Sustainable Investing: On the relation between sustainability rating and greenhouse gas emissions

(1)

Department of Business Administration Master of Science in Business, Economics and Statistics Degree Project, Business Administration, 30 Credits, Spring 2021

Supervisor: Jörgen Hellström

Sustainable Investing

On the relation between sustainability rating and greenhouse gas emissions

Gustav Grundström, Isabelle Miedel

(2)

[THIS PAGE WAS INTENTIONALLY LEFT BLANK]

(3)

Acknowledgements

We would like to express our deepest gratitude to our supervisor Jörgen Hellström for his continuous feedback and suggestions. Your input has been has given us valuable insights and helped us improve the quality of this thesis. A special thanks to Umeå University library for providing access to the data resources and previous literature. Finally, we appreciate all the discussions and seminars with other students that contributed to improving our thesis.

Gustav Grundström Isabelle Miedel

Contact: gustavgrundstrom@outlook.com Contact: isabelle.miedel@gmail.com

(4)

(5)

ABSTRACT.

Sustainability and finance should go hand in hand. A financial system that supports sustainable growth is necessary for the transition to a carbon-free society. Environmental, Social and Governance (ESG) is a sustainability performance measurement used worldwide. Previous research within the ESG area has mainly focused on ESG score and financial performance.

Environmental performance gets more attention from investors, and the Nordic countries are all in the top five when it comes to sustainability ranking. This research examines the relation between sustainability ratings (E score and ESG score) in the Nordic countries as well as if the relation differs between different rating agencies. To study the relationships, a regression analysis was performed, and we could not draw any concrete conclusions whether low CO2 emissions are associated with a higher E- or ESG score in the Nordic countries. The result indicates that a high E- or ESG score does not seem to be associated with lower CO2 emissions.

A significant result was found on the fact that the E- and ESG scores relation to CO2 are different between rating agencies. However, full access to one of the rating agencies has not been granted, which entails some limitations and further research on the questions is recommended.

(6)

(7)

List of Tables

Table 1: Selection of material ESG factors (Clark et al., 2014). ... 16

Table 2: Variables in the regression models. ... 27

Table 3: Descriptive Statistics of variables. ... 28

Table 4: Descriptive Statistics of variables in agency comparison. ... 29

Table 5: VIF Test for multicollinearity. ... 37

Table 6: Multiple regression on E score as dependent variable and independent variables. . 40

Table 7: Multiple regression on ESG score as dependent variable and independent variables. ... 42

Table 8: Simple linear regression Refinitiv vs Sustainalytics ... 43

List of Figures

Figure 1. ESG Categories and Weights (Thomson Reuters, 2017). ... Error! Bookmark not defined. Figure 2: Correlation Matrix from the main dataset. ... 30

Figure 3: Correlation matrix of scores from Refinitiv vs Sustainalytics ... 30

Figure 4: Average E- and ESG scores ... 31

Figure 5: Average E scores Refinitiv vs Sustainalytics ... 31

Figure 6: Average ESG scores Refinitiv vs Sustainalytics ... 32

Figure 7: Residuals vs Fitted Values of E score. Figure 8: Residuals vs Fitted Values of ESG score. ... 33

Figure 9: Residuals vs Fitted Values of E score. Figure 10: Residuals vs Fitted Values of ESG score. ... 33

Figure 11: Residuals vs Fitted of E. Figure 12: Residuals vs Fitted of ESG. ... 34

Figure 13: Residuals vs Fitted of Elog. ... 34

Figure 14: Histogram of E Residuals. Figure 15: Histogram of ESG Residuals ... 35

Figure 16: E residuals Refinitiv vs Sustainalytics. Figure 17: ESG residuals Refinitiv vs Sustainalytics. ... 35

(11)

1

1 INTRODUCTION.

This introductory chapter starts with the problem background of the chosen topic. Further the problem will be discussed, followed by the purpose of this thesis and the research questions will be presented. The chapter ends with the authors preconceptions and delimitations of this study.

1.1 Problem Background.

Global climate change is one of the biggest challenges that are facing humanity today. Climate change is mainly an issue accelerated by greenhouse gas emissions and affects the environment such as shifting weather patterns and rising sea levels, therefore all kinds of sustainability work is becoming more important to save our planet.

Investing sustainable has become a key factor for investors as the analysis moves from only looking at the financial performance to including the environmental, social and governance (ESG) aspects of a company. Since 2015 the market with a ESG mandate has grown by 170 % and since the coronavirus outbreak, European investors have increased their exposure towards ESG-funds where households, pension and insurance funds hold most of the funds (Belloni et al., 2020).

In 2019 the EU Commission presented a growth strategy called “European Green Deal” where the goal is to fight climate change by having zero net emissions of greenhouse gases by 2050, disconnect economic growth from resource use and to include all places and people. To accomplish this, the European Commission will inject at least €1 trillion to sustainable investments over the next ten years (European Commission, n.d.). According to EU’s policy, sustainable finance is playing a major role for the EU’s climate and sustainability objectives.

In 2015 the United Nations adopted “The 2030 Agenda for Sustainable Development” for the members. It is a global partnership between countries with 17 Sustainable Development Goals (SDGs). The agenda is an action plan for the people, the prosperity, and the planet (European Commission, n.d.).

