Impact of sustainability factors on cost of equity of the firm

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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

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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

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3 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_Inve stment_Portfolios_Does_the_Optimization_Process_Matter/links/56389daa08ae78d01d39d9ca.pdf

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4 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}

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5 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

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6 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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7 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 non-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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8 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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9 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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10 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

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11 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 investing8_{. 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.

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12 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

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13 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,

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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.

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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.

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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

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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.

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 + 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)

Dependent variable: Cost of equity 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) Significane Level: 10% = *, 5% = **, 1% = ***

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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19

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.

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 + β11 * environmentalit-1 + β12 * corp_gov_it-1 + β13 * social_scoreit-1 + β14 * economic_score it-1*environmentalit-1 + β15 * economic_scoreit-1*corp_gov_it-1 + β16 * economic_scoreit-1*social_score it-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)

Dependent variable: Cost of equity 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) Significane Level: 10% = *, 5% = **, 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 * 1)*environmental(it-1) + β15 *

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21 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.

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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.

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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

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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

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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

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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

Impact of sustainability factors on cost of equity of the firm

MIF 2016 Master Thesis