Accounting for sustainability – The Inquisitive Investor

Reading Time: 3 minutes

Last week I heard about a body called the Sustainability Accounting Standards Board (SASB). This was in the context of ESG investing. Katherine Collins, who heads sustainable investing at Putnam Investments, was speaking about their process in ESG investing. She talked about how they had used the SASB standards to identify factors that measure sustainability. What’s more, she said that by building portfolios based on sustainability factors over the last decade generated alpha in double digits. Naturally, I was intrigued.

So here’s the low down. The SASB was founded in 2011 to develop sustainability accounting standards. The idea is to build an extension to the current financial reporting standards so that companies can report on their sustainability metrics. Also, unlike a lot of corporate governance reporting standards for example, the metrics they recommend are quantitative in nature. What this means is that if the standards become widely adopted, it would allow systematic assessment of the goodness of companies’ sustainability practices.

Now in case you’re shaking your head and wondering why you would bother, especially as an investor, here’s why. As I mentioned before, Putnam has found that companies that score highly on sustainability generate materially higher returns compared to markets. This is not hard to imagine (although there’s a caveat that we will get to). Companies that do well by their employees are likelier to have more engaged and productive employees. They’d naturally do better. Similarly, if mining companies are more mindful of their environmental impact, they are less likely to be hit with fines, stop orders etc.

Also Read on FinMedium:  Throwing in the towel

SASB has identified 77 industries and published (evolving) reporting standards for each of them. Metrics include things like, total energy consumption by vehicle fleets and percentage of such energy being renewable. They also provide documents that explain why these metrics matter for the long-term well-being of the company/investors.

Being a quant, I love the idea of having quantitative metrics to measure soft parameters about a company. At a recent discussion at the CFA Institute in Mumbai, some participants reported that some quantamental models depend as little as 30% on the financial statements of the company and derive signal for other sources. The SASB standards could be an important source of this non-financial information.

A little caution though. ESG investing has definitely become a thing. For instance, the Indian markets already pay disproportionate premiums for good Corporate Governance. While sustainability and good governance probably mean that the company would do well and better in the time to come, as the market takes cognizance of this fact, it could easily get priced in. Which would mean that forward looking returns could be subdued or at par with other, non-sustainable, businesses. A recent paper verbosely titled The Unintended Impact of Academic Research on Asset Returns: The CAPM Alpha, makes a beautiful case. From the paper:

I sort US stocks by their generated CAPM alphas and find that portfolios of assets having low realized alphas have higher ex-post average returns and Sharpe Ratios than portfolios constructed with assets having high realized alphas.

These patterns emerged with the development of the CAPM in the 1960s and became more salient as the related literature expanded, especially after 1992 with the increasing popularity of the CAPM anomalies in academia and of factor investing in the private sector.

Alex Horenstein

Something similar might happen or may already be happening with ESG investing as well. One has to watch out. Dan Ariely, the behavioral economist of “Predictably Irrational” fame, currently runs a fund called Irrational Capital. He says quite explicitly that they don’t factor in valuation in their investment decisions, deciding instead based on how much human capital a company is creating. When valuation stops being a factor, we do run the risk of going too far.

Also Read on FinMedium:  The Coming Psychological Revolution in the Housing Market



Source link

Every Wednesday and Saturday, we send Info-Graphic and FinMedium Weekly Digest newsletters to our 25000+ Subscribers.

Join Them Now!

Please Share :)
Parijat
On a quest to understand what makes a business great and what makes a great investment.
Back To Top