Topic 47: Visionary Companies During the Financial Crisis The impact of ESG factors on Firm Value and

Stock Returns
MSc. FInance and Investments Thesis Proposal

Thesis Coach: Michiel Wolfswinkel Thesis Co-Reader: Niels Agatz

Student:

Sorin Silviu Zaicovici 344677sz@student.eur.nl

1. List of Abreviations
CFP = Corporate Financial Performance CRSP = Center for Research in Security Prices CSP = Corporate Social Performance CSR = Corporate Social Responsibility ESG = Environmental, Social and Corporate Governance FTSE = Financial Times Stock Exchange Index NGO = Non-Governmental Organization NYSE = New York Stock Exchange OECD = Organisation for Economic Co-operation and Development OLS = Ordinary Least Squares R&D = Research and Development ROA = Return On Assets ROE = Return On Equity SRI = Socially Responsible Investment US = United States

2. An Introduction
Jim Collins together with Jerry Porras [2001] identified a set of companies that, according to their study, made the transition from good companies to great ones. Then, they studied these firms, and came up with a set of steps that enable companies to transform themselves into great organisations. Verne Harnish [2002] analysed the managerial factors that can make a company last over time and changing environments. Although this topic has been widely studied troughout the years, all the supporting literature has not yet identified a series of factors and procedures that guarantees a firms success. In this paper great companies are defined in accordance with their financial performance: A subjective measure of how well a firm
can use assets from its primary mode of business and generate revenues. We look at companies

with 20% higher risk adjusted returns than the market, and 15% higher risk adjusted returns than industry peers. Recent studies have shown that companies who are implementing sustainable investment strategies have outperformed the market and their industry peers during the financial crisis. Indeed, over the last decade, investors have paid increased attention to sociable responsible investments and their influence over corporate performance. According to the shareholder perspective, the ultimate goal of a company is to increase firm value. Investments in Corporate Social Performance have been shown to increase firm performance and firm value. This paper tries to find a direct relationship between particular ESG performance metrics and risk-adjusted returns, Tobins Q and return on assets, supporting this theory. The European Sustainable and Responsible Investment Forum (Eurosif), describes socially responsible investing as a generic term covering ethical investments, responsible investments, sustainable investments, and any other investment process that combines investors financial objectives with their concerns about environmental, social and governance (ESG) issues 1 . The European Federation of Financial Analysts Societies (EFFAS) has defined topical areas for the reporting of ESG issues, and developed Key Performance Indicators (KPIs) for use in financial analysis of corporate performance. EFFAS has identified nine topical areas that apply to all sectors and industries: Energy efficiency; Greenhouse gas

European SRI Study, Eurosif, 2008

(GHG) emissions; Staff turnover; Training & qualification; Maturity of Workforce; Absenteeism rate; Litigation risks; Corruption; and Revenues from new products. ESG analysis can provide insight into the long-term prospects of companies which allows mispricing opportunities to be identified. Investors can find new market opportunities with companies that place the management of ESG factors at the core of the business. Company-specific ESG factors offer a benchmark for investors to judge the overall quality of the boards governance and risk management processes and their positioning within an industry sector. The UN-backed Principles for Responsible Investment (PRI) 2 provides a voluntary ESG framework for companies and funds, from which investors can make informed investment decisions that relate to sustainability and governance practices. The study will focus especially on the impact that the financial crisis had on ESG companies, and it will test the speed in which they recovered (or not). My assumption will be that if the firms are indeed visionary ones, they should have less struggle to survive and even have better returns than ordinary companies. The link between ESG and Corporate Financial Performance has also been discussed for more than forty years, ever since Milton Friedman well-known article The social responsibility of business is to increase its profits (Friedman, 1970). Since then, Friedmans perspective has been undermined by opponents and became obsolete during the recent years. The relation between ESG performance and investment returns is difficult to analyze, both theoretically and empirically, mostly because of the multi-dimensionality of the ESG concept. On the one hand, most empirical evidence suggests that good stocks, i.e. those with high ESG scores, earn positive abnormal returns (Derwall et al., 2005; Statman and Glushkov, 2009). This is supposed to be due to investors underestimating the benefi ts of ESG or overestimating its costs, i.e. mispricing the value relevance of ESG concerns, or to compensation for risk (Derwall et al., 2005). There are a few studies also showing that some good stocks earn negative abnormal returns, also explained as either mispricing or compensation for risk (Derwall and Verwijmeren, 2007). Alexander and Buchholz (2008) give a more fundamental reason that links financial performance to ESG related influences. Companies showing strong Corporate Social
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In this study, the terms socially responsible investing, socially responsible investor, socially responsible behavior and social responsibility are used interchangeably. The abbreviation for all is SRI