The Paris Climate Agreement is another agreement that was adopted in 2015. It is a global climate change agreement between all member states of the United Nations Framework Convention on Climate Change (UNFCCC) to limit global warming with below two degrees Celsius. The framework also aims to support and strengthen the countries' different impacts on the climate. The Paris Climate Agreement has a 20/20/20 target to meet the goals of the agreement. The target is to reduce the carbon dioxide (CO2) with 20%, to raise market share of renewable energy with 20% and to improve energy efficiency through existing technologies by 20%. The long-term strategy is to become carbon neutral by 2050. The global average atmospheric CO2 is increasing and has never been higher. The main reason is because of the fossils fuels that humans are burning for energy (Lindsey, 2020).

Apart from governmental agreement there are also independent organizations with a mission to help companies and organizations to develop sustainability reports. Global Sustainability Initiative (GRI) has developed global standards to report their impacts. GRI released their first guidelines in the year 2000, which was the first global framework for sustainable reporting.

(12)

2

During the past 20 years GRI has developed into the most comprehensive standard for sustainability in the world, and as a non-profit organization the standards are free and available for the public (GRI, 2020). The GRI list consists of general information about the organization, management approach, direct and indirect economic performance, environmental, social, and governmental measurement points (Total, 2019).

A financial system that supports sustainable growth is necessary for the transition to a more sustainable future. Sustainable finance supports economic growth, with less impact on the environment and taking social and governance into account. Different agencies are evaluating companies' ESG performance transparently and objectively and convert them to ESG scores.

ESG investing is when investors consider environmental, social and governance factors in the investment decision-making process in the financial sector. ESG investments have been growing rapidly during the past few years and so has the company's ESG reports. Companies' ESG scores have become a driver for both risks and opportunities for investors (MSCI, n.d.).

According to Unruh et al. (2016) a growing number of investors is paying more attention to companies ESG performance and are moving from short-term perspectives of risk and returns to long-term sustainability perspectives in investments performance.

The MSCI is an American finance company and a big provider of ESG products for better investment decisions. The MSCI ESG Research found that ESG investors have three common objectives: integration, personal values, and positive impact. The investments should reflect their values, have a positive impact, and make a difference in the world. An ESG investor believes that ESG incorporating will improve their investment results. The growth of ESG investing has led to more companies adopting sustainable practices to remain their legitimacy (MSCI, n.d.). A company who adopts the image of caring about the environment does not mean that they do. Corporate greenwashing is a phenomenon when a company is providing misleading information about environmental practices, performance, or products (Rust, 2019).

Pei-yi Yu et al. (2020) has identified three types of greenwashing (1) where companies as a strategy tries to manipulate the disclosure in order to get a higher value on the company. (2) To mislead investors by bad transparency, hide negative results and publish good results. (3) Highlighting individual products performance instead of the whole firm's ESG performance.

Since the market of ESG investing has increased the questions about corporate greenwashing has become more important (Rust, 2019).

Today there are several different actors on the market who have their main focus on sustainability, where RobecoSAM is an international investment company with a focus on only sustainable investments. In RobecoSAM’s Sustainability Ranking 2009 Sweden was the most sustainable nation with the highest country ESG score. The ESG scores can sometimes be misleading (Schieler, 2019). Large companies have for example more data available and have bigger budgets for addressing sustainability issues which results in a higher ESG rating than smaller companies. In 2017 the Swedish government submitted a legislated proposal on sustainability reporting. The law requires large companies to publish a sustainability report with a focus on ESG factors for better insight and transparency in the company (Nordqvist & Roos, 2017). The problem according to Pei-yi Yu et al. (2020) is that sustainability reports are often unaudited, there is a lack of standardization and the ESG disclosures are more developed in Sweden, which will generate a higher score compared to for example India (Schieler, 2019).

(13)

3

1.2 Problem Discussion.

The ESG score is divided into three pillars. Environmental (E), Social (S) and Governance (G).

Every pillar consists of numerous categories. The Environmental pillar focuses on resource use, emissions, and innovation. The Social pillar on workforce, human rights and product responsibility, and the Governance focus on management, shareholders, and CSR strategy. ESG ratings and reports are provided by a third party, ESG rating agencies. Today there are numerous different ESG providers, and the most known agencies are Sustainalytics, MSCI and Refinitiv. The rating scale and methodology differs between the agencies. The rating agencies cover for example different companies and sectors, they use different scopes and data sources, their analysis and outputs are not the same and it will obtain different scores. Investors, however, rely on these reports and ratings, that is why it is important to be aware of the complexity of measuring ESG performances; how are the ratings calculated and who produces them, is it the company or an agency? From an investors perspective you cannot rely on one single provider (SICM, 2016). To understand how investors use ESG related information in their investing process the CFA institute made a survey in 2015. The survey resulted in that most of the professional investors got the ESG data from public information and then from ESG rating agencies (CFA Institute, 2015).

Since environmental, social and governance factors have become the “new normal” to integrate in an investors investment process have resulted in increasing numbers of ESG rating providers (Henisz, Koller & Nuttall, 2019). SICM (Sustainable Insight Capital Management) has compared credit ratings agencies with ESG rating agencies. The main difference is that the company who is being analysed is paying the credit rating agency and it is that the user that pays the ESG agency for the ESG data. A problem with the ESG agencies is their business model. The agencies have collaborations with different users, for example investment managers and consultancies, which results in a lack of independence. This is another main reason to not just rely on one single ESG rating agency (SICM, 2016).

The most obvious components of the environmental pillar are the emissions and the use of resources. However, the capacity and ability to reduce the use of materials or to implement a strategy towards renewable energy are also metrics that affect the environmental pillar. Within the environmental pillar there is no prioritization on for example carbon footprint or new innovations for reducing emissions in the future, this makes it difficult to separate long-term strategic decisions that will have a great impact on the company's future from a short-term action (OECD, 2020).

