Master Thesis Proposal - scripties.uba.uva.nl

MIF 2016 Master Thesis

Impact of Sustainability factors on cost of equity of the firm

University of Amsterdam

Amsterdam Business School, MIF

August 2016

Pinzhao Wang 10996435

Supervisor: Dr. Jens Martin

MASTER THESIS MIF 2016 August


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Table of Contents

1 Abstract......................................................................................................................................... 2

2 Introduction .................................................................................................................................. 2

2.1 Rationale for conducting this study....................................................................................... 5

3 Literature Review .......................................................................................................................... 7

3.1 Sustainability investment and social and ecological system ................................................. 9

3.2 Shareholder v.s Stakeholder theory .................................................................................... 11

3.3 Doing good, doing well ........................................................................................................ 13

4 Data and Hypothesis ................................................................................................................... 14

4.1 Association of financial sustainability performance on cost of equity ................................ 14

4.2 Association of ESG sustainability performance on cost of equity ....................................... 16

4.3 Interaction between financial and ESG performance, and association with cost of equity 19

5 Methodology .............................................................................................................................. 21

5.1 Picking independent variables ............................................................................................ 21

5.2 Data processing ................................................................................................................... 24

5.3 Forming models .................................................................................................................. 24

5.4 Model testing ...................................................................................................................... 25

6 Empirical result ........................................................................................................................... 25

7 Robustness Check ....................................................................................................................... 26

8 Discussion ................................................................................................................................... 27

9 Limitation of this study ............................................................................................................... 30

10 Bibliography ............................................................................................................................ 31



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1 Abstract Sustainable investment and impact investment has emerged as the theme of the 21st century (Anthony

C. Ng, 2015). This study is to find out whether and how different sustainability driven measurements,

both from economic and environmental, social and governance (ESG) aspects, affect cost of equity of

the firm, individually and in aggregate. By following (Francis, 2005) (Liu, 2002), this study is using

variance of the price multiple – the industry adjusted earning-price ratio (IndEP) as the proxy for cost

of equity capital. We take the sample pf 136 listed firms for the period 2004-2014. And findings of this

study is that Economic sustainability factor is significantly positively associated with cost of equity, but

no single sub-elements of the economic sustainability measurement has individual strong association

with cost of equity. Between ESG sustainability measurements, only social score negatively correlates

to cost of equity. Financial measurements and ESG measurements interactively do not affect cost of

equity.

2 Introduction In recent years, sustainable investment practices have been increasing at a fast pace (Bauer R. K., 2005)

(Galema, 2008), (Orlitzky M. , 2013).The overall evidence suggests that the market share of sustainable

investments has been growing rapidly in recent years (Eurosif, 2012) and is further expected to increase,

as illustrated by a survey among pension fund experts (Boersch, 2010) (Timo Busch, 2016). Likewise

recent investor polls indicate the increasing relevance of sustainability for capital markets (Novethic,

2010). This trend is also reflected by the signatories of the Principles for Responsible Investment, which

increased from 100, worth US$6.5 trillion, in 2006, to 1,188, worth US$34 trillion, in 20141. These

developments are, in turn, mirrored by practices of institutional investors at the same time: some

choose to exclude companies based on Environmental, Social, and Governance (ESG) related screens,

whereas others integrate this ESG information in the overall investment decision-making process.

Moreover, many institutional investors have set up proxy voting processes and increasingly developed

engagement programs in which they discuss material ESG issues, in addition to regular issues, with

management in a public fashion—by filing shareholder proposals—or in a private fashion (Bauer R. C.,

2014) (Bauer R. M., 2012).

ESG, Ethical, Green, Impact, Mission, Responsible, Socially Responsible, Sustainable and Values are all

labels investors apply today to their strategies to consider environmental, social and corporate

governance (ESG) criteria to generate investment returns and at the same time make positive societal

1 See http://www.unpri.org/about-pri/about-pri/



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impact2. This is also so-called Socially Responsible Investing (SRI)3 which becomes increasingly popular.

One of the major forces behind the surge in such investment is increasing demand for it from

institutional and even individual investors, partly because of increasing awareness of environmental

risk (e.g. climate change) and social risk.

Some of the developments been found in 2014 according to US SIF include: Increasing conventional

investment firms are active in creating and marketing targeted products for sustainable investors. The

expansion of sustainable, responsible and impact investing is found across all asset classes. Expansion

in the issuance of “green bonds” and the continued growth in alternative investments engaging in

responsible investment. Other emerging trends are the perspectives of millennials on sustainable

investing, investment products geared towards advancing women, crowd funding as a tool for ESG

investors, and place-based investing.

According to the Global Sustainable Investment Review 2012, which is a product of the collaboration

of a variety of organizations and sustainable investment forums across the world, approximately

US$13.6 trillion of assets under professional management incorporate environmental, social or

governance considerations into the investment selection process, and includes positive and negative

screening, shareholder activism strategies, norm-based screening, best-in-class approaches and other

forms of SRI. While the criteria for an investment to be deemed socially responsible are not strict, it is

undeniable that SRI is nowadays a large and expanding segment of the financial markets4.

Sustainable investments can be broadly defined as an investment process that involves identifying

companies with high corporate social responsibility profile, where the latter are evaluated as the basis

of environmental, social and corporate governance (ESG) criteria ( (Renneboog, 2008), which implies

that investors do not primarily wish to derive financial utility from investment decision but also strive

for non-financial utility resulting from holding portfolio that are consistent with personal and societal

values (Bollen, 2007). Thus sustainable investments is regarded as a generic term for investments that

seek to contribute toward sustainable development by integrating long-term ESG criteria into

investment decisions. Meanwhile the regulators are increasingly interested in both financial economic

sustainability disclosure and non-financial ESG sustainability performance information (Kiron, 2013).

Emergence of both factors, brings new challenges and opportunities to the firms contested in the

2 Sustainable Development and Financial Markets: Old Paths and New Avenues Timo Busch, Rob Bauer, and Marc Orlitzky 3 Also referred to as Environmental, Social, and Governance Investing, Sustainable Investing and Impact Investing, though

there are some conceptual differences between these terms.

4 Socially Responsible Investment Portfolios: Does the Optimization Process Matter? 24 September 2015 https://www.researchgate.net/profile/Ioannis_Oikonomou/publication/283451820_Socially_Responsible_Investment_Portfolios_Does_the_Optimization_Process_Matter/links/56389daa08ae78d01d39d9ca.pdf

https://www.researchgate.net/profile/Ioannis_Oikonomou/publication/283451820_Socially_Responsible_Investment_Portfolios_Does_the_Optimization_Process_Matter/links/56389daa08ae78d01d39d9ca.pdf

https://www.researchgate.net/profile/Ioannis_Oikonomou/publication/283451820_Socially_Responsible_Investment_Portfolios_Does_the_Optimization_Process_Matter/links/56389daa08ae78d01d39d9ca.pdf



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fiercely competitive environment, from one hand need to catch up with the new demand from external

regulatory parties and investment communities, from the other hand, also face the risks and returns

dilemma when comes to managing relationships with shareholders and other stakeholders, meeting

the corporate social responsibilities

While it has been widely accepted that sustainability is a new way of doing business, sustainability is

not as a tangible asset can be bought and sold in the market but rather, more and more companies

incorporate sustainability as an integral part of company’s long term strategy and practice. In the same

way such as “re-engineering” or “just in time” were in 1980’s5.

Sustainability is not only playing more and more important role in individual company value creation

but also meanwhile forming increasing part of investment portfolios of individual, corporation, and

institutional investors. Risk and return, value creation are the ultimate considerations of the potential

investors in the conventional view. So how do we get better understanding of ESG factors and measure

their impact on the total value of the invested asset, in a structured and recognized way, in order to

facilitate more effective and maximum beneficial way of allocating capital?

