The Eco-Efficiency Premium Puzzle

By Jeroen Derwall, Nadja Guenster, Rob Bauer, Kees G. Koedijk. 2004

975 citations recorded by the source corpus.

Does socially responsible investing (SRI) lead to inferior or superior portfolio performance? This study focused on the concept of “eco-efficiency,” which can be thought of as the economic value a company creates relative to the waste it generates, and found that SRI produced superior performance. Based on Innovest Strategic Value Advisors' corporate eco-efficiency scores, the study constructed and evaluated two equity portfolios that differed in eco-efficiency. The high-ranked portfolio provided substantially higher average returns than its low-ranked counterpart over the 1995–2003 period. This performance differential could not be explained by differences in market sensitivity, investment style, or industry-specific factors. Moreover, the results remained significant for all levels of transaction costs, suggesting that the incremental benefits of SRI can be substantial. In recent decades, a large number of investors have embraced the concept of socially responsible investing (SRI). Currently, nearly 12 percent of assets under management are invested according to ethical criteria. Despite the increasing popularity of SRI, however, debate continues over whether adding an ethical dimension to the stock selection process adds value. Our study focused on a concept called “eco-efficiency,” which can be thought of as the economic value a company produces relative to the waste it generates. Using corporate eco-efficiency scores from Innovest Strategic Value Advisors, we evaluated self-composed equity SRI portfolios. Focusing exclusively on the environmental element of social responsibility, we investigated whether a long-run premium or penalty exists for holding environmentally responsible companies. In the first part of the research, we constructed two mutually exclusive portfolios with distinctive eco-efficiency scores. We applied performance attribution models to test whether any performance differential between the portfolios was significant and attributable to the environmental component. This method allowed us to examine the long-term benefits of including environmental criteria in the investment process. We demonstrate that a stock portfolio composed of U.S. companies with high eco-efficiency scores sizably outperformed stocks with low scores over the 1995–2003 period. Using single-factor and multifactor attribution models, we also show that this performance differential cannot be explained by differences in market risk, investment style, or industry exposure. Obtaining evidence by adjusting returns after the fact may not be very useful, however, from an investor's perspective. Therefore, we also outline the economic implications of our findings by demonstrating how one can construct an environmentally responsible investment portfolio under practical conditions. For this part of the study, we constructed industry-balanced SRI portfolios based on “best-in-class” analysis, in which all stocks were allocated into specific industries and, subsequently, ranked relative to their industry peers. Stocks with high (low) eco-efficiency scores were allocated into the best-in-class (worst-in-class) portfolio. In the absence of transaction costs, the best-in-class portfolio outperformed the worst-in-class portfolio by approximately 6 percentage points on a risk- and style-adjusted basis. Even in the presence of transaction costs, the differential return between the portfolios remained large. Our evidence suggests that the incremental benefits of SRI can be substantial. Our results are puzzling because it is difficult to reconcile the observed performance differential with the well-established return–risk paradigm. The fact that common risk factors fail to account fully for the observed results raises the possibility of a mispricing story.

Subfields: Accounting, Finance, Strategy and Management

View Paper: https://www.semanticscholar.org/paper/1023a5a2faa4efaacc805e316d8668fc0a07956d

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Citations in the corpus

The impact of corporate governance on corporate performance: Evidence from Japan (2008, background): “Finally, we expect a positive relationship between corporate behavior and corporate performance because recent evidence shows the positive relationship between the social behavior of firms and their performance (see Derwall et al., 2005 ).”
The economic value of corporate eco-efficiency (2011, positive): “This percentage strongly resembles the abnormal returns outlined in Derwall et al. (2005). The patterns shown by Table 5 and Figure 1 are consistent with recent evidence of abnormal returns on stocks of eco-efficient companies, since an abnormal return differential would explain relative differences”
The Effect of Socially Responsible Investing on Portfolio Performance (2007, positive): “3 See, e.g., Cohen et al. (1997), Yamashita et al. (1999) and Derwall et al. (2005).”
Corporate Goodness and Shareholder Wealth (2015, background): “Di Giuli and Kostovetsky (2014) study how political opinions of the main executives affect the stakeholder relations of a company, and provide evidence that democratically leaning executives tend to pay more attention to stakeholders than republican ones. Cheng, Hong, and Shue (2013) provide evidenc”
A tale of values-driven and profit-seeking social investors (2011, background): “Derwall et al. (2005) evaluate equity portfolios based on “eco-efficiency scores”.”
Stakeholder relations and stock returns: On errors in investors' expectations and learning (2013, result): “This rise in attention is in line with the fact that academic evidence of positive risk-adjusted returns on environmental stakeholder information became increasingly public after 2003 (e.g., Derwall et al. 2005).”
Does the stock market value the inclusion in a sustainability stock index? An event study analysis for German firms (2013, neutral): “…is influencd by fund management decisions that cannot be separated from the SRI impact, other portfolio analyses focus on specific corporate sustainability performance assessments, such as those by Innovest (e.g., Derwall et al., 2005) or KLD Research & Analytics (e.g., Kempf and Osthoff, 2007).”
Post-innovation CSR Performance and Firm Value (2015, neutral): “…financing cost effects (e.g., Porter and van der Linde 1995; Hart and Ahuja 1996; Feldman et al. 1997; King and Lenox 2001; Pil and Rothenberg 2003; Derwall et al. 2005; Hong and Kacperczyk 2009; Goss and Roberts 2011; Aktas et al. 2011; El Ghoul et al. 2011; Deng et al. 2013; Xiao et al. 2013;…”
Corporate Carbon and Financial Performance: A Meta‐analysis (2018, background): “In the case in which this term is flipped, the ratio is called carbon efficiency (Brattebø 2005), which reveals the economic value a company adds in relation to its environmental impact (Derwall et al. 2005; DeSimone and Popoff 1997; Ehrenfeld 2005; Schaltegger and Sturm 1990; Schmidheiny 1992).”
Corporate Environmental Responsibility and Firm Performance in the Financial Services Sector (2014, background): “Proponents of CER argue that firms invest too little in it (Derwall et al. 2005; Guenster et al. 2006; Weber et al. 2008).”
Voluntary Corporate Environmental Initiatives and Shareholder Wealth (2011, positive): “However, Cohen, Fenn, and Konar (1997) and Derwall et al (2005) both find that portfolios containing stocks of companies with high environmental performance scores have positive returns and, in the case of Derwall et al (2005), even outperform portfolios containing low environmental performing…”