Performance (CSP) are likely to have superior management, relating CSP with one or several elements of running a successful business. Following the same line of thought, Donaldson and Preston (1995) examine the CSP/CFP link relying on stakeholder theory3, which postulates that in order to be successful companies are not only responsible to shareholders, but rely on the management of a variety of stakeholders who have a stake in the social and financial performance of the firm. The stakeholder approach shifts a firms CSP away from discretionary activities, such as philanthropy, charity and other public relations programs, toward a group of critical stakeholders including shareholders, owners, employees, management, customers, suppliers, communities and the environment 4 . Hence, business strategies directed at successful stakeholder management that reflect overall management strength determine the quality of a companys Corporate Social Performance (Graves S. and Waddock S. 1997) and are positive related to CFP. Furthermore, CSP or ESG reduces the cost of conflicts such as claims, environmental disasters and government fines, which again could make a company more financially attractive, and thus improves corporate performance. (Renneboog et al., 2008). In addition, ESG analysis can lead to an improved understanding of how future trends could affect a certain industry or the entire economic landscape for that matter. Financial professionals for instance anticipate that ESG issues and climate change in particular will gradually but powerfully change the economic landscape in which companies operate and cause periodic sharp movements in asset prices (Llewellyn, 2007). Besides their fundamental relevance within socially responsible investment (SRI) strategies, ESG measures actually bare significant importance for mainstream business valuation and investment decision-making, especially in the context of long-term performance and risk evaluation (Derwall 2007).

3. ESGs link to Corporate Financial Performance

Linking these arguments together with their implications for stock returns, leads to three mutually exclusive scenarios regarding the risk-adjusted returns of high-ESG firms relative to low-ESG firms, which are briefly discussed below. Renneboog et al. (2008) provide a critical
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A stakeholder is; any individual, group or organization who can affect or is affected directly or indirectly by the realization of companys objectives (Freeman, 1984:25). Key stakeholders are employees, clients, financiers, stockholders, communities, government and the natural environment. 4 Waddock, Sandra A., Samuel B. Graves. "The Corporate Social Performance-Financial Performance Link." Strategic Management Journal, 1997

review of the literature on SRI and thoroughly discuss the causes and the shareholder-value impacts of ESG, among other related issues. In the no-effect scenario, there is no difference in the risk-adjusted returns of high-ESG firms relative to low-ESG firms. This is entirely consistent with the efficient market hypothesis when the ESG performance of firms doesnt provide any relevant information for pricing (Statman and Glushkov, 2009). Even if ESG performance provides information relevant for pricing, if this information is publicly available and already fully incorporated into asset prices, then there should still be no difference in the risk-adjusted returns of ESG and nonESG firms (Wall, 1995). In this scenario we cannot distinguish whether ESG costs are higher or lower than ESG benefits by looking solely at stock returns. In the mispricing scenario, ESG performance has an impact on firms cash-flow streams (i.e. it is value relevant) but it is not efficiently reflected in stock prices due to insufficient information. This translates into either higher or lower risk-adjusted returns for high-ESG firms depending on the net benefit of ESG (by the economic argument). If the benefits of ESG outweigh their costs, and, on average, investors consistently underestimate the benefits or add more weight to the costs, then the risk-adjusted returns of high-ESG firms would be higher than those of low-ESG firms (Statman, 2006). Underestimating the benefits of ESG could lead to positive earnings surprises (Edmans, 2011) or reduce earnings volatility (Derwall and Verwijmeren, 2007). High environmental performance during 19952003 (Derwall et al., 2005) or good employee relations during 19842005 (Edmans, 2011) have been found to provide positive abnormal returns. In a sample of multinationals, Dowell et al. (2000) also found that firms that respect high environmental standards had higher firm value than others, measured by Tobins Q. Kempf and Osthoff (2007) show that portfolios built on specific ESG dimensions had positive abnormal returns over long periods. We could also argue that, the risk-adjusted returns of high-ESG firms will be lower if the benefits of ESG strategies are lower than the costs and uninformed investors overestimate benefits or underestimate costs. Barnea and Rubin (2010) show that ESG performance can be a source of agency problems because the firm managers have a perverse incentive to promote ESG investments for their reputational benefits, at the expense of shareholders wealth. Their hypothesis is supported by a negative link between insiders ownership and the social rating of firms, found in empirical research.

