When businesses invest, they are expected to maximize financial profits for their owners. Investors look at firms’ financial performance to guide capital allocations. Increasingly, they also look to material environmental, social, and governance (ESG) indicators as these have been shown to be leading indicators of future financial performance in developed countries (Khan et al., 2016). There is now a growing movement to integrate sustainability into the practices of all firms, including those in developing countries (Business and Sustainable Development Commission, 2017). But some developing countries have expressed concerns that high costs and new conditionalities for sustainability could undermine their growth (OECD, 2012). This paper analyzes the causal ESG/financial performance relationship in developing countries to address these concerns.
To understand the complementarity between financial performance and ESG performance, we analyzed investments carried out by the International Finance Corporation (IFC), the private sector arm of the World Bank Group in close to 100 lower- and middle-income countries between 2005 and 2014. During this period, the IFC invested in 2,475 firms in IFC-eligible, developing countries. This is a large and unique data set with which to explore the relationship between financial performance and developmental outcomes.
Current thinking on the relationship between ESG reporting and financial performance in developing countries is that there is indeed a positive correlation:
[A] convincing correlation exists between those investments that do well on a financial yardstick and those that show strong development results; moreover, integrating ESG criteria into the investment process appears to enhance financial performance (Wilson, 2013).
This carefully worded view underscores the considerable causal ambiguity in interpreting the ESG/financial performance relationship. Better sustainability may trigger better financial performance, but the reverse can also be true. Better financial returns can permit more attention and resources to be dedicated to sustainability practices. Equally, when financial performance is poor, firms might cut sustainability activities first.
In fact, both sustainability and solid financial performance might result from an omitted variable: good management. In this case, it would not be fair to claim that ESG performance itself caused better financial performance, but only that the quality of management jointly determines both ESG and profits. The policy prescription would be to improve management, not to introduce regulations on ESG reporting. There is also reason to worry that subjective metrics like ESG performance that are constructed as judgments made by environmental and social specialists might be biased, again affecting empirical results, even though these judgments might be based in part on measurable indicators.
We address these identification issues by using instrumental variables (IV) estimation. We use two country-level variables as sources of exogenous variation in the ESG rating: (i) a measure quantifying a country’s environmental performance; and (ii) the presence of the country as a member on the United Nations Security Council. We show that both these variables are highly significant determinants of project level ESG ratings—satisfying the relevance criterion—and argue that neither would be plausibly correlated with firm-level profitability—satisfying the exclusion condition.
The importance of correcting for endogeneity and measurement error is borne out by the empirical analysis. A simple ordinary least squares (OLS) shows a significant positive correlation between ESG and profitability, but this finding is not robust to our IV strategy.
We find no adverse causal link from ESG to lower profits (the principal concern of developing countries mentioned above). Conversely, however, there is no evidence that better ESG performance at the firm level causes improved financial performance. Moreover, there is limited evidence that both ESG and profitability independently contribute toward broader private sector development in the industry as a whole. One caveat: our project-level data usually only extend for two or three years, so we cannot explore how time lags may impact the ESG/profitability relationship.1 Furthermore, we based our data set on clients of the International Finance Corporation, who have gone through several rounds of due diligence processes, and therefore our sample may not be representative of all firms in a country.
We draw two policy implications for the nature of public-private cooperation in developing countries from this analysis. First, there is evidence that individual firm activity can make markets in developing countries work better through improved competition, demonstration effects of a profitable business model that may not have been tried before in that context, or by spurring sectorwide policy, legal, or regulatory reforms. This suggests that commercial business activities can have a developmental impact beyond firm-level profits, providing a potential rationale for public intervention and the blending of public and private funds.
Second, we also find that ESG performance, by itself, can encourage firms to undertake activities that contribute to sustainable development, without noticeable harm to individual firms. Because there does not appear to be a financial incentive for firms to undertake ESG improving activities, governments may need to tilt incentives through regulatory requirements, or condition funding, technical assistance, or capacity building programs on ESG performance.
We find, additionally, no evidence to suggest that financial returns depend on geography or on the income level of the country. This finding has implications for portfolio adjustments (e.g., toward low-income countries), suggesting that such changes may be possible without foregoing financial returns. This conclusion, however, does not take into account any difference in origination costs that a company may incur in different regions. It is possible that these differ markedly across regions and in terms of size of the investment made. Finally, we find domestic financial sector investments tend to be more profitable than real sector investments, but real sector investments tend to have a greater impact on broad private sector development. If both profitability and sustainable development are objectives, then a balanced portfolio of financial and real sector investments will be needed.
Report Produced by Global Economy and Development
- By contrast, studies that focus on the ESG/stock price relationship implicitly factor in long-term impacts, as the stock price represents the discounted sum of all future profits. The short- to medium-term nature of our analysis is an inevitable limitation.