From companies stand point, should management executives interpret their mandates as creating

maximum shareholder value which as traditionally recognized, or should they start to taking into

consideration also of other stakeholders, by engaging actively and practice more corporate social

responsibilities to follow the tide of more and more demand from regulatory parties on social

responsible practice, sustainable development principles, in order to compete with its peers who are

also facing similar challenges. Sustainability and corporate responsibility advocates claim the

shareholder value framework is not sufficient, because of its narrow focuses on financial performance,

and lacking of capture and reflect the value added by the soft element of sustainability. When

management executives interpret their mandates as creating shareholder value, measured by

Enterprise value, share price, derived from variant market methods of DCF, Earning Multiplier Models,

EVA or other traditional valuation method, the factor of sustainability seems been ignored. But from

companies’ capital allocation point of view, most of the sustainability initiatives and practices may not

seem obviously justifiable from sound business case perspective. Some appear to be pure cost such as

investment in renewable energy, investment on innovation for more efficient use of natural resources,

creating comfortable working environment for employees, etc. The trade-off between ESG

5 Environmental leader: Sustainability and its impact on brand value. 28 September 2008 http://www.environmentalleader.com/2008/09/28/sustainability-and-its-impact-on-brand-value/#ixzz46q6Rxys7

http://www.environmentalleader.com/2008/09/28/sustainability-and-its-impact-on-brand-value/#ixzz46q6Rxys7



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performance and investment returns is difficult to analyse, both theoretically and empirically, primarily

because of the multi-dimensionality of the ESG concept.

2.1 Rationale for conducting this study This study intents to find out whether and how the different sustainability factors, both from economic

and environmental, social and governance (ESG) aspects, affect cost of equity of the firm, individually

and in aggregate.

Shareholder theory suggests that the goal of the firm is to create shareholder value while protecting

the interests of all stakeholders (Freeman R. , 1984) (Jensen M. 2., 2001). The case for shareholder

value maximization was first made by General Electric’s Jack Welch in his famous 1981 speech “Growing

Fast in a Slow-Growth Economy.” It became the standard corporate management paradigm in the

1990s, however faced growing criticism after the dot-com bust, and came under even more vigorous

attack in the wake of the 2008 credit crisis6. Shareholder value creation is conventionally recognized as

the financial returns generated by the firm through engaging in positive Net Present Value NPV projects

that maximize shareholder wealth. Shareholders are the owners of the firm and management has a

fiduciary duty to act in their best interest to maximize their wealth (Shleifer, 1997). Traditional

measurement of this dimension is by looking at firm’s growth, operational efficiency, and long term

financial sustainability via research and development effort.

Stakeholder theory suggests that sustainability activities and performance enhance the long-term value

of the firm by fulfilling the firm’s social responsibilities, meeting their environmental obligations, and

improving their reputation (Eldar, 2014). Obviously it is nice to create social impact, doing good things

for the stakeholders and communities, such effort also naturally require considerable amount of

company resource allocation, which is contradicting to achieve operational efficiency in order to meet

shareholder wealth maximization objective. Apart from the monetary capital expenditures, opportunity

costs can result from managerial time and efforts spent on sustainability, the proprietary cost of

voluntary disclosure of ESG strengths and concerns can be significant if the firm reveals valuable

information such as trade secrets, information about profitable customers and markets or operating

organizational or reporting weakness to unions regulators, investors, customers, suppliers or

competitors (Leuz, 2004).

6 PwC: Sustainability valuation: An oxymoron? April 2012 http://www.pwc.com/us/en/audit-assurance-

services/valuation/publications/assets/pwc-sustainability-valuation.pdf

http://www.pwc.com/us/en/audit-assurance-services/valuation/publications/assets/pwc-sustainability-valuation.pdf

http://www.pwc.com/us/en/audit-assurance-services/valuation/publications/assets/pwc-sustainability-valuation.pdf



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Externally, Investment environment is becoming more and more leaning towards sustainable

investment and allocating increasing amount of capital into this field. Take pension fund as typical

example, rigorous screening process is imposed on investment selection, to filter out unethical,

negative social impact, and environmentally harmful projects. With regulation and compliance

environment on one side, we also see social pressure on encouraging more ethical and responsible

behaviour of the corporations. With massive capital allocation and with growing trend, we want to see

if such supply increase will decrease the cost of capital.

Thus interestingly on one side, ESG considerations create extra cost to the firms, on the other side, they

also gain the opportunity being recognized on the list of investors. So at the end how the risk and

returns profile of the firms change under the influence of such capital market shift? Can we see

companies with higher ESG ratings, which could imply that more monetary capital expenditure and

managerial effort been put into non-financial sustainability aspects, would create more value to the

firm? As market is following such trend, more intentional flow of capital goes into this area, does it

mean lower cost of capital to those ESG better compliant firms? Or non-financial sustainability

investments would just naturally mean higher cost for the firms now to maintain the same level of

overall performance, due to the fact of extra monetary cost and opportunity cost incurred by engaging

more non-financial related sustainability practices, for instance on waste management, creating

employee friendly workplaces, more complicated governance processes to integrate ESG

considerations, etc. And which implies the higher cost of capital to the firm. It could also be that the

total effect of benefit and cost at the end cancelling out each other which does not significantly impact

on the risk and returns of the firm and ultimate investors, thus neutral business case of sustainable

engagement. And this can be one of the possibilities if we don’t find significant correlations between

rating and rate of returns of the investment.

If ESG rating is positively correlated to cost of equity, thus equivalent to expected rate of return, may

we draw the inclusion that investors are willing to take additional risk which is compensated with higher

return by holding sustainable portfolios. If ESG rating is however negatively correlated to cost of equity,

due to the fact of extra effort out into meeting ESG requirements, what actually drives the increasing

interest of investors on impact investment? Or does conventional shareholder theory still hold or

investment society is leaning towards more ecological friendly consideration, and willing to sacrifices

financial returns to gain social, environmental returns?

How does financial market reflect this shift, is ESG factors fairly priced. How higher ESG rated companies

valued differently comparing to lower ESG rated companies. This study is to find out from cost of equity

angle, how the ESG factors affect the cost of equity, whether intuition of high rated ESG companies are



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superior than low ESG rated companies is true, thus carrying lower risk, and being granted with the

advantage of lower cost of equity. Is high ESG rating companies enjoying lower cost of equity because

of their high rating ESG score, or there is no correlation between level of rating and level of cost of

equity, but probably due to broad scale of promotion or marketing of sustainable investment.

The study is organized as following, Firstly we introduce both financial and non-financial dimensions of

sustainability measurements used in this study. We intent to investigate whether cost of equity is

associated with these financial or non-financial ESG dimensions of sustainability performance or both.

Secondly we examine whether Cost of equity is associated and the significance of association with

integrated financial sustainability score, then its association and significance of association with

individual different components of financial performance measurements. Thirdly, we investigate

whether different components of non-financial ESG sustainability performance lead to value creation

and affect cost of equity, and significance of its individual factor. Lastly we investigate whether the

relationship between financial sustainability measurement and cost of equity is also affected by non-

financial ESG sustainability scores and to what extent ESG interacts with financial sustainability

performance dimension when determining cost of equity.

3 Literature Review Because of the sheer size and importance of sustainable investment (Rob Bauer, 2005) the existing

literatures have ample studies in the field of responsible investment, especially the financial

consequences of investing ethically, both from investor point of view and also from company point of

view. We can see a mix picture, there are studies find that stocks reflecting on sustainability issues may

outperform the market (Derwall, 2005) underperform the market (Chong, 2006) or show no clear or

detectable link in terms of firms’ share price performance (Bauer R. D., 2007). One common conclusion

is that, at the very least, there is no clear indication of a negative relationship, or trade-off, between

corporate social/environmental performance and corporate financial performance (Margolis, 2003)

(Mercer., 2009) (Mercer, 2007). There some of the studies take the approach from performance of

portfolio point of view, some studies were from individual company stock performance point of view.

Some examples of those literatures are as following.

(Rob Bauer, 2005 ) Rob Bauer studied the performance of portfolio consists of sustainable company

stocks. After controlling for investment style, he found no evidence of significant differences in risk-

adjusted returns between ethical and conventional funds. Their results also suggest that ethical mutual



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funds even underwent a catching up phase, before delivering financial returns similar to those of

conventional mutual funds.

(Henke, 2016) Henk’s study performed in 2015, measures the financial impact of screening for

environmental, social and governance (ESG) criteria on corporate bond portfolios. Specifically, risk-

adjusted financial performance of 103 US and Eurozone socially responsible bond funds is compared

with a matched sample of conventional funds. The study found socially responsible bond funds

outperform by half a percent annually. An evaluation of fund holdings and a performance attribution

analysis suggest that this outperformance is directly related to the exclusion of corporate bond issuers

with poor corporate social responsibility (CSR) activities.