The third scenario is the risk-factor scenario. Here, expected returns of low-ESG firms are higher because they carry a premium for non-sustainability risk. The exposure to a nonsustainability risk factor can be revealed by the ESG rating of that company. Other risk factors that can be included here are product and commercial-practice risks, or risk associated with workplace quality of life (Dufresne and Savaria, 2004). It can also be related to litigation risk, investor trust and other intangible advantages (Becchetti and Ciciretti, 2006; Derwall and Verwijmeren, 2007) that might dramatically affect the financial performance of a company (i.e. value-seeking SRI). Given the increased awareness of non-sustainability risk, it is expected that this premium has increased in the last few years. Another explanation under the risk-factor scenario, might be that expected returns of highESG firms are higher because they carry a premium for some missing risk factors, others than the common factors like beta, size, value and momentum. This alternative explanation has been used to account for the higher risk-adjusted returns observed in high-ESG firms, in studies such as the eco-efficiency premium puzzle (Derwall et al., 2005). ESG performance might thus affect expected stock returns, due to ethical beliefs (values) or (non-) sustainability risk factors, if two conditions are met: information on ESG performance must be available to investors, and there must be enough investors who care. Since both of these premises can change, the effect of ESG performance on stock returns can vary over time. There is a lot of controversy about the relative risk-adjusted returns that investors expect from ESG investments because the two stock universes are not exclusive. Good firms are generally those with an outstanding record with respect to at least one of the several ESG concerns. At the same time, bad firms are not necessarily those with the lowest ESG rating, but are rather ignored by ethical investors simply because of the industry in which they activate, i.e. because of ethical beliefs (tobacco, guns, nuclear energy).

4.1 ESG Dimensions - The Environment

The effects of environmental behavior upon firm value is being studied by a growing body of empirical studies, although their findings have been mixed. However, even though it is not compatible with economic logic, the majority of studies concluded in a positive relation between corporate environmental performance and firm value. Environmental performance is defined as: Measurable results of the environmental management system related to an organization's control of its environmental aspects, based on its environmental policy,
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objectives and targets. It includes: the environmental effects of resources consumed, the environmental impacts of the organisational process, the environmental implications of its products and services, the recovery and processing of products and meeting the environmental requirements of law5. Economic logic would suggest that a high environmental standard can lead to increased production costs and manufacturing time, hurting corporate profitability. However, in the last few years, environmental awareness and environmental practices have become top priorities to stakeholders. Today, companies that exhibit poor environmental performance are likely to become unpopular while running the threat of litigation and a loss of their reputation. Environmental performance does indeed bear high costs but can usually compensate with cost savings (e.g. litigation costs, government fees) finally leading to a higher firm value. Tobins Q has been used in some research studies to investigate whether stringent environmental standards yield higher market values. The majority of results using this measure report a positive relationship between environmental performance and firm value. Dowell et al. (2000) find that the adoption of higher environmental standards leads to higher market values for multinational companies based in the US. More recent empirical studies focus on the relationship between stock returns and environmental performance. Diltz (1995) finds that high environmental awareness has significantly influenced stock performance in a positive way during 1989 and 1991. Contrary to a large body of literature, Barnett and Salomon (2006) find in their study that the costs of high environmental performance may exceed the benefits mentioned above. However, due to the impressive number of previous studies that show contrary results, they argue that their findings could be based on limitations in their empirical study. In conclusion, aligning myself to the large body of literature, I believe that the benefits from a high environmental performance outstrip the related costs, and I hypothesize that environmental projects and concerns lead to a higher risk-adjusted stock return.