This means that a company with high emissions, where they have a strategic goal to either develop new production methods to reduce the emission or working towards using renewable energy and a company who have decreased their emissions both can have high E scores. As an investor who is looking for a high E score, it is hard to know the variables behind the E score.

Depending on investing philosophy, you might look for sectors to invest in where you can see potential for alternative energy sources, but there are still high emissions within it. Or sectors that have developed their technology and will dramatically decrease their carbon footprint in the future. Or you do not want your investments to be associated with high emissions at all. By simply looking at the E score, it does not give a clear picture of how the relationship between the E score and emissions looks like.

Decision makers constantly release new goals regarding climate change (The Paris Climate agreement, European Green Deal) to reduce greenhouse emissions and a large amount of capital

(14)

4

is reserved to sustainable investments. A company with high emissions might still earn a good ESG score, due to the numerous Key Performance Indicators (KPI: s) and get included in ESG- funds that attract both institutional and private investors where the initial purpose is to reduce greenhouse emissions.

The average person with savings in funds or equities with limited knowledge and interest in their savings may invest their money into companies with high emissions and not as sustainable as their intention. This raises questions about potential greenwashing within ESG funds.

According to Wall Street Journal eight out of the ten biggest sustainable funds in the U.S were investing in oil and gas companies. Vanguard Group’s FTSE Social Index Fund is a fund that is supposed to exclude their investments in companies who damage the ecosystem or have a controversial opinion regarding environmental pollution. However, large ESG funds including this one had investments in Oil companies, who were accused of contaminating the Amazon, and paying local villages to settle the lawsuit. The president of Green Century Capital Management Inc, Leslie Samielrich who runs three fossil-fuel-free funds said that a majority of the investors don't know what the funds they invest in includes (Otani, 2019).

Thinking, acting, and relating about sustainability in a proactive way has led to an increase in the volume of studies dealing with ESG. ESG falls under Corporate Social Responsibility (CSR) and according to Friede, Busch & Bassen, (2015) studies related to CSR can be traced back to the beginning of 1970s. However, most previous studies on ESG have primarily focused on ESG-scores and financial performance. How ESG disclosures in financial reports have an impact on firm value, positive ESG activities will increase firm value and negative ESG activities will decrease firm value. ESG disclosure will for example decrease firm value if investors find out that a corporation is greenwashing (Fatemi et al., 2018). Fatemi et al. (2015) analyses the effect of firms CSR engagement and effects on firm value. The authors arguments for the firm's probability of survival and the reducing cost of capital with CSR engagement.

From the Stakeholder theory perspective ESG and CSR activities will increase firm value. The purpose of a business is to create value for all stakeholders and not just shareholders (Freeman et al., 2010).

Previous studies have investigated if better environmental performance, with lower pollution levels will lead to better financial performance (King & Lenox, 2001). Pollution-intensive industries gain when they reduce emissions and prevent pollution because it is easier for them to make low-cost improvements for the environment. The closer a firm gets to zero pollution the more expensive it gets (Hart & Ahuja, 1996). According to Friedman (1970) and the traditional view of the purpose of a corporation, the Shareholder Theory, ESG activities are additional costs and will reduce firm value.

When comparing the E score with ESG score between different data providers, previous studies have shown that the correlation varies. This can depend on different methodologies when building the models. It shows that investors cannot rely on a high ESG score when focusing on the environmental effects of a company (Buffo et al., 2020, p. 13). These results also raise questions about the E score between providers, how much do they differ? As far as we know, no previous research has investigated the relationship between the sustainability scores (E score and ESG score) and emissions, in particular for the Nordic countries. Thousands of both institutional and retail investors use the E- and ESG score in their analysis to invest more sustainable. It can be assumed that many investors who call themself sustainable investors have the intention to develop portfolios with low emissions and use E- and ESG scores to do so.

However, what does the E- and ESG scores tell the investor about the company's environmental

(15)

5

impact, and how good of a predictor for low CO2 emissions is the E- and ESG score? It drives us to investigate this further.

1.3 Thesis Purpose.

Sustainable finance is growing and both institutional and private investors demand corporations to account for their sustainability. The outcome of this is ESG score, where the corporations get graded on how well they are managing their Environmental, Social and Governance responsibilities. This thesis aims to investigate the relationship of CO2 emissions on the E- and ESG score. The thesis will also examine if and how the score differs between different ESG rating agencies. If the same company gets different scores from separate rating agencies. If that is the case, who should the investor rely on?

By examining CO2 emissions and the rating agencies, the goal of this thesis is to give investors a deeper understanding of the ESG rating process and use the knowledge as a complement to their research process.

1.4 Research Questions.

What is the relationship between the E score and emissions within the Nordic countries?

What is the relationship between the ESG score and emissions within the Nordic countries?

Does the E- and ESG score differ between different rating agencies?

1.5 Choice of Subject and Preconceptions.

This study is a degree project made by two students at Umeå School of Business, Economics and Statistics. Both students are currently studying their final semester of a programme that will lead to a Degree of Master of Science in Business and Economics with a major in Finance.

The program covers a variety of courses within business, statistics, finance, and accounting.

Both students have been working part time during their studies in a Swedish financial institution. The education and work experience has provided the students’ knowledge, skills, values, beliefs and especially a deeper understanding of financial terms. The combination of theory and experience is a valuable tool for this study and generates an understanding of how to apply learnings.