The study of Hamilton (Hamilton, 1993) found that socially responsible mutual funds do not earn

statistically significant excess returns comparing to conventional mutual funds. Thus socially

responsible investing does not add or destroy value in terms of risk-adjusted return, because corporate

social responsibility is not priced correctly by the markets.

Moskowitz (Moskowit, 1972) conducted a study to compare socially responsible stocks with market

index and found that socially responsible companies outperforms the market.

Herriman’s study (Irene M. Herremans, 1993) found positive association between reputation for CSR

and accounting measures of profitability and stock market returns.

(Benjamin R. Auer, 2015) Benjamin’s study analyses the performance of socially (ir)responsible

investments in the Asia-Pacific region, the United States and Europe. And the analysis delivered the

insight that regardless of geographic region, industry or ESG criterion, active selection of high- or low-

rated stocks does not provide superior risk-adjusted performance in comparison to passive stock

market investments.

(Timo Busch, 2016) Study of Timo explores the role of financial markets for sustainable development.

More specifically, triggers the thought of till what extent financial markets foster and facilitate more

sustainable business practices. Two main challenges were identified within the field of sustainable. First,

a reorientation toward a long-term paradigm for sustainable investments is important. Second, ESG

data must become more trustworthy.

(Anthony C. Ng, 2015) Anthony in the study performed in 2015 find that financial sustainability

performance and ESG is negatively associated with cost of equity, but only growth and research

(environmental and governance) sustainability performance dimensions contribute to this relationship.

Operation efficiency is positively, while social sustainability performance is only marginally, related to



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cost of equity. Study also finds that ECON and ESG sustainability performance interactively affect cost

of equity, which means the relationship between ECON (ESG) and cost of capital is strengthened when

ESG (ECON) performance is strong.

For this study, we will follow the philosophy of Timo (Timo Busch, 2016), to define the scope of business

sustainability under our considerations. We are inspired by Anthony and Benjamin (Anthony C. Ng, 2015)

(Benjamin R. Auer, 2015) with their take on looking at corporations responsibilities under shareholder

theory and stakeholder theory. At the end we follow the methodology applied by Anthony to form our

test model and hypothesis testing.

3.1 Sustainability investment and social and ecological system With philosophy of Timo (Timo Busch, 2016), sustainable investment is viewed from broader term in

this study, not only to consider its financial performance, but also whether the initial intention of

sustainable investment, which is to create impact on ecological system and human-social system has

delivered results. Thus two main challenges were identified by Timo’s study, when comes how to help

sustainable investment enter new avenues. First is a reorientation toward a long-term paradigm for

sustainable investments is important, with this stand the ESG factors should be looked at associating

with cost of equity from long time horizon. Second challenges been identified is that ESG data must

become more trustworthy.

From financial market perspective, how it has foster and facilitate more sustainable business practice

has been questioned. On one hand financial market participants increasingly integrate ESG criteria into

their investment selection and decision making, whereas on the other hand, in terms of organizational

reality, there seems no real shift toward more sustainable business practices, which is opposite to what

was intended and is expected. With financial market sentiment and flow of massive capital into

sustainable practice, business practices are expected to become more ecologically and socially

sustainable. Evidences gathered by Timo however, including some estimates by WWF 2010, (WWF,

2010) that, the human ecological footprint exceeds the Earth’s capacity by 50% to sustain life, while

the global resource consumption and carbon dioxide emission are still growing. Similarly, on the social

dimension, at least on a global scale, problem remain, as many observers note. For example, the world

is very likely to fail to meet several Millennium Target by 2015 (Nations, 2013). This factors raised the

question of whether sustainable investment are fact a myth (Entine, 2003).

In order to achieve a self-sustainable system, the economic dimension cannot be omitted. Profitability

is central in allocating resources efficiently, and thus to sustain economic and business systems. Under



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this context, corporate governance aspects have also been suggested to be relevant (Berrone, 2009)

(Cogan, 2006) (Cremers, 2007).

According to Timo (Timo Busch, 2016), some studies in this subject field also pointed out that currently

available ESG data often lack reliability and validity (Griffin, 1997) (Mattingly, 2006) (Orlitzky M. &.,

2012). The general untrustworthiness of ESG data can be summarized as following: Firstly, rating

agencies appear to disagree on the meaning and scope of CSR (Orlitzky M. &., 2012) (Chatterji, 2009).

Secondly, CSR assessments have been found to be influenced more by organizational rhetoric than

concrete action (Cho, 2012). Thirdly firms have been found to be socially responsible and irresponsible

at the same time (Strike, 2006). Such well-founded concerns on ESG data trustworthiness, makes

overall evaluation of corporate social responsibility problematic, and also makes the shift towards long-

term paradigm challenging. Practitioners have been started to address this shortcoming. For instance,

Goldman Sachs7 (2011) developed an assessment framework and named GS SUSTAIN Focus list to

incorporate ESG criteria into stock picking process. Apart from traditional investment metrics, such as

return on capital and company’s industry positioning, the assessment process converts a set of ESG

criteria (depending on particular industry characteristics) into quantitative scores. Although such an

approach may probably be considered current best practice, the choice and weighting of ESG criteria

still remains largely arbitrary.

Despite the finding of shortcoming of ESG data. From theoretical point of view, potential market

consequences of using ESG investment criteria could be as following. Firstly, investors intent to achieve

superior financial returns by relying on ESG criteria. When the social environment imposes new

constraints and offers new opportunities, firms need to sufficiently respond to sustainability challenges

in order to compete with its peers (Busch, 2011) (Orlitzky M. , Payoffs to social and environmental

performance., 2005) (Hart, 1999). Such changes in the business environment can affect business risk,

opportunities, and ultimately firms’ competitive advantage, according to some studies (Orlitzky M. ,

2001) (Orlitzky M. , 2008) (Orlitzky M. &., 2001) (Orlitzky M. S., 2008). This situation has led certain

investors to start examining a focal firm’s ESG criteria reflecting a company’s broader competitive

advantage by applying a number of soft nonfinancial criteria. Next, consequential investors seek to

influence firms by directing their investments to more sustainable firms. (Waygood, 2011) Waygood

argues that capital markets may influence firms in their sustainability efforts in two principal ways: via

financial influence and investor advocacy influence. The former refers to the fact that the cost of capital

for listed companies is determined by the buying and selling of equity shares and debt. Moreover, many

institutional investors motivate their activities in the field of sustainable investing by stating that

7 Goldman Sachs, GS SUSTAIN, http://www.goldmansachs.com/our-thinking/archive/gs-sustain-2011/



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sustainable firms will have higher stock returns. This expectation has led to many best-in-class portfolios

as well as many ESG-based strategies in institutional investing 8 . However, meanwhile we should

question is whether security prices already reflect the material ESG-relevant information. Some

research shows that markets have difficulties with pricing intangible information (Edmans, 2011)

(Gompers, 2003). But other studies show that the market has already picked up some of this

information (Bauer R. &., 2014) (Chava, 2014).

Next to the concern over the trustworthiness if current ESG data, Timo also pointed out that current

ESG information is backward looking, however for investment portfolio management, investors should

be more forward looking, which also trigger us to think whether current method of ESG measurement

can give full insight on the expected performance of the portfolio and if no and how we can integrate

this perspective into current measurement system. At the meantime, sustainability investment

strategies need to be reflected in strategic asset allocation following current global scale trends, which

affecting the risk and returns across asset classes (Garz, 2011).

3.2 Shareholder v.s Stakeholder theory Adopting Corporate Social Responsibility (CSR) by corporations has becomes a global trend 9, which can

be either driven by voluntary initiative to integrate it into business strategy, or can be under the

pressure from regulatory bodies to adapting triple line reporting 10, and could also be driven by

monitoring and reports by Non- Governmental Organizations (NGO’s)11.

The long debating questions related to this trend are around the responsibility of the corporation.

Should corporation only serve the interest of shareholders by creating maximum shareholder value or

should corporation also take into account of interests of other stakeholders. Having a good

understanding of both theories, is relevant to our study of the effect of ESG ratings on cost of equity,

baring the thoughts that this could influence how the investors and the markets perceive and evaluate

the performance of the firm and price the stock. Are they just taking into financial performance aspects

into scope (shareholder theory) or also taking into account of non-financial (ESG) performance

(stakeholder theory)?