4.2 Corporate Governance

Corporate governance mainly deals with the principal agent problem and tries to find sollutions for it, with frameworks that align incentives between managers and shareholders.
5

ISO 14001 1996 definition 3.8

The problems between the principal and the agent mainly stem from the separation of ownership and control in a modern organization and induce agency costs. The effect of superior corporate governance on firm performance has widely been researched and shows that superior corporate governance is positively related to firm value. Gompers et al. (2003) test the relationship of power between managers and shareholders in a sample of 1,500 companies. They took 24 corporate governance measures during the 1990s to build a Governance Index, which they referenced against stock returns, firm value, operating measures, capital expenditure and takeover activity. The authors find a strong correlation between corporate governance and stock returns during the 1990s. A long-short investment strategy is used, where firms with strong shareholder rights are bought and firms with weak shareholder rights are sold. This portfolio earned abnormal risk-adjusted returns of 8.5% per year. The results are measured by the Carhart (1997) four factor model. Moreover, the governance index is highly correlated with firm value, which is measured by Tobins Q. They concluded that since the corporate governance structure of a firm is not exogenous, a causality claim between the direction of firm performance and corporate governance can not be made. Furthermore the stock market can under-estimate the agency costs, or managers might have inside information about the poor future performance of the firm, thus entrenching themselves and reducing shareholder rights as a consequence. Bauer et al. (2004) apply the same methodology as Gompers et al. (2003) to a European set of data. Similar to earlier studies, empirical evidence shows a positive relationship between corporate governance and financial performance. Thus, good corporate governance leads to higher stock returns and higher firm value in Europe. Therefore, I expect higher risk-adjusted returns in the presence of high corporate governance measures.

4.3. Corporate Social Responsibility

Corporate social responsability is defined as the corporate initiative to assess and take responsibility for the company's effects on the environment and impact on social welfare. The term generally applies to company efforts that go beyond what may be required by regulators or environmental protection groups. Corporate social responsibility may also be referred to as "corporate citizenship" and can involve incurring short-term costs that do not provide an immediate financial benefit to the company, but instead promote positive social and environmental change.
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Superior relations with stakeholders can be identified as a competitive advantage compared to companies with worse stakeholder relations. Stakeholders include all parties who are affected, or can be affected by the company's actions (i.e. employees, customers, trade unions, suppliers, communities). Hillmann and Kiem (2001) argue that Corporate Social Responsibility is made out of of two components: stakeholder management and social issue participation. The first component refers to improving the companies relationship with stakeholders like employees, customers and suppliers. The second component deals with e.g. a ban on nuclear energy, getting involved with current social problems, avoidance of sin industries and not doing business with countries with bad human rights records. The authors conclude, that stakeholder management leads to higher shareholder value, whereas social issue participation is likely to destroy value. Sen, Bhattacharya and Korschun (2006) investigate the impact of CSR on stakeholder reactions. Their findings indicate that stakeholders with CSR awareness reacted positively to the analysed companies, in the retail, employment and investment industries. Therefore, their study shows the importance of CSR stakeholder awareness and its implications on financial performance. Several studies have shown that superior labor relations encourage better financial performance (Greening and Turban, 2000; Jones and Murrell, 2001). Employees are crucial to a firms success because they are the front line of the firm and are responsible for the creation of output. In todays demanding environment, companies rely more and more on the knowledge, innovation and motivation of their employees to create higher value. As Freeman has stated: Positive labor relations have become increasingly important as they can lead to increased productivity, decreased turnover and decreased strife 6. A company with excellent labor relations and equal employment practices is likely to attract more qualified employees leading to a more talented workforce (Greening and Turban, 1996). The authors use social identity and signaling theory and show that firms can use their corporate social performance strategy to attract better job applicants. Signaling theory states that a firm's CSP sends signals to new job applicants about the working conditions for a firm. Moreover, social identity theory suggests that prospective job applicants obtain a higher satisfaction when working for socially responsive firms over their less responsive counterparts. In order to prove these hypothesis, the authors looked at the relationship between a companys CSR and its
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Freeman, R.E.; McVea, J; A stakeholder approach to strategic management; Darden Graduate School of Business Administration, University of Virginia, 2002