The choice of subject was decided together with a supervisor. Both students are interested in Finance and since sustainability is becoming more important for companies, the ESG rating and the three pillars within the ESG score seemed relevant and interesting to evaluate.

Business research is influenced by different factors. The main factors are the theoretical perspective, the ontology and epistemology stance, practical considerations, and personal values. It is important to take these factors into account because different scholars offer different definitions and perspectives on them (Bryman & Bell, 2011, p. 29). Limited preconceptions existed since none of the students have been working with sustainable finance or ESG ratings before.

(16)

6

1.6 Delimitations.

In practice it is hard to measure a company's environmental performance because some activities cannot be measured. According to Krotzinger (1998, p. 66) a firm's environmental performance is complex and will differ depending on what kind of information that is available.

Some environmental aspects are not visible now but will be in the future. That is why this study has been focused on the output measure of carbon dioxide emissions. Data on toxic releases are available and can be quantified.

In the analysis between the two rating agencies, the study did not get as comprehensive as the initial plan. Limited financial resources and time complicated the process of access data from a second rating agency. Only a small dataset of E- and ESG scores from Sustainalytics were granted. The sample was also different from the sample in the main study, which were used to study the relationship between E score, ESG score and CO2 Emissions.

(17)

7

2 SCIENTIFIC METHOD.

In this chapter the philosophical standpoints will be discussed. The decisions regarding the philosophy, strategy approach and design will be explained for this study.

2.1 Research Philosophy.

Research is an investigation and important for the future to establish truth facts or explain social phenomena. In business research there are two basic stances of knowledge; the ontology philosophy and epistemology philosophy (Solomon et al., 2018). Researchers need to decide when planning a study of the philosophical worldview (Creswell, 2014, p. 5). According to Solomon et al. (2018) is it important to identify the ontology at the beginning of the research because the choice of the research design is going to affect the research approach, the research strategy, methods of data collection and the analysis.

2.2 Ontology.

The ontology philosophy is the relationship between the researcher and the nature of reality. It has to do with how the researcher sees the world. The ontology has two positions: objectivism or subjectivism. The researcher is concerned with the question of “What is there?” and depending on the choice of position it will affect the study (Solomon et al., 2018).

The positivist ontology believes there is only one reality and takes an objective stance where the social reality is external to the researcher. Reality exists regardless of social factors and cannot be influenced (Collis & Hussey, 2014, p. 47). Since the reality is made of measurable objects, positivists often use quantitative methods as research tools. The result of a study will therefore not be influenced by the researchers' opinions, biases and beliefs (Bryman & Bell, 2011, p. 32). According to Solomon et al. (2018) the results are more generalizable and replicable with an objective stance.

The interpretivist ontology believes the opposite, there are multiple realities, and that each individual has their own reality. The interpretivist takes a subjective stance where the social reality is socially constructed (Collis & Hussey, 2014, p. 47). The researcher is open to new knowledge throughout the study because humans have the ability to adapt. In a study from a subjective standpoint a researcher is trying to understand human behaviour and then describe the phenomena (Solomon et al., 2018).

The researcher of this study has taken an objective standpoint with no preconceptions or emotions in the deduction. A quantitative study is going to be conducted where the data collection and results are not going to be influenced by the researchers’ opinions, biases and beliefs. Data collection is undertaken based on statistics and with a large number of participants.

The results of the statistical test are going to be analysed, discussed and conclusions will be drawn from the findings.

(18)

8

2.3 Epistemology.

The epistemological philosophy is concerned with the nature of valid knowledge, and it is the theory of knowledge. The epistemology researcher is concerned with the questions “What do you know?” and “How do you know it?”. There are two main perspectives for knowing when a researcher is conducting a study in the social world: positivism and interpretivism (Solomon et al., 2018). The positivist takes an independent and objective stance with high levels of generalisability. They believe that phenomena are observable and measurable. The interpretivist epistemology is a part of the research and takes a subjective stance. Reality and knowledge are influenced by people (Collis & Hussey, 2014, p. 44).

An objective ontology is often aligned with a positivist therefore from an epistemology approach the researcher of this study has taken a positivism perspective. The positivism perspective has been criticized mainly because it is impossible to separate people from the social context and it is hard to be objective as a researcher. The researcher of this study had tried to handle the main criticism of positivism. All findings are revealed, and the researchers own interest and values are disregarded (Collis & Hussey, 2014, p. 47).

We are going to objectively interpret data from a reliable source, the Refinitiv Eikon database.

The source is independent from any person. This study is therefore following a positivism perspective.

2.4 Research Approach.

To describe a research theoretical structure there are two main approaches: inductive approach and deductive approach. The inductive approach is following the idea of collecting data from observations of empirical reality and new theories are developed from the collected data. The deductive approach is built on theory and hypotheses to test if they are supported or not (Collis

& Hussey, 2014, p. 7-8).

From an inductive approach the researcher has a clear mind with no theories or hypotheses in the beginning of the research. The observations are used to study specific patterns in order to find new contributions to either existing theories or to develop new theories based on the findings. A study with an inductive approach is often characterized with qualitative methods of data collection and data analysis from a small sample, for example through interviews. The approach is more concerned with the context in which phenomena are taking place (Bryman &

Bell, 2011, p. 23).

A researcher with a deductive approach has the opposite state of mind than the inductive researcher. The deductive process has its start in a theoretical structure, where a hypothesis is developed and later tested by empirical observations to either confirm or reject the hypothesis.

