definitive. (i.e. Some papers found a significant relationship while others did not.) This paper takes a longer term view of financial performance (three year change in stock price). Despite the longer horizon, we were surprised to find that environmental friendliness appears to be inversely related to financial performance. It is possible, however, that due to the recent emphasis and growing importance of environmental issues, companies may not have had sufficient time to reap the full benefits of their decisions.

Introduction

The trend of increased corporate social responsibility worldwide has forced companies to be aware of and to evaluate the social consequences of their business actions. Expectations of business behavior worldwide have changed as sustainability issues are becoming increasingly more important to employees, clients, investors, financial regulators, the public, and colleges and universities (Cusack, 2008). An online survey conducted by The Economist Intelligence Unit in October 2004 showed that 85% of executives and investors believe that corporate responsibility was central and important to investment decisions, compared to only 44% five years earlier (Economist Intelligence Unit, 2005). As more and more companies employ efforts to become socially responsible, how does this affect their bottom line? Skeptics believe corporate social responsibility is counterproductive to the profitability of a firm because it pits business against society. It has often times in the past been hard to see how increasing costs, through hard-tomeasure efforts, will help the bottom line. On the other hand, many others believe that corporate social responsibility can create opportunities for innovation and a competitive advantage. If corporate social responsibility efforts are aligned with a company's business strategy and are focused on long-term economic performance they can create significant value for the firm and society (Harvard Business Review, 2006). A study done in 2008 analyzed the performance of socially responsible companies, all members of the Dow Jones Sustainability index, showing that there was a direct link between increased corporate social responsibility and better financial performance (McPeak, Tooley, 2008). Additionally, socially responsible investing has seen higher returns than the market. For example, from 2002-2008, Light Green Advisor's, LGA Eco performance portfolio, had returns in excess of 7.74% over the S&P500, and an annualized Alpha of 1.61% (Cusack, 2008).

Overall, there is a positive relationship between recent corporate social responsibility efforts and profitability. Does environmental sustainability, one aspect of corporate social responsibility, enhance profitability by itself? Corporations have been accustomed to viewing environmental efforts as a cost that is not consistent with increasing shareholder value, which is the ultimate goal of a corporation. Environmental efforts that are based solely on public relations without a real business case probably will not increase a firm's profit. Additionally, environmental legislation has been seen as a huge cost for business. Prior studies and research have showed historically that being green does not contribute to the profitability of a firm. These studies may have produced results that are inaccurate due to various reasons such as the time frame of the study being too short, inadequate measurement of benefits due to green initiatives, or inadequate measurements of costs related to not being environmentally friendly. Conversely, it has also been shown that it is possible for companies to profit by implementing environmentally friendly strategies. A study by George Mason University showed that companies that invest in environmentally friendly production processes both offset the cost of regulations, and have additional benefits. For example, a company can improve their production process to reduce waste, which will allow them to get their product to market quicker and avoid longterm liabilities. Additionally, a company could develop green products, which would allow them to take advantage of the increasing market demand for environmentally friendly products (George Mason University, 2008). Although some companies like Ford have seen mixed results with environmental products such as hybrid cars, if current social trends continue, environmentally friendly products will provide more profits in the future due to increasing demand. Since 2005, General Electric has reduced their carbon emissions by 13% by implementing an environmentally conscious business plan. In addition, their "Ecomagination program" has contributed $17 billion to their revenue. (Burdick, 2009) Around 75% of chief executives of the 1,000 largest corporations believe issues like climate change affect their profitably and that they can create a competitive advantage by managing these sustainability issues (Cuscak, 2008). The Winslow management study showed that environmental responsibility can be profitable because companies that care about the environment are well positioned to produce better returns. In the last four years the Winslow Green index, an equally weighted index of 100 green companies, has had returns of 98.5% compared to -10.69% for the S&P500 and 32.77% for the Russell 2000. Furthermore, Ralph Earle III, in his book, "The Emerging Relationship between Environmental Performance and Shareholder Wealth," found that there is a link between environmental efforts and financial and investment performance (Winslow Management Company, 2009). Most agree that the key is for companies to align their environmental efforts with their business strategy and core competencies. Environmental efforts based on critical value drivers can create both a competitive advantage and opportunities that will increase shareholder value (Cusack, 2008). This study set out to determine if there is a quantifiable link between environmentally friendly companies and profitability.

KLD Data Set Background

KLD Analytics is one of the most wellknown global sustainability research firms (Cuscak, 2008).