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atractiveness and reputation as an employer. They found that prospective job applicants are more likely to pursue jobs from companies that use CSR strategies than from firms with poor social performance. Edmans (2007) analyses the link between employee satisfaction and and long-run stock performance. The author argues that superior working conditions and selfimage can enhance employee satisfaction leading to a higher corporate performance. He finds an alpha of 4% per year, economically and statistically significant, for a portfolio of the 100 Best Companies to Work For in America. The author finds that employee satisfaction is positively related to risk-adjusted returns. Along with labor relations, good community relations also play an important role. Due to the fact that firms have to position their headquarters and buildings within communities, poor community relations can lead to costly problems and decreased financial performance. Positive community relations are likely to increase the likelihood to obtain zoning permits from local municipalities, decrease litigation expenses and increase the likelihood of negotiating lower tax breaks or favorable regulations with governments. Companies that treat local communities well will reap many returns, including better schools, fewer local restrictions, and a better infrastructure to support the firm. In the long-run these advantages decrease corporate operating costs 7. Barnett and Salomon (2006) study the link between community relations and corporate financial performance. The authors apply the Carhart (1997) four-factor model. They find a positive connection between community relations and a companys financial performance. Strong community relations also reduce the risk of attacks by shareholder activists or protest groups (Rehbein et al. 2004). Therefore, I hypothesize that Corporate Social Responsibility measures have a positive impact on corporate financial performance.

4.4. Corporate Sustainability

A fundamental question that many scholars try to answer, is why profit differences exist across companies and industries, and why some of these profits are persistent across time while others are not. What firm characteristics enable such behaviour? Jacobsen et al. (1988)

Waddock, S.; Smith, N.; Relationships: The real challenge of corporate global citizenship, Business and Society Review, Volume 105, 2000, p.79

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show that profit existence and profit persistence are not always driven by the same factors. Sustained financial performance is driven primarily by the firm-specific component rather by the industry profit component. Acording to the resource-based view of the firm (RBV), a sustainable company will deliver strong risk-adjusted returns, and will focus on the long term, having intangible assets, e.g. particular technology, brand name, reputation and corporate culture. Villalonga (2004) studies the relationship of sustainability with financial performance, using Tobins Q as a proxy for intangible assets. Companies that adjust their corporate strategy to sustain their human and natural resources for the long term, and are showing a true commitment to sustainability, appear to have outperformed their industry peers during the financial crisis (Mahler 2009). There are already numerous studies made on several financial markets e.g. Korea, Japan, Norway, Sweden that track portfolios of sustainable companies. In the past three years, these portfolios outperformed their market indexes (Nakajima, 2011; Amenc, 2010; Semenova and Hassec, 2009). Although measuring sustainability is a demanding task, that doesnt always lead to concluding results (Boehringer and Patrick 2007), it is worthwhile the time and effort. In a recent survey done by MIT Sloan Management Review, 92% of the respondents said that sustainability related issues will affect their firm value within the next year, and 74% said they are already addressing these issues in their corporate strategy. Thus, I hypothesize that sustainability will have a positive influence on financial performance.