The deductive approach is referred to “as moving from the general to the specific” (Collis &

Hussey, 2014, p. 7-8). According to DeCarlo (2018, p. 155) deductive research is when “The researcher studies what others have done, reads existing theories of whatever phenomenon they are studying, and then tests hypotheses that emerge from those theories”.

According to Bryman & Bell (2011, p. 23), the use of the deductive approach does not have to exclude the use of the inductive approach. But since this study is going to rely on previous research and theories to develop our hypothesis and not on observations the deductive approach

(19)

9

is adopted. The deductive approach is also most suited when quantitative methods are going to be used to collect data and the data analysis.

2.5 Research Strategy.

An important part of the research process is to choose a research strategy. There are two approaches or methods for a researcher to use, it is qualitative or quantitative approach.

However, the researcher can combine both qualitative and quantitative depending on what metrics that fulfil the purpose of the study in the most appropriate way. When using a qualitative approach, the researcher designs the research question to collect new data by conducting interviews, surveys, observations, content analysis or focus group discussions. This qualitative data is then analysed by using interpretative methods, to describe and identify issues, behaviours, or events where the aim is to develop new theories to the research area (Collis &

Hussey, 2014, p. 6-7; Hennink et al., 2020, p. 10).

Quantitative approaches involve collecting data that can be quantified and analysed by using statistical methods. The researchers can collect new data or use secondary data from a database, archive, or other published data (Collis & Hussey, 2014, p. 6). The starting point in quantitative research is a problem statement, and to establish a hypothesis where different variables can influence a dependent variable, with the intention to validate, confirm or establish relationships (Williams, 2007).

Our study will not consist of any surveys nor observe any discussions, only numerical data.

This means that a quantitative approach will be best suited for this study. Our dataset will consist of historical secondary data from Nordic companies such as CO2 emissions, E score and ESG score combined with some profitability measures and market cap. The data will be used to investigate if there is a relationship between emissions and the E score and further to see how reduction and different levels of emissions affect the E score. The data will be collected from the Refinitivs database Eikon and Sustainalytics. Statistical tools will be used to interpret the data and draw conclusions.

2.6 Research Design.

The design of the research aims to steer the author in the direction where suitable methods can be used to fulfil the purpose. According to Bryman & Bell (2011, p. 40) there are five different types of research designs:

• Experimental design

• Cross-sectional or social survey design

• Longitudinal design

• Case study

• Comparative design

The research design is most relevant in quantitative research because it is dealing with how data is gathered and customized in order to produce meaningful data, analysis and results (Bryman

& Bell, 2011, p. 40).

Experimental design is associated with high validity, but it is not common in business research.

The samples are divided into two groups, the experimental group and control group in order to compare them. In a Cross-sectional design a lot of data is collected on more than one case at a

(20)

10

single point in time. The Longitudinal design is often used to identify changes in business research. The research is based on a sample on more than one occasion during a longer time period. A Case study design is based on a single case and the Comparative design is when a researcher is comparing two or more cases with each other (Bryman & Bell, 2011, p. 45-63).

In order to explain and understand the relationship between CO2 emissions, E score and ESG score for a period of time this study applies a longitudinal research design. The data are collected in a sample, the data contains more than one case and during and during a period of ten years. According to Bryman & Bell (2011, p. 58) there are two types of longitudinal designs, the panel study and cohort study. A panel study involves a sample, the data is collected on more than two occasions and with different types of cases. In a cohort study the sample experiences the same event at a given point in time (Bryman & Bell, 2011, p. 58). Since we have collected data from the same sample at different points in time and with different types of cases for example country and industry, a panel study is used for the quantitative analysis. In a longitudinal design with a panel study, it is easy to observe change and to better explain the causal relationship between the characteristics and variables in an extended period.

2.7 Literature Search.

To deepen our understanding within the ESG investing area, we have conducted a thorough literature search. The literature search started in the Diva Database where previous research from students was found. The research there was then used to search for potential sources that could be used in this research. The database accessible from Umeå University library and Google Scholar has also been used to gather information. In order to guarantee a high reliability, the gathered articles are peer reviewed which means that they are reviewed by other researchers before they get published. Other sources than scientific articles and well-known theories that have been used originate from institutions and organizations with high validity and credibility such as: The European Commission; MSCI and CFI Institute. Keywords used in the search for the gathered information are: ESG investing; Environmental pillar within ESG; CO2 emissions effect on E performance; CO2 emissions and ESG score.

2.8 Source Criticism.

In this quantitative study the theories are used deductively. The objective is to test or verify a theory rather than developing a new one. Therefore, it is important to evaluate sources because the theory becomes a framework for the entire study (Creswell, 2014, p. 59). Different sources have been used for this study, for example sources of data and official documents. Depending on the documents the relevance of the sources varies, which is another argument to be critical and evaluate information.

According to Scott (1990, p. 6) there are four criteria’s that the sources must be assessed against and will determine the quality of the source. The criteria’s are:

- authenticity, if the material is genuine or of questionable origin.

- credibility, if the material is honest and accurate.

- representativeness, if the material is reliable.

- meaning, if the evidence is clear and comprehensible.

Sources of information are often provided primary or secondary. To ensure the quality and the relevance of the source primary references have been used in this study. The authors have been

(21)

11

trying to avoid secondary references because the primary source is often modified. Sources have been analysed and questionable to meet Scott (1990, p. 6-8) four criteria with an aim for the primary source.

2.9 Ethical and Social Considerations.

It is crucial for a researcher to deal and reflect over the ethical issues that can occur when conducting a research. The ethical scrutiny has increased and as a researcher it is important to be ethically aware. Attention toward ethical issues needs to be considered prior to conducting the study, beginning a study, during data collection, data analysis, in reporting, sharing, and storing the data (Creswell, 2014, p. 92, 95).