8 Timo Busch, R. B. (2016). Sustainable Development and Financial Market: Old path and New Avenues. Business and Society. 9 Global directory of information resources on CSR, where a lot of corporations register their CSR reports: www.corporateregister.com. 10 Reporting initiatives: General Reporting Initiatives (GRI): www.globalreporting.org. 11 Best practices guidelines, Organisation for Economic Co-operation and Development (OECD), www.oecd.org. Stop Child Labor report and statistics: www.stopchildlabor.org Environmental pollution website by United Nations at www.un.org Consumer safety: US Product Safety Commission at www.cpsc.gov.

http://www.oecd.org/

http://www.stopchildlabor.org/

http://www.un.org/



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According to shareholder theory, corporation has the primary goal of maximize the wealth of

shareholders only. As proponent of shareholder theory, Friedman (Friedman, 1970) argued that:

“ (…)there is one and only one responsibility of business - to use its resources and engage in activities

designed to increase its profits so long as it stays within the rules of the game (…)”

Under such theory, management of the corporation act as agent of shareholders to execute only

positive NPV projects for the company and with the ultimate and with the only goal is to maximize

wealth of the shareholders. So the activities which are the interest of other stakeholders, and incurs

extra cost and decrease profitability should not be undertaken.

This theory is based on the principle-agent model. Where corporation nowadays is characterized by

separated ownership and control. The managers are the agents who are hired by the owner of the

corporation to direct the business in accordance to their interests, which means that managers have

the only primary task to maximize the profits of the shareholders of the corporation, because profit

maximization is the only primary interest of the shareholders. However agency problem (Jensen M. C.,

1976) was also pointed out along with this model. Agency problem means the conflicts of interests

between the managers and the shareholders of the corporation. Such problem exists when managers

are believed to some extent pursue their own interests instead of the interests of the shareholders and

what serves the best for the corporation. So from the point of view of Friedman, managers who are

pursuing social goals at the expense of corporate profits are drifting away from their primary duty and

destroying shareholder wealth.

On the other hand, stakeholder theory notes: there are other groups to whom the corporation is

responsible in addition to shareholders. It was first formulated by Stanford Research Institute in

California in the early 60’s12. And a stakeholder in an organization is defined as “any group or individual

who can affect or is affected by the achievement of the Organisations objectives (Freeman E. R., 1983).”

And as pointed out by Jone (Jones, 1995) that stakeholder theory had become the paradigm for the

business and society field, and is useful to assess social and economic performance of the corporation

(Clarkson, 1995). Stakeholders include investors, employees, customers, suppliers, governments, local

communities, etc. and can be further categorized into primary and secondary stakeholders (Freeman

E. R., 1983). Primary stakeholder groups are the ones critical to the survival of the company, and include

investors, employees, customers, suppliers, governments, and communities. Secondary stakeholder

groups influence or are influenced by the corporation, but they are not as critical as primary

stakeholders to the survival of the companies. By judging the relative power and interest of the various

12 Origin of formulation of stakeholder concept: https://tamplc.wordpress.com/2013/09/20/the-origins-of-the-stakeholder-concept/

https://tamplc.wordpress.com/2013/09/20/the-origins-of-the-stakeholder-concept/



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stakeholder groups the company should take into account their stake when develops and adopts

corporate policies and strategies (Freeman E. R., 1983). (Jensen M. C., 2002 ) Jensen noted that good

stakeholder management is necessary to create long term firm value, and maximizing firm value as well

as engaging on voluntary activities that result in the achievement of ESG sustainability performance

that concerns all stakeholders, enhances social welfare in the long-run.

3.3 Doing good, doing well Under consideration of above elaborated theories and difference stands taken by academia studies,

we like to now turn into the investors and markets side, to take a look how their behaviours

corresponding to such factors, and whether and how ultimately markets evaluate and reflect such

information.

As sustainable investment is becoming more and more popular, and stakeholder concept has also been

gradually implemented by the corporations. It is interesting to see how such phenomenon impact the

economic performances. There are many studies conducted to search the impact, and the results of

the studies give however different pictures. Some of them revels that there is positive relationship

between ESG and financial performance (Eichholtz, 2012), underlying argument (“Doing good while

doing well” (Anthony C. Ng, 2015)) is that high financially performing companies would have vacant

company resource to promoting social responsible initiatives, for instance, create better workplace for

the employees, improving customer experiences, which in turn would lead to stronger employee

performance, customer loyalty, and contribute to higher financial performance. In such way, higher

rated ESG stocks is corresponding to higher expected return. On the other hand, some studies revel

opposite findings, (Posner, 1992) (Aupperle, 1985), and the underlying argument (“Doing good but not

doing well” (Anthony C. Ng, 2015)) is socially responsible initiative consumes extra company resources,

which putting the firm in a relatively disadvantage position comparing to its peers who conduct less

social responsible activities, which view is more matching with shareholder theory. Lastly, some studies

report no correlation between level of expected return of the stock and its social responsible

performance, and stated that this is conforming financial framework as ESG factors are not proxies for

risk, and do not affect expected returns, thus preference of socially responsible investors towards

sustainable stock does not reduce cost of capital. (Hamilton, 1993)

Next, we take a look at sustainable investor communities. Timo (Timo Busch, 2016) pointed out that

Investors are not necessarily homogeneous, and their consideration of ESG criteria also depends on the

investors’ different objectives and can varies by asset class. Motivation of some investor to

incorporating ESG stocks is from the perspective of optimizing total returns and risks of the portfolio,



14

motivation of others can be from the strategic goal of contributing to more sustainable environment,

and at the meantime, some large pension funds can be bound by legislation, or social pressure to

exclude unethical companies.

According to study of Derwall (Derwall J. K., 2011.), we categorize social responsible investors into three

groups. First group is Value driven, who have the main interest in non-financial utilities, and willing to

compensate the extra cost of maintaining high ESG performance with financial loss. Ultimate side of

this group of investor is like philanthropist who seeks to promote the welfare of others, by donating

money for free. The second group is responsible profit seekers, who have the interest in non-financial

utilities, and want to contribute on the sustainable practices, but also gain financial returns from it,

which can be derived equivalently from conventional portfolio. The last group of investors are

irresponsible profit seekers, as this group of investors are purely interested in financial returns, thus it

makes no difference for them whether to pick sustainable stocks or conventional stocks as long as

financial return is delivered, so they are not purposely picking sustainable stocks.

4 Data and Hypothesis Samples used for this study are downloaded from Datastream. We took initially the complete market

data set including in total global 5361 firms which have ESG records from year 2000 to year 2015. After

adding data records of different variables13 used for building hypothesis and equation, large portion of

the sample firms had to be eliminated due to lacking of data records for them, and for the same reason,

time frame used for this study has been shortened. Sample size of the firms used for this study thus at

the end contains 136 firms with complete datasets available for this research. Meanwhile the time

period under study had been refined to year 2004-2014.

4.1 Association of financial sustainability performance on cost of equity Following the methodology of (Anthony C. Ng, 2015), the first hypothesis to be tested here is the

association between financial sustainability and stock cost of equity. The study is to look for the

correlation between costs of equity at time t, with independent variables at time t-1. The data is

arranged as panel data, and we run panel regression with fixed intersection. Explained variable is cost

of equity, explanatory variables here are economic score, Tobin’s Q, Price to book, ROE, sales growth,

Research and development, beta, Liquidity, Leverage, and size.

13 Definition and rational of choosing individual variables will be mentioned below.



15

We want to see if there is significant correlation between

Overall economic score with cost of equity (hypothesis 1)

Growth factor (Tobin’s Q, Price to Book) with cost of equity (Hypothesis 1a)

Operation efficiency (ROE & Sales Growth) with cost of equity (Hypothesis 1b)

Research and development effort with cost of equity (Hypothesis 1c)

Our basic model used to test the effect of financial sustainability and cost of equity, which is a lead-lad

regression after controlling for company and year effects. We include both the general financial

sustainability score (economic score), and also the individual elements playing part of financial

sustainability, such as Growth, operational efficiency, and research and development, which we

consider as critical factor to maintain financial sustainable.