5. Research Design and Methodology

The purpose of this research is to answer the following questions: Are ESG firms great companies? Did they outperform their peers during the financial crisis? How much do the ESG metrics explain firm performance? As a first step, I will construct a portfolio of high rated ESG companies, and compare the risk-adjusted returns with the equaly wheighted portfolio of low rated ESG companies during the period of the financial crisis. I hypothesize that the high-ESG portfolio will outperform the market index, the low-ESG portfolio, and across industries. I will use the 10 Dow Jones market sector classifications: oil & gas, basic materials, industrials, consumer services, healthcare, consumer goods, telecom, utilities, financials and technology, and I will select the companies from the S&P 500 universe, excluding the top 5% performers and the bottom 5%.
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In the second part of my analysis, I will go into detail, using cross-sectional regression of risk adjusted stock returns, Tobins Q and ROA on ESG scores and four factors known to explain stock returns: beta, size, value, momentum and some controll variables that influence profitability such as: R&D, leverage, liquidity and retained earnings, i.e. the FamaFrench three-factor model (Fama and French, 1992) plus the momentum factor identified by Jegadeesh and Titman (1993). Because this study will focus on the financial crisis period, I would also include liquidity and other proxies for profitability. I use the cross sectional approach instead of the portfolio approach because I want to show the monotonic effect of individual ESG concerns on stock returns, not just in the return differential between high- and low-ESG portfolios. The test for the effect of ESG concerns is whether their estimated effect is statistically indistinguishable from zero as the four-factor model predicts. The four-factor model estimated here is extended with several ESG variables or with an aggregate ESG variable as:

where the excess stock return for firm j in month t + 1 (Rjt+1) is a function of , the estimated market risk of the firm; Size - the firms log of market capitalization; BookToMarket its bookto-market ratio; Momentum the average return over the period t 2 and t 12 months; ESG fourteen individual firm ESG variables or an overall ESG variable; Liquidity is measured as the firms cash and cash equivalents over total assets; Intangibles are measured as the firms R&D expenditures over total assets; Leverage is measured as the total long term debt over total assets; RetainedEarnings are measured as the book value of retained earnings as a percentage of total assets and an error term, jt+1, with zero mean and constant variance. Size, book-to-market ratio, intangibles, momentum and liquidity are updated monthly (as did Galema et al., 2008), while estimated beta, leverage, retained earnings and the ESG variable(s) are updated every year. Beta is estimated for each asset j ( j = 1, . . . , N) through a time-series regression up to time t of the assets returns and the market-index return. A large body of ESG related literature points out that ESG is industry specific. For example, firms operating in certain industries might have both high ESG ratings and high stock returns, while those in other sectors might have low ESG ratings and low returns. Without controlling for such industry effects, there is a risk of a false positive association between ESG and riskadjusted returns. Conversely, any ESG measures that might have different effects across
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industries would render their overall effect unnoticeable. Belu (2009) reveals the substantial differences in terms of ESG performance between various economic sectors. I will use the same aggregated industry ESG approach, thus testing for robustness, e.g. to test if the diffrences in industries are driving the results. Thus the main estimation model will change to:

In the third part of my analisys, I will run a backward stepwise regression on the individual ESG measures, to determine which of them have the most relevant significance (Darlington, 1990; Hocking, 1966).

6.1. Corporate Social Performance Measures

Understanding the relationship between the dimensions of ESG and financial performance is made difficult by the lack of consensus on how to measure these indicators, and what indicators to choose. Various proxies have been used over the years as measures of ESG performance with an evolution that goes from highly subjective (surveys of business faculty members or Fortune rankings, see McGuire et al. 1998) or extremely specific (annual reports to shareholders, CSR reports as in Hamilton 1995). SAM Group ESG Measures I chose the Sustinable Asset Management Group, one of the leading institutions specializing in sustainability investments, as the data provider. I considered this data set to be relevant, because in a partnership with Dow Jones Indexes and STOXX Limited, the SAM publishes and licenses the Dow Jones Sustainability World Indexes (DJSI), a family of indexes that provides a growing number of asset managers with objective and professional benchmarks for sustainability investments across the US, European and Asian markets. Another important reason for my choice was the comprehensive, multi-dimensional nature of the CSR measure built by SAM Group. The scores cover all of the main ESG dimensions: economic, social, sustainability and governance issues. The economic dimension is monitored in close relation to the ethics of conducting the business, i.e. to how the company is managed and how it maintains the relationships with
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third parties. There are five criteria/scores quantifying the relevant information in this dimension. They are Risks Crises Management, Corporate Governance, Codes of Conduct/Corruption/Bribery, Investors Relations, Customer, Relationship Management (Ricart and Rodriguez, 2005). Social criteria is reflecting the values and practices of the company with respect to those directly involved in the profit maximization process, such as employees and shareholders. There are five relevant scores belonging to this group8: Labor Practice Indicators, Human Capital Development, Talent Attraction/Retention, Stakeholder Engagement, Corporate Citizenship/Philanthropy. The environmental dimension of ESG is being examined by looking at Environmental Policy and Eco-efficiency, Social Reporting and Environmental Reporting. The major source of information used in obtainig the fourteen scores are the answers to the SAM Questionnaire that the firms are requested to fill in9. Although there is a high level of standardization and a thorough methodology applied in the process of constructing the scores, it is practically impossible to determine whether these sophisticated ESG performance measures are objective since the original source of information begins within the company itself and few firms have their CSR reports externally verified. Thus, CSP metrics are still subject to questions about impression management and subjective bias. The Sustinable Asset Management Group has included a number of safeguards for limiting the impact of the above mentioned subjectivity issues. First, the companies need to support any disclosed information with official documentation. The qualitative answers are limited through a system of predefined multiple-choice questions and subject to a clear set of rules that convert the answers in points while making regular checks to verify the results. The whole process of constructing the scores is highly standardized and is assessed by an external auditor. All these measures try to alleviate the subjective bias without fully removing it.