Diener & Crandall, (1978) referred in Bryman & Bell (2011, p. 128-137) discuss ethical principles in business research and break it down into four areas that are of most importance:

- Harm to participants; participants can be harmed in numerous ways, physical; harm to self-esteem; stress; damage of one's career.

- Lack of informed consent; the researcher should disclose as much information needed in order to help the participant to make an informed decision whether they want to be involved in the research.

- Invasion of privacy; the participant should be comfortable that the researcher does not intrude on their privacy and respect the individuals’ personal values.

- Whether deception is involved. Occurs when the researchers are dishonest with what their research represents.

Since this study is based on existing publicly disclosed data and there are no direct participants involved, the ethical issues arise mainly from the data collection, the data analysis and reporting, sharing, and storing data. In the data collection ethics relate to the sample size, lack of control and the inclusion of as many predictors. In the data analysis it is important to use appropriate statistics and that all findings should be included. The ethical issue in reporting the research is to provide accurate information and not falsify authorship, evidence, data, findings, or conclusions. Improper data analysis can for example result in misleading conclusions (Creswell, 2014, p. 97-99). Ethical considerations concerning this quantitative research have been considered to ensure objectivity and transparency when retrieving the secondary data from Refinitivs database Eikon, conducting an appropriate statistical test and analysing the results.

Since this study examines the relationship between the sustainability scores, E and ESG towards companies CO2 emissions, we think the topic of this study provides a societal aspect. The public concern about the environmental issues is growing and how business operates and engages in environmental activities is becoming more important. Hopefully, our findings can lead to a deeper understanding of how investors could create low CO2 portfolios and evaluate company's sustainability practices through different rating agencies.

(22)

12

2.10 Summary.

The purpose of this study is to investigate companies' CO2 emissions relationship towards both the E- and ESG score, also if the scores differ between rating agencies. In order to do so the researcher of this study has chosen an objective ontology with a positivism perspective. From a deductive research approach a quantitative strategy is chosen to collect and analyse data within a longitudinal design and a panel study.

(23)

13

3 THEORETICAL FRAMEWORK.

The theoretical frameworks that support this study are the Shareholders theory, Stakeholder’s theory, and Legitimacy theory. The Shareholder theory and the Stakeholder theory have an opposite view to each other to try to understand the complexities of today's business challenges.

From our point of view how the environmental corporate behaviour with studying E- and ESG scores affects different parties, depending on their interest in the company.

3.1 Shareholder Theory - the traditional view.

The American Nobel Prize winner and Economist Milton Friedman developed the Shareholder Theory and according to Friedman (1962, p. 133) corporations only have one responsibility, to maximize the shareholders wealth. Friedman (1970) further argues that only individuals can have responsibilities, an executive can have responsibilities towards his employees, his family, and other personal responsibilities. An executive is an employee of the shareholders. If that executive increases the expenditures more than what is optimal for the corporation in order to reduce emissions, he is spending the shareholders money for a social interest. The consequence of that social interest will be a reduced return to the shareholders, and that it is a violation of his responsibility. Friedman (1962, p. 113-135) further argues that corporations take their social responsibility by paying tax. If they are able to increase their sales and profits, the higher sales leads to an increase in tax payments.

3.1.1 Criticism.

There has been some criticism against the Shareholder Theory. It says that it is a short-term view by only focusing on maximizing profits and not trying to build strong relationships with employees and other stakeholders. That vision is not value creating in the long run (Fontrodana

& Sison, 2006). Another critique against the Shareholder Theory is that it has been accused of being unethical, where you can see the results in different financial scandals. However, Danielson et al. (2015) argues for how this criticism is misunderstood, where the actions that result in scandals are not what is best for the shareholders and can therefore not be associated with the Shareholder Theory. Further, Danielson et al. (2015) also point out that it’s important how the theory is defined and how it’s implemented, and that it should be viewed from a long- term perspective where the focus should be in investing in objects with positive net present values.

(24)

14

3.2 Stakeholder Theory.

The Stakeholder Theory is a theory developed in the late 1970 by scholars and practitioners.

They wanted a theory that explained the management problems with uncertainty and change.

The Stakeholder Theory was later described by Edward Freeman. Freeman et al. (2010) stated that corporations are dealing with three interconnected business problems and have a responsibility towards all stakeholders. Stakeholders are anyone who is involved and affected by the company for example employees, customers, suppliers, shareholders, government, and environmentalists. The three problems are:

- How value is created and traded

- The connections between capitalism and ethics

- The managerial mindset, how to better create value and connect business with ethics.

Compared to the Shareholders Theory, which is all about profit maximization, the Stakeholder Theory focuses on value creation (Freeman et al., 2010).

Since ESG investing has become a point of interest for all kinds of investors towards a better life, safer workplace and cleaner environment is an argument for the Stakeholder Theory (Li, Y et al., 2018). With increasing environmental problems stakeholders are more aware of environmental considerations. ESG activities and disclosures strengthen its interactions with its stakeholders and are having the potential to increase firm value and create competitive advantages (Branco & Rodrigues, 2006). According to Li, Y et al. (2018) improved business reports with ESG disclosures, and more transparency will reduce agency costs. Environmental regulations such as the frameworks to fight climate change and the Swedish law that require larger companies to publish sustainability reports will lead to improved competitiveness.