Equation applied to test the correlation is as following:

Cost of equity it = c + β1 *economic_scoreit-1 + β2 * tobin_s_qit-1 + β3 * price_to_bookit-1 + β4 * roeit-1 +

β5 * sales_growthit-1 + β6 * rnd01it-1 + β7 * beta_1it-1 + β8 * LIQit-1+ β9 * LEVit-1 + β10*sizeit-1 + errorit

i represents cross-sectional dimension which is the country and

t represents time in years

(1) Hypothesis 1: There is no significant association between cost of equity and financial sustainability

performance

(2) Hypothesis 1a, There is no significant association between cost of equity and financial sustainability

performance related to growth opportunities

(3) Hypothesis 1b, There is no significant association between cost of equity and financial sustainability

performance related to operational efficiency

(4) Hypothesis 1c, There is no significant association between cost of equity and financial sustainability

performance related to long term orientation-research and development

Finding: results (Table 1)show that Economic score, is positively correlated to cost of equity, which is

consistent with prior research. However we find that none of the rest of individual control variables has

significant correlation with cost of equity, which is contradicting with some of the research findings,

such as (Hou, 2012) (Anthony C. Ng, 2015) whose study find negative correlation between beta and

cost of equity, and (El Ghoul, 2011) whose study finds positive correlation between beta and cost of

equity.



16

4.2 Association of ESG sustainability performance on cost of equity To test the association between ESG performances with cost of equity, we first add individual E, S, G

factor into previous basic model, with control factor of economic score, and other variables included in

Table 1:

Effect of financial sustainability on cost of equity

Variable (1) (2) (3) (4)

Dependent variable: Cost of equity

N = 1397

ECONOMIC_SCORE(-1) 0.00006

(0.00001)***

TOBIN_S_Q(-1) 0.00002

(0.00033)

PRICE_TO_BOOK(-1) 0

(0.00001)

ROE(-1) 0.00002

(0.00001)

SALES_GROWTH(-1) 0.00301

(0.00157)

RND01(-1) 0

(0)

BETA_1(-1) -0.00006 -0.00005 -0.00004 -0.00005

(0.00004) (0.00004) (0.00004) (0.00004)

LIQ(-1) 0.00006 0.00009 0.00008 0.00009

(0.00011) (0.00011) (0.00011) (0.00011)

LEV(-1) -0.00576 -0.00658 -0.0068 -0.00667

(0.00327) (0.00344) (0.0033) (0.0033)

SIZE(-1) -0.00041 0.00007 0.00001 0.00007

(0.00042) (0.00041) (0.00041) (0.00041)

Significane Level: 10% = *, 5% = **, 1% = ***

This table shows the results of regression of cost of equity on a set of financial sustainability measurements. Column (1)

shows the result of hypothesis (1) which tests the association between average financial sustainability score and cost

of equity. Column (2) shows the result of hypothesis 1a, which tests the association between growth opportunity and

cost of equity. Column (3) shows the result of hypothesis 1b, which tests the association between operational efficiency

and cost of equity. Column (4) shows the result of hypothesis 1c, which test the association between long-term

orientation effort and cost of equity.

Cost of equity it = c + β1 *economic_score(it-1) + β2 * tobin_s_q(it-1) + β3 * price_to_book(it-1) + β4 * roe(it-1) + β5 *

sales_growth(it-1) + β6 * rnd01(it-1) + β7 * beta_1(it-1) + β8 * LIQ(it-1)+ β9 * LEV(it-1) + β10*size(it-1) + errorit



17

the 4.1 equation, to test the correlation between individual factor and cost of equity. Then we add

them at the same time to conduct the test to see if and how the correlation might change.


β5 * sales_growthit-1 + β6 * rnd01it-1 + β7 * beta_1it-1 + β8 * LIQit-1+ β9 * LEVit-1 + β10*sizeit-1 + β11 *

environmentalit-1 + β12 * corp_gov_it-1 + β13 * social_scoreit-1 + errorit

(5) Hypothesis 2. There is no significant association between cost of equity and environmental, social

and governance (ESG) sustainability performance

(6) Hypothesis 2a, there is no significant association between cost of equity and environmental

performance.

(7) Hypothesis 2b, there is no significant association between cost of equity and social performance.

(8) Hypothesis 2c, there is no significant association between cost of equity and corporate governance

performance.

Our finding shows (Table 2), that contradicting to what some studies such as (Anthony C. Ng, 2015)

found, we could not see significant correlation, either positive, nor negative between E(environmental),

G (Corporate Governance Score) and cost of equity. And opposite to Anthony found, our model test

shows significant negative correlation between S (Social score) and cost of equity, both as one individual

factor adding to the equation, and as one of ESG factors when adding to the equation.



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Table 2:

Effect of ESG sustainability on cost of equity

Variable (5) (6) (7) (8)


N = 1397

ECONOMIC_SCORE(-1) 0.00008 0.00006 0.00008 0.00006

(0.00001)*** (0.00001)*** (0.00001)*** (0.00001)***

TOBIN_S_Q(-1) -0.00035 -0.0003 -0.00041 -0.00029

(0.00035) (0.00035) (0.00034) (0.00034)

PRICE_TO_BOOK(-1) -0.00002 -0.00002 -0.00002 -0.00002

(0.00002) (0.00002) (0.00002) (0.00002)

ROE(-1) 0.00003 0.00003 0.00003 0.00003

(0.00002) (0.00002) (0.00002) (0.00002)

SALES_GROWTH(-1) 0.00223 0.00241 0.00209 0.00252

(0.00157) (0.00157) (0.00156) (0.00156)

RND01(-1) 0 0 0 0

(0) (0) (0) (0)

BETA_1(-1) -0.00004 -0.00005 -0.00005 -0.00005

(0.00004) (0.00004) (0.00004) (0.00004)

LIQ(-1) 0.00009 0.00006 0.00009 0.00006

(0.00011) (0.00011) (0.00011) (0.00011)

LEV(-1) -0.00587 -0.00647 -0.00575 -0.0065

(0.00342) (0.00343) (0.00342) (0.00342)

SIZE(-1) -0.00022 -0.00036 -0.0002 -0.00028

(0.00044) (0.00043) (0.00042) (0.00044)

ENVIRONMENTAL(-1) 0.00002 -0.00001

(0.00002) (0.00001)

SOCIAL_SCORE(-1) -0.00006 -0.00005

(0.00002)*** (0.00002)***

CORP_GOV_(-1) -0.00001 -0.00002

(0.00002) (0.00002)


This table shows the results of regression of cost of equity on a set of ESG sustainability measurements. Column (5)

shows the result of hypothesis 2, which tests the association between combined ESG sustainability score and cost of

equity. Column (6) shows the result of hypothesis 2a, which tests the association between environmental performance

and cost of equity. Column (7) shows the result of hypothesis 2b, which tests the association between social score and

cost of equity. Column (8) shows the result of hypothesis 2c, which test the association between corporate governance

score and cost of equity.

Cost of equity it = c + β1 *economic_score(it-1) + β2 * tobin_s_q(it-1) + β3 * price_to_book(it-1) + β4 * roe(it-1) + β5 *

sales_growth(it-1) + β6 * rnd01(it-1) + β7 * beta_1(it-1) + β8 * LIQ(it-1)+ β9 * LEV(it-1) + β10*size(it-1) + β11 *

environmental(it-1) + β12 * corp_gov_(it-1) + β13 * social_score(it-1) + errorit



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4.3 Interaction between financial and ESG performance, and association with cost of

equity We use following equation to explore the interactive effect of Economic score and ESG on cost of equity.

Specifically, we are testing if ESG sustainability performance has any effect on relationship between

financial sustainability and cost of equity, both individually and in combination.

We add each single ESG factor in to the equation to test their individual effect on the relationship

between economic score and cost of equity, and at the last include three of them at same time into the

equation to test their combined effect on the correlation between economic score and cost of equity.