6.2. Firm Performance Measures

Based on financial theory, a large number of empirical studies use risk-adjusted market returns (on individual stocks, portfolios or mutual funds) as a measure of financial
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Dow Jones Sustainability World Index Guide Book, Version 11.5, CME Group, SAM Group, 2011 For details see http://www.sustainability-indexes.com/06 htmle/assessment/overview.html

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performance (McGuire et al. 1988, Bauer et al. 2005, Derwall et al. 2004). Tobins Q is considered to be a good proxy for firm value (Guenster et al. 2005), because it also measures the intangible value of the company (Dowell et al 2000). Firm profitability is a central issue in economics, also measured by the return on assets. Several variables have been shown to help explain financial performance, and a relation between these variables and CSP has been proved in the related literature; therefore they must be included in any analysis on the impact of adopting of ESG principles. Since the market value of a firm is the present value of its future net cash flows, measures of market valuation are usually used in studies on company performance. It is assumed that market valuation metrics pick up variation in the expected profitability missed out by dividends (Fama and French 2000). Most studies on performance have used the size of a company as a proxy (usually in the form of the log of market capitalization). Size has been found to influence not only the performance of a company but also the ESG performance (Ullman 1985, McWilliams et al. 2000). Larger firms are likely to adopt these ESG principles more often due to the fact that their size permits them to afford allocating more resources to the adoption of ESG standards. Leverage has been showed to be an important variable related also to the governance structure and ownership (Berger and Ofek, 1997). I hypothesize a negative relationship between leverage and financial performance because firms with strong financial performance fund themselves using internal resources. Leverage can also be negatively correlated to the ESG standards as well, because highly leveraged firms will not be able to make long-term investments necessary to enhance ESG performance (Dowell et al. 2000). Retained earnings measures the capacity of a company to reinvest in its core business. Usually, companies use their retained earnings for investing in areas where the firm can create future growth opportunities, such as buying new machinery or spending the money on R&D or debt repayment. Because firms with retained earnings have already available resources for ESG projects, I assume a positive relation between retained earnings and CSP. All the above mentioned data can be found in the Thomson One Banker Financial Databse and CRSP.

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7. Limitations
We would have to take into consideration the size of our sample, and to have sufficient data for the regressions. We would have to take only companies that have reached a steady growth rate, are publicly traded, and of a considerable size (S&P 500). The ability to gather the data, and to properly quantify the variables would also be a challenging task. We would also have to consider the significance of the results, and their managerial and practical implications. Also when using a stepwise regression, there are a few limitations. It presumes there is a single best subset of independent variables, and tries to identify it, leading to an inherent bias in the process itself. Endogoneity Problem Another problem that can affect our model is if the independent variables (the regressors) is correlated with the error term. This problem arises when the variables that are supposed to affect a particular outcome, depend themselves on that outcome. Possible solutions for this problem is finding a proxy or lagging the variable one or two periods.

8. References

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