Environmental regulations are necessary and force corporations to be innovative, improve efficiency and mitigate pollution (Porter & Van der Linde, 1995).

3.2.1 Criticism.

The Stakeholder Theory has been criticized and problems have been discussed both in conception and implementation. The theory is paying attention to multiple stakeholders rather than just maximizing shareholders' wealth, which makes it hard to avoid conflicts between different stakeholders (Preston & Sapienza, 1990). According to Li, Y et al. (2018) stakeholders react differently towards ESG activities, some activities may be praised by one group and criticized by another. Preston & Sapienza (1990) writes about difficulties to find the right balance between stakeholder with competing interests but also identifying specific stakeholders. Managers implement the Stakeholders Theory and are stakeholders themselves and individuals and groups have multiple roles for example employees and shareholders.

Investors in large publicly held companies own a lot of shares which raises questions about the implementation of the Stakeholder Theory (Preston & Sapienza, 1990). Since the managers, mainly the CEO implement the Stakeholder Theory they have a lot of power and the ability to influence for example ESG activities and disclosure policies (Li, Y. et al., 2018).

(25)

15

3.3 Legitimacy Theory and Greenwashing.

Companies’ disclosure on ESG data varies with different regulatory guidelines, behavioural issues on firm level and the data is unaudited. Selective disclosure is when companies retain negative information and expose positive information regarding its environmental performance (Pei-yi Yu et al., 2020). The relationship between sustainability performance and sustainability disclosure from a theoretical perspective are based on Legitimacy Theory. The Legitimacy Theory can explain the motives and incentives for firms to engage in social and environmental disclosure activities (Hummel & Schlick, 2016). Environmental information is a legitimacy tool for firms to gain or maintain legitimacy and should therefore be disclosed in financial reports to maintain legitimacy (Lindblom, 1994). According to Cho & Patten (2007) the Legitimacy Theory and the environmental disclosure a function of exposure to public pressure, both political and social. Firms with poorer environmental performance should be based on the theory provide more environmental disclosures to remain their legitimacy. The results from the study made by Cho & Patten (2007) showed that the environmental disclosure is higher for firms with worse environmental performance and for firms who operate in environmentally sensitive industries. Meanwhile, Hummel & Schlick (2016) argues that companies disclose low-quality sustainable information to cover their poor sustainable performance to maintain legitimacy. It is difficult for stakeholders to evaluate the firm's environmental performance since the quantity and the quality of the data differs. Companies in countries that are more exposed to scrutiny are less likely to be identified as “greenwashers” because they disclose large quantities of ESG data and are more transparent (Pei-yi Yu et al., 2020).

Lyon & Maxwell (2011) are writing about the activist pressure and how they are affecting different firms. Firms with low environmental performance will increase their disclosures, meanwhile high-performance firms deter from disclosing because they are afraid of being attacked as “greenwashers” by aggressive activists. Activists' punishments for greenwash is another thing that strongly affects the firm's incentives to make environmental disclosure.

Legitimacy Theory and environmental disclosure can create competitive advantages for firms.

But according to Lindblom (1994) all environmental information is not a legitimacy tool and does not have to be disclosed in the financial report.

3.4 ESG Performance and ESG Rating.

ESG or sustainable investing is a branch in finance where investors evaluate the environmental, social and governance aspects in their investment analysis. The demand is high from both investors and regulators to publish sustainability reports. There has been a steady growth in published reports over the past ten years, and 90% of the companies in the S&P 500 published sustainability reports in 2020 (G&A Institute, 2020). There are several different organizations that are working with collecting data and ranking the sustainability reports. The results from the reports are into three pillars with different subcategories and KPI: s, that are presented in Table 1.

Refinitiv provides ESG data of more than 6000 public companies today and uses more than 400 different ESG metrics. Out of these different ESG metrics they choose the 178 most relevant metrics and groups them into 10 categories. The categories are resource use, emissions, innovation, management, shareholders, CSR strategy, workforce, human rights, community,

(26)

16

and product responsibility. Refinitivs platform Eikon provides two ESG scores and the rating scale is 0-100 that can be converted to a grade of D- to A+.

1. Refinitiv Eikon ESG score - measures a company’s performance based on reported public information.

2. Refinitiv Eikon ESG Combined score - measures a company’s performance based on reported public information with an ESG controversies overlay captured from global media sources. The main objective with ESG Combined score is to calculate a comprehensive ESG score for those companies who are involved in ESG controversies (Huber & Comstock, 2017).

This study will use the Refinitiv Eikon ESG score for the main study.

Table 1: Selection of material ESG factors (Clark et al., 2014).

Environmental ("E") Social ("S") Governance ("G")

Biodiversity/land use Community relations Accountability

Carbon emissions Controversial business Anti-takeover measures Climate change risks Customer relations/product Board structure/size

Energy use Diversity issues Bribery and corruption

Raw material sourcing Employee relations CEO duality

Regulatory/legal risks Health and safety Executive compensation schemes

Supply chain management Human capital management Ownership structure

Waste and recycling Human rights Shareholder rights

Water management Responsible marketing and R&D

Transparency

Weather events Union relationships Voting procedures

To be able to compare the E- and ESG score between different rating agencies, Sustainalytics will be used to download E- and ESG scores to compare against Refinitivs Score. Sustainalytics is a leading sustainability rating and analytics firm. They have over 25 years of experience and provide ratings and to institutional investors and companies (Sustainalytics, 2021, p. 2). In 2019 Sustainalytics changed the way they grade ESG scores. The ESG score went from grading 0- 100 where a high score is better (similar to Refinitivs ESG score), to their new ESG risk ranking (scoring scale 0-100) where a lower score is better (Bauman, 2019). The ESG risk rating measures a company's exposure to risk and how well the company is managing these risks (Sustainalytics, 2020, p. 1).