β5 * sales_growthit-1 + β6 * rnd01it-1 + β7 * beta_1it-1 + β8 * LIQit-1+ β9 * LEVit-1 + β10*sizeit-1 + β11 *

environmentalit-1 + β12 * corp_gov_it-1 + β13 * social_scoreit-1 + β14 * economic_scoreit-

1*environmentalit-1 + β15 * economic_scoreit-1*corp_gov_it-1 + β16 * economic_scoreit-1*social_scoreit-

1 + errorit

(9) Hypothesis 3. The association between cost of equity and financial sustainability performance is

not affected by ESG sustainability performance

(10) Hypothesis 3a. The association between cost of equity and financial sustainability performance is

not affected by environmental sustainability performance

(11) Hypothesis 3b. The association between cost of equity and financial sustainability performance is

not affected by social sustainability performance

(12) Hypothesis 3c. The association between cost of equity and financial sustainability performance is

not affected by corporate governance sustainability performance

Test results tell us that (Table 3), in each model, we can see social sustainability has negative effect on

cost of equity, which is consistent with the findings we had from last two models. At the same time,

contradicting to what other literatures ( (Anthony C. Ng, 2015) found, we did not see any significant

correlation between financial sustainability factor and cost of equity, nor between environmental score,

corporate governance score and cost of equity respectively. We also did not see significant effect of

any of ESG factors on the correlation between economic score and cost of equity.



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Table 3:

Effect of interaction between financial and ESG sustainability on cost of equity

Variable (9) (10) (11) (12)


N = 1397

ECONOMIC_SCORE(-1) 0.00004 0.00007 0.00005 0.00005

(0.00004) (0.00003) (0.00003) (0.00003)

TOBIN_S_Q(-1) -0.00035 -0.00035 -0.00032 -0.00034

(0.00036) (0.00036) (0.00035) (0.00035)

PRICE_TO_BOOK(-1) -0.00002 -0.00002 -0.00002 -0.00002

(0.00002) (0.00002) (0.00002) (0.00002)

ROE(-1) 0.00003 0.00003 0.00003 0.00003

(0.00002) (0.00002) (0.00002) (0.00002)

SALES_GROWTH(-1) 0.00232 0.00223 0.00229 0.00226

(0.00157) (0.00157) (0.00157) (0.00157)

RND01(-1) 0 0 0 0

(0) (0) (0) (0)

BETA_1(-1) -0.00004 -0.00004 -0.00004 -0.00004

(0.00004) (0.00004) (0.00004) (0.00004)

LIQ(-1) 0.00008 0.00009 0.00008 0.00008

(0.00011) (0.00011) (0.00011) (0.00011)

LEV(-1) -0.00568 -0.00587 -0.00578 -0.00582

(0.00343) (0.00343) (0.00342) (0.00342)

SIZE(-1) -0.00019 -0.00022 -0.00024 -0.00021

(0.00045) (0.00045) (0.00045) (0.00044)

ENVIRONMENTAL(-1) 0.00007 0.00002 0.00002 0.00002

(0.00004) (0.00003) (0.00002) (0.00002)

CORP_GOV_(-1) -0.00004 -0.00001 -0.00001 -0.00005

(0.00003) (0.00002) (0.00002) (0.00003)

SOCIAL_SCORE(-1) -0.00012 -0.00006 -0.00009 -0.00006

(0.00005) (0.00002)*** (0.00003)*** (0.00002)***

ECONOMIC_SCORE(-1)*ENVIRONMENTAL(-1)

ECONOMIC_SCORE(-1)*CORP_GOV_(-1)

ECONOMIC_SCORE(-1)*SOCIAL_SCORE(-1)


This table shows the results of regression of cost of equity on a set of financial and ESG sustainability measurements, and focus on

the interaction between those factor. Column (9) shows the result of hypothesis 3, which tests the impact of interaction between

overall ESG sustainability score on the association between financial sustainablity performance and cost of equity. Column (10)

shows the result of hypothesis 3a, which tests the impact of interaction between Environmental sustainability score on the

association between financial sustainablity performance and cost of equity. Column (11) shows the result of hypothesis 3b, which

tests the impact of interaction between social sustainability score on the association between financial sustainablity performance and

cost of equity. Column (12) shows the result of hypothesis 3c, which test impact of interaction between corporate governance

sustainability score on the association between financial sustainablity performance and cost of equity.

Cost of equity (it) = c + β1 *economic_score (it-1) + β2 * tobin_s_q (it-1) + β3 * price_to_book (it-1) + β4 * roe(it-1) + β5 *

sales_growth(it-1) + β6 * rnd01(it-1) + β7 * beta_1(it-1) + β8 * LIQ(it-1)+ β9 * LEV(it-1) + β10*size(it-1) + β11 * environmental(it-1) + β12

* corp_gov_(it-1) + β13 * social_score(it-1) + β14 * economic_score(it-1)*environmental(it-1) + β15 * economic_score(it-

1)*corp_gov_(it-1) + β16 * economic_score(it-1)*social_score(it-1) + errorit



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In conclusion, we find in 4.1 and 4.2 that economic score has significant positive correlation with cost

of equity. And from 4.2, we find Social factor has negative correlation with cost of equity. And 4.3 tells

us that social factor has negative correlation with cost of equity. And from 4.3, we did not find any

interaction effect of economic score and ESG factors associated with cost of equity, however consistent

with 4.2, we still find negative correction between social score and cost of equity.

5 Methodology We started our study with defining the scope. After defining the scope, we decide on the relevant

independent variables based on theories and massive amount of literatures review. We use Datastream

as the source for out data generation. Then based on the availability of the dataset, we narrowed down

to the sample size, and time period under this study.

5.1 Picking independent variables After large quantity of literature review, we decided to have the scope of our sustainability

measurement covering both the financial aspects of the company, and also the ESG aspects of the

company. The reason behind this scope definition is that business sustainability is long term effort. As

business is surviving on making profit and maximize shareholders’ value, financial sustainability should

always be the consideration for companies aiming for long term existence, ie. Financially sustainable,

ESG factors should be running parallel next to financial sustainability, as taking stakeholder theory view,

business existence is not purely for money making purpose but also practice its social responsibilities

as one of the stakeholders in the society. As corporate responsibilities got more and more demanded

and prompted by the regulators and also by the society, companies head for long term development

cannot narrow itself only on profit-making, but also actively adapt and practice more social

responsibilities.

For Corporate responsibility variables we take the widely adopted measurement ESG factors (E, S, G).

For financial sustainability consideration, we take the conventional view of how enterprise value is been

determined. Factors taken into calculation of enterprise value are FCF, Growth factors and cost of

capital (WACC). Cost of capital (WACC) is measured by weighted cost of debt and equity, thus is treated

as linked to our dependent variable cost of equity. FCF is mainly driven by operational efficiency and

profitability, which we use ROE, sales growth, as representative measurement of FCF generating power

(definition, and measurement of each variables can be found in corresponding section). Growth aspect

of financial sustainability, are been presented by the variables of price to book ratio, and Tobin’s Q.



22

Long term investment effort is been represented by the variable R&D expenditures. Economic score is

used as the average score measuring the overall financial sustainability performance.

Table 4 Definitions of Variables

Name of Variables Definition of variables

Adjusted_indep

Industry adjusted EP ratio, which is used as proxy for cost of equity, it is calculated as the difference between the firms's EP ratio and the median industry EP ratio in year t.

beta_1

beta_1, here is calculated based on CAPM model, using stock returns of the company correlation with market premium.Measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns.

Corporate Governance Score

The corporate governance pillar measures a company's systems and processes, which ensure that its board members and executives act in the best interests of its long term shareholders. It reflects a company's capacity, through its use of best management practices, to direct and control its rights and responsibilities through the creation of incentives, as well as checks and balances in order to generate long term shareholder value.

Economic Score

Is used as variable as financial sustainability meansurement. The economic pillar measures a company's capacity to generate sustainable growth and a high return on investment through the efficient use of all its resources. It is reflection of a company's overall financial health and its ability to generate long term shareholder value through its use of best management practices.

Environmental Score

The environmental pillar measures a company's impact on living and non-living natural systems, including the air, land and water, as well as complete ecosystems. It reflects how well a company uses best management practices to avoid environmental risks and capitalize on environmental opportunities in order to generate long term shareholder value.

