ESG has become an increasingly important topic for investors and stakeholders, with demands for ESG-related disclosures growing louder. But while it is clear that ESG is value-relevant and decision-relevant for investors, an important question remains: how much should a company invest in ESG and how should it communicate this to investors?
One of my recently published studies argues that ESG spending should primarily be viewed as an investment decision, with the optimal level of investment determined by the marginal costs and benefits associated with ESG activities. This model is based on a microeconomic equilibrium, with a firm’s ESG investment optimum determined by company-specific characteristics such as size, financing costs/structures, financial constraints and growth.
For example, larger firms are expected to engage more in ESG, so their ESG-related marginal benefits are likely to be higher compared with smaller firms. On the other hand, firms with more financial constraints will have higher marginal costs for any ESG-related spending. Thus, each firm has its own optimal ESG investment point, which must be determined through careful analysis of the firm’s specific circumstances.
Under and overinvesting in ESG
Empirical results of this study provide evidence for such an equilibrium point, with both under- and overinvesting in ESG resulting in lower financial returns. Underinvesting in ESG may result in missed opportunities to engage in profitable ESG projects, while overinvesting may result in net resource outflows, with marginal costs outweighing marginal benefits. In both cases, our empirical evidence suggests the negative impact on company profitability is non-linear, with firms that are further away from their optimal ESG investment level suffering more in relative and absolute terms. Hence, it is crucial for firms to identify their optimal level of ESG investment.
To determine this level, companies must consider a range of factors, including stakeholder pressures, financial constraints, growth prospects and the potential risks and opportunities associated with ESG factors. Firms that are able to successfully integrate ESG considerations into their business strategies are more likely to achieve sustainable long-term financial performance.
Relying solely on peer company behavior may not be sufficient, as firms have unique circumstances that require a tailored approach to ESG investment decisions. As such, stakeholder involvement is crucial in determining the optimal level of ESG investment for each firm, as it helps to ensure ESG investments are aligned with the company’s specific circumstances and goals.
In addition to determining the optimal level of ESG investment, companies must also communicate this decision effectively to investors and other stakeholders. This requires a clear understanding of the positive impact ESG activities can have on a firm’s financial performance. Companies that are able to effectively communicate the financial benefits of their ESG investments are more likely to gain the support of stakeholders and avoid accusations of greenwashing or ‘wasting’ money.
Political tensions
Certainly, the increasing political tensions around ESG issues in the US and elsewhere pose a significant challenge for companies when it comes to disclosing their ESG performance. On the one hand, companies need to respond to increasing demands from stakeholders for greater transparency and accountability around their ESG practices. On the other hand, they also face pressure from political leaders who view ESG as part of a ‘woke agenda‘ and seek to limit companies’ ESG efforts.
In this context, it is important for companies to be transparent about their ESG practices and communicate the value of ESG to their stakeholders. Companies need to take a strategic approach to ESG disclosure, taking into account both the needs of their stakeholders and the current political climate. A crucial element companies should incorporate into their ESG disclosure strategy is a focus on the financial implications of their ESG efforts. By demonstrating the financial benefits of ESG investments, companies can help to counter the perception that ESG is simply a political or social issue or part of a ‘political agenda’.
This can involve highlighting the link between specific ESG investments and improved financial performance, as well as outlining the potential risks that might arise due to a lack of ESG activities in particular areas – for instance, litigation risks due to failed governance mechanisms within a firm’s global supply chain. Such a disclosure strategy requires specific and careful crafting – it needs to be tailored to each firm’s specific circumstances. As previously stated, the optimal level of ESG investment (and how it affects financial success) differs between firms and varies based on a range of factors. For example, a large multinational corporation with significant environmental impact may need to invest more heavily in ESG than a small, service-based firm.
Determining the optimal level of ESG investment is a complex decision that requires careful analysis of a firm’s specific circumstances but research evidence suggests companies that successfully integrate ESG considerations into their business strategies are more likely to achieve sustainable long-term financial performance. Effective communication of ESG investments to investors and other stakeholders is also crucial and companies should take a strategic approach to ESG disclosure, focusing on the financial implications of their ESG efforts. Ultimately, ESG is not just a social or political issue; it is a value-relevant and decision-relevant factor for investors that can have a significant impact on a firm’s long-term financial success.
Dr Sebastian Tideman is an assistant professor of accounting at Syracuse University