(27)

17

3.4.1 The E (Environmental) factor.

The environmental pillar covers a broad spectrum. The most obvious is how the climate is affected. Analysing a company's footprint is a leading question for shareholder, institutional investors, and money managers. As shown in Table 1, there are several other issues associated with the environmental pillar, and if they are not managed in the right way it could be a problem for their long-term financial stability. However, analysis of the environmental pillar is not only associated with the negative effects a company has on the environment. It also focuses on if the company has opportunities for example to switch to renewable energy sources, develop clean energy, minimize their greenhouse gas emissions or their work with restoring the planet (THB, 2019).

3.4.2 The S (Social) factor.

The social pillar consists of several components, like Table 1 shows. It can play a major role in how different stakeholders view the company. How a company deals with supply chain transparency and human rights are two aspects that may increase the long-term risk (THB, 2019). This also concerns the company's long term financial stability. Bad management in the social pillar harms the reputation and will impact their ability to increase sales, as well as their ability to attract investors and creditors. If the social practices are managed in a proper manner, stakeholders will earn the benefits of loyal customers and higher demand for investors (Collin, 2009).

3.4.3 The G (Governance) factor.

The governance factors manage the risks and sets the rules for shareholders rights, anti- corruption, decision making, board of directors, and owner structure, see Table 1 for more variables. It is important to understand that there can be enormous consequences for a company if the factors in the governance pillar are handled incorrectly because it can have significant effects financially and reputational. Two recent events concerning governance scandals are Facebook's misuse of data and Volkswagen’s manipulation of emissions tests. It has been shown that companies that rank below the second quartile in governance measurements have a lower probability to capitalize on business opportunities in the long run (S&P Global, 2020).

3.4.4 Understanding the ESG Score.

As one of the main ESG data providers in the world, Refinitiv will be used to collect data have over 70 Key Performance Indicators (KPI: s) with over 400 data points that are used to calculate the ESG score and stored in the Refinitivs database Eikon. The data is grouped in ten different categories. See Figure 1 for categories and the corresponding weight to the ESG score. The weight for each pillar sums up to: Environmental = 34% (11% + 11% + 12%), Social = 35,5%

(16% + 8% + 7% + 4.5%) and the Governance = 30.5% (19% + 7% + 4.5%). The weight for Governance is slightly underweighted when comparing the three pillars (Thomson Reuters, 2017). The results are then presented within a range from 0-100, where the first quartile indicates poor performance and transparency. Second quartile indicates satisfactory performance and moderate degree of transparency. The third quartile shows good performance and above average in transparency, and the fourth quartile indicates excellent performance and a high degree of transparency (Refinitiv, n.d.).

(28)

18

Figure 1. ESG Categories and Weights (Thomson Reuters, 2017).

3.5 Summary.

The Shareholder Theory focus is mainly to maximize the financial return to shareholders. But how value is created is not entirely about maximizing the expected return to the lowest risk possible. Stakeholders such as investors are demanding more and more transparency from corporations when it comes to their environmental behaviour. When including ESG scores in an investment analysis it is critical that the retrieved information is accurate in order to make it value creating. If there is a significant difference in the information gathering process and in quality of the information, it can lead investors to make costly mistakes. The Legitimacy Theory motivates companies to increase their ESG disclosure and the pressure from environmental activists can lead to improvements in their sustainability work.

Environmental, social and governance factors are going to drive how we are going to construct our portfolios and manage risk. Accurate information is therefore necessary for an investor to be able to create portfolios that only includes green companies for the transition to a low carbon society. The increasing number of environmental legislation and environmental activists are playing a crucial role for the future. Even though Shareholders Theory is to maximize profits to their shareholders, climate change is forcing companies to adapt to the change and not to fight against it. It makes us think that the future can be better explained with the Stakeholder Theory and the Legitimacy Theory and raises questions about the traditional view, the Shareholder Theory.

(29)

19

4 LITERATURE REVIEW.

Chapter four presents a systematic overview of previous academic literature based upon on the chosen topic. The literature review will further support the process of answering the research questions.

4.1 Previous Research.

Numerous studies and literature have been conducted about whether sustainability can increase the financial profitability of firms. According to Viviers & Eccles (2012) investment decisions that consider and integrate environmental, social and governance factors go way back. The movement began with Corporate Social Responsibility (CSR) several decades ago, to SRI (Socially Responsible Investment) and has now shifted to ESG, to deal with climate change and to ensure a sustainable future. CSR, SRI and ESG are very similar and links between them can be seen (Eccles & Viviers, 2011). From an investors point of view ESG has become more central and a way for companies to attract investors (G&A Institute, 2020).

Hart & Ahuja (1996) studied the relationship between emissions reductions and firm performance, i.e. if it does pay to be green. The study is based on firms from the Standard and Poor's 500 list of corporations composed of a sample of firms involved in manufacturing, mining, and production where emissions could be quantified. The results of the study indicated that it does pay to be green to prevent pollution within one to two years of initiation. High polluter firms gain, because it is easier for them to make low-cost improvements in the beginning. The closer to zero pollution a firm gets, the more expensive it gets to prevent and reduce emissions (Hart & Ahuja, 1996).

According to Hart & Ahuja (1996) companies should not stop to act environmentally because they have reached the “bottom line”. The bottom line is when the