EP Ratio Is calculated as 1/PE ratio



23

General Industry Classification

This item represents the company's general industry classification. It is defined as follows: 01) Industrial 02) Utility 03) Transportation 04) Bank/Savings & Loan 05) Insurance 06) Other Financial

LEV Ratio of total debt to tal assets in year t

LIQ

Liquidity measure, equals to common shares traded during fiscal year divided by number of total shares outstanding

Market_return

Market return used here is MSCI globle annual market index. (http://pages.stern.nyu.edu/~adamodar/)

PE Ratio Price Earning ratio

Price to book Market to book value, One of Growth factors, belongs to Financial sustainability aspect

R&D

Research and development expenditure, used as company's long term investmnet effort, belongs to finanical sustainability aspect

Risk_free rate US 10 year T-bond rate (http://pages.stern.nyu.edu/~adamodar/)

ROE Return on Equity, One of Operational Efficiency factors, belongs to Financial sustainability aspect

Sales Growth Growth rate of sales, One of Operational Efficiency factors, belongs to Financial sustainability aspect

SIZE Market capital of the firm

Social Score

The social pillar measures a company's capacity to generate trust and loyalty with its workforce, customers and society, through its use of best management practices. It is a reflection of the company's reputation and the health of its license to operate, which are key factors in determining its ability to generate long term shareholder value.

Tobin's Q

One of variables used as Growth factor for financial sustainability. Tobin's Q Ratio provides information on how well a company's investments pay off. It is calculated as (Equity Market value + liabilities market value) / (equity book value + liabilities book value) = TQ. On macroeconomic level: Value of stock market / corporate net worth = TQ. Values larger than 1 say investments have been good



24

5.2 Data processing Company data used for this study are downloaded from Datastream. We took initially the complete

market data set including in total global 5361 firms which have ESG records from year 2000 to year

2015. After adding data records of different variables mentioned above, to be used for forming

hypothesis and equations, large portion of the sample firms had to be eliminated due to lacking of data

records, and for the same reason, time frame used for this study has been shortened. Sample size of

the firms used for this study thus at the end contains 136 firms with complete datasets available for

this research. Meanwhile the time period under study had been refined to year 2004-2014.

5.3 Forming models Models developed under testing are inspired by the literature (Anthony C. Ng, 2015), which studies

business sustainability correlation to cost if equity, and philosophy of our study is adopting the

framework illustrated in this literature.

Three main models are developed and tested in our study (see section 4.1, 4.2, and 4.3). 4.1 model is

to test the correlation between financial sustainability and cost of equity. 4.2 model is to test the

correlation between ESG factors and cost of equity. 4.3 is to test the interactive effect of ESG on the

Table 5 Descriptive Statistics

Sample: 2002 2014

BETA_1 ECONOMIC_SCORE ENVIRONMENTAL ADJUSTED_INDEP LIQ LEV TOBIN_S_Q

Mean 0.18 74.26 75.30 0.01 1.68 0.22 2.17

Median 0.43 81.67 88.04 0.00 1.00 0.21 1.89

Maximum 28.02 99.10 97.28 0.09 75.02 0.66 10.75

Minimum -55.91 3.96 9.84 -0.06 0.67 0.00 0.77

Std. Dev. 5.31 22.36 25.36 0.02 2.62 0.13 1.13

Skewness -3.67 -1.08 -1.30 1.88 15.75 0.35 2.69

Kurtosis 32.33 3.33 3.28 5.94 406.14 2.98 14.22

Observations 1524 1524 1524 1524 1524 1524 1524

SOCIAL_SCORE SIZE SALES_GROWTH ROE RND01 PRICE_TO_BOOK CORP_GOV_

Mean 73.68 17.09 0.07 22.62 7,101,213.31 4.23 66.41

Median 84.57 16.82 0.06 18.79 325,300.00 3.03 75.71

Maximum 98.78 22.88 1.60 527.88 453,046,000.00 742.39 97.78

Minimum 3.77 10.47 -0.58 -44.23 0.00 -35.49 1.69

Std. Dev. 25.43 2.09 0.14 23.15 38,669,405.49 19.32 26.57

Skewness -1.23 0.34 2.07 9.51 7.39 36.68 -0.94

Kurtosis 3.41 3.12 25.72 172.25 60.06 1,399.86 2.74

Observations 1524 1524 1524 1524 1524 1524 1524



25

correlation between financial sustainability and cost of equity. (See section 4, for detailed building up

of the models, hypothesis, sub hypothesis and findings.)

5.4 Model testing To assess the explanatory power of the variables, econometric analysis is in order. We will do this

analysis in there stages.

We structure the company data for time period 2004-2014 into panel data. For each variables, we first

run ADF Unit Root test, to tests the null hypothesis of whether a unit root is present in a time series

sample. We run such test for each individual variables, and for the ones unit root is not present, we use

the same test again at its first difference. For the variables have unit root present in its first difference,

we use the first differences of the variables in the model and equations forming and testing.

After performing ADF test, we run LS regression on the panel data, with fixed cross section (companies).

After running the LS regression on the equation, we test the Autocorrelation and Heteroscedasticity by

calculating Q-statistics (correlogram) for the lagged residuals and for squared residuals respectively. If

we find that the resultant equation has autocorrelation, then we will check if it goes away by introducing

lags of the dependent variables. For heteroscedasticity, we will use robust standard errors (like Huber-

White) as coefficient variances.

6 Empirical result As explained and illustrated in section 4.

4.1, Correlation between financial sustainability score and cost of equity.

We find significant positive correlation between economic score and cost of equity. Which can be

interpreted as such that higher economic score, thus highly capable of the company to generate

sustainable growth and a high return on investment through the efficient use of all its resources, the

higher cost of its equity, thus higher expected return of the stock. However, when comes down to

individual financial sustainability measurement, we do not see significant correlation between each

single aspect of financial performance with company’s cost of equity, which can be explain by the fact

that return of stock, is not purely driven by any individual financial factor alone. Such as that company

with only high growth but not operate efficiently or does not invest into long term innovation and

growth, cannot lead to high return of its stock. In the same way that one company only operates highly



26

efficient but not making high profit, or does not orient into long term growth, also does not produce

higher return of stock to its shareholders.

4.2, correlation between ESG factor and cost of equity

Consistent to findings in model 4.1, we see significant positive correlation still between economic score

and company’s cost of equity. In addition, we find only negative but not highly significant correlation

between S factor (social score) and cost of equity. Which can be interpreted as such that companies

putting more effort into generating trust and loyalty with its workforce, customers and society, through

its use of best management practices, setting up governance to facility and monitor the progress on

this, have slightly lower cost of equity, thus lower expected rate of return comparing to its peers who

put less effort into this field and gained lower score on social performance. Social score is also a

reflection of the company's effort and governance put in place to maintain and improve its public

reputation and the health of its license to operate. The explanation behind this association can be due

to the fact that such initiatives, companywide practice, education, and governance around the practices,

and integration into strategic planning, and monitoring naturally require large scale of stakeholder

engagement, and additional cost layer and monetary capital investments, which would increase the

operating cost base of the companies comparing to its peers, and lower the profitability, and final

financial return of stock. However this view is still from financial performance perspective, we may

argue that if ESG factor is fairly reflected in the stock price. As ESG factor add-in would been different

risk/opportunity profile of the company, and if we don’t see such factors reflecting two peer companies

performing differently on such dimension, we can argue if this risk (eg. Reputation, image maintaining

or damage) is being fairly priced by the market.

7 Robustness Check During regression analysis process, in order to check the robustness of our results, we conducted

several combination tests.

Firstly for each model, we took out sustainability irrelevant control factors individually and completely,

such as beta, leverage, liquidity, size, and regression results generated didn’t show significant difference.

Next, we also did time series test, we used time t, t-2, t-3, and t-4, to see if time factor plays a role in

the association. In the way we wanted to see if the impact of sustainable performance of the company

on cost of equity would take longer period for the market to pick up. However, the results of the tests

also did not show significant different from t-1.



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8 Discussion Underlying drive behind this study is the phenomenon of recent years’ global scale and fast paced

increase of sustainable investment practices. We want to take closer look into the drivers behind this

increase, and to test if such shift is making impact on cost of equity of the firm, and if yes in which

direction is it impacting the cost of equity of the firm. The study is from the angle of business

sustainability definition itself, from investors, and also from companies' point of view.

First of all, what is sustainable investment? Sustainability can be interpreted in a broad sense, such as,

in the complete process, total produce is equivalent to what has been consumed. We take the view

from Timo (Timo Busch, 2016), that corporate social responsibility (CSR) is often summarized by the

confluence of ecological and social concerns. And contested concept of the triple bottom line promotes

the simultaneous consideration of all three dimensions of sustainable development: economic,

ecological, and social-ethics (Dyllick, 2002) (Schaltegger, 2005/2006). Following these definitions above,

sustainable investments should—at least from a conceptual point of view—be investments that are

aligned with each of these three dimensions. Thus, sustainable investment should be, as aligned to CSR,

create economic, ecological and social contributions. This contribution to sustainable development can

be described from a systems perspective. It is important that the financial capital provided for

investment purposes is aligned with, and supports the existence of human social and ecological systems.

This relationship means that, in both dimensions, systems can be designed so that they are self-

sustaining over the long term. We take this understanding of sustainable investment as a fundamental

philosophy for building our test models and hypothesis.

Next, as elaborated in literature review section, when we take the stand point of the investors, we want

to further understand what their drive behind allocation capital into sustainable investment is. Does

sustainable investment portfolio deliver higher returns compared to investment portfolios consisting

of non-sustainable ones? Does better ESG rated investment portfolio give them better return compared

to the lower rated ones? Do investors primarily wish to derive financial utility from investment decision

(Renneboog, 2008) or at the meantime, they also strive for non-financial utility resulting from holding

portfolio that are consistent with personal and societal values (Bollen, 2007).

At the same time, we also take the companies’ perspective to understand how companies had

perceived and reacted to this investment trend in the market. Are the companies primarily focussed on

the goal of wealth maximization for shareholders? Or companies in parallel, should also fulfil their social

responsibilities, meeting their environmental obligations, and create social impact? Companies do not



28

only have obligations towards shareholders to create financial return but also have obligations towards

stakeholders in the broader context. Does market recognize the effort companies put into social

obligation fulfilment? Is this effort being fairly reflected in their share price? Can we see that markets

would appraise higher ESG rating companies more than the ones with lower rating?

With above stated perspectives and questions in mind. We reviewed ample literature and searched

information from various sources. As mentioned in the literature review section, we follow the model

and hypothesis of Anthony (Anthony C. Ng, 2015) to run the regressions on these models.

Our finding shows that financial sustainability is strongly and positively correlated to the cost of equity.

Only social performance of ESG measurement shows negative but not significant correlation with cost

of the equity. Environmental and Governance performance do not show significant influential effect on

cost of the equity. And when we were testing the interactive effect of ESG factor on the correlation

between financial sustainability and cost of equity, we also could not see significant influence.

By considering the finding that social factor is negatively correlated to the cost of equity, we take the

view that the market currently is not fully reflecting the risk and return of the added value of companies’

commitment on social responsibilities, which can be intangible value created, such as brand image,

reputation, employee recognition, etc. In another word, the company share price has not been fully

reflecting the risk and opportunity of such efforts. This interpretation matches with the finding of Kiron

(Kiron, 2013), which is, despite the fact that regulators are increasingly interested in both financial

economic sustainability disclosure and non-financial ESG sustainability performance information,

financial markets however have difficulties in pricing such intangible information. However, it seems

that the market, at the same time, does reflect the extra capital expenditures and opportunity cost of

the companies working towards improving its social image. This could imply that from shareholders'

point of view, primary goal of the companies is to increase shareholders wealth and this wealth is

measured by the market in monetary terms. Interestingly the same explanation cannot be applied to

Environmental and Corporate Governance performance. One of the explanations could be that both

environmental and corporate governance factors are more and more regulations and social principles

driven, such as the increasing pressure from both regulatory bodies to limit CO2 Emission, and at the

same time from non-regulatory institutions setting principles and widely promoting sustainable

development. So, it could be that compliance to the regulations and alignment to social principles are

not considered by the financial market as extra value addition but as "necessity".

Some studies in this field have pointed out that currently available ESG data lacks reliability and validity

(Griffin, 1997) (Mattingly, 2006) (Orlitzky M. &., 2012). The general untrustworthiness of ESG data can



29

be summarized in the following fault-lines. Firstly, rating agencies appear to disagree on the meaning

and scope of CSR (Orlitzky M. &., 2012) (Chatterji, 2009). Secondly, CSR assessments have been found

to be influenced more by organizational rhetoric than concrete action (Cho, 2012). Thirdly, firms have

been found to be socially responsible and irresponsible at the same time (Strike, 2006). Taking into

above concerns on ESG data, we can question if the investment community are able to make sound

selection of intended sustainable projects, and make correspondingly right sustainable investment

decisions. Once the capital distribution is not guided by trustworthy standardized and harmonized

underlying data, it is questionable to trust the match between actual company stock performances and

their ESG ratings. Consequently, if the ESG ratings we used for our study may not validly reflect what

we want to measure and study, then we cannot draw absolute interpretation and conclusion of the test

findings with complete confidence in our underlying data been used for model testing.

Putting above considerations aside, let us look at the sustainable investment's impact on ecological and

social systems. Evidences tell us that although technological advances typically pave the way to greater

sustainable development such as increased eco-efficiency (Frederick, 1995) (Hawken, 1999), current

efforts to increase eco-efficiency may not be enough to move towards long-term ecological

sustainability yet. This could be because of overall production growths and rebound effects (Ehrenfeld,

2013). Regarding human-social systems, United Nations established eight international development

goals in 2000. Progress has been uneven across countries. While Brazil achieved many of the goals,

other countries mostly African countries are not on track . Furthermore the goal for access to clean

water was met in 2012. Thus, there were improvements, however, still much remains to be done to

maximize progress on achieving the target set by the goals (Sachs, 2013, August 27). The progress made

so far, tells us that we can see incremental improvements and more sustainable investments can

contribute to a better future. However, the theoretical claim of the truly sustainable investment would

only be met if such investments orient towards long-lasting and self-supporting ecological and human-

social systems (Timo Busch, 2016). Porter and Kramer, pointed out through study of business case of

sustainability that win-win scenarios for sustainable investment may be possible, but such low-hanging

fruits cannot be the foundation for shift towards a long-term paradigm (Porter, 2006, December) ,

(Porter, 2011, January-February)(Dominic Barton, 2014) the emphasis of current business case of

sustainability is often on short run. As noted by Timo (Timo Busch, 2016), the field of sustainable

investments requires a mental shift towards long-term risk and opportunity perspective. Such as mental

shift acknowledges the community that a change in these systems significantly alters the world and

thus certain businesses are at risk and new business models may emerge. More importantly such shifts

and resulting effects on business and financial markets can only be captured and reflected in a long-

term systematic analysis.



30

In the long run, if such systematic mental and perspective shift would lead (rational) investors to learn

how to price (at this moment) intangible ESG information, then ESG factors will automatically be

factored while calculating stock price. In such state, high-scoring companies will have lower cost of

equity, under condition of keeping other performances equivalent. This would result in higher valuation

on stock market. Similarly, poorly rated companies can be motivated to engage strongly in improving

ESG performance and if engagement is successful, and other market participants agree with the

materiality of the engagement topics, stock returns of these firms will rise (Timo Busch, 2016).

In conclusion, sustainable investments should be viewed in a broad context. Not only in terms of

financial returns but more vitally, going back to its original intention to measure its real impact on

Ecological system, Human-social system. Although from this study, we do not see clear correlation

between ESG rating and return on investment, except the social factor, we are triggered to think of the

next step to firstly work on improving the creditability of ESG data, and secondly to study further if

current financial market is driven by rational investors to price ESG information in the stock price.

Through time the market might learn how to reflect rightly the risks and opportunities of engagement

in ESG performance improvement, firms would be more motivated to contribute towards more

sustainable businesses and social systems.

9 Limitation of this study First of all, at described in the data process session, even though we initially intended to have much

larger sample size to support our study, data of some independent variables for large amount of

companies were not available. Same data availability challenges applies to the time period. We started

the data collection for the period between years 2000-2015, however data availability limits the study

to the period between years 2004-2014. Although we think current sample size is fairly reasonable to

support regression analysis, larger sample size, and longer time horizon might provide new insights.

Secondly, as mentioned above, general critic about trustworthiness of the ESG data should be kept in

mind. ESG data we used for this study is from trust worthy academic source, however probably much

deeper dive into the ESG data measurement system used by the ESG rating agencies, could help future

studies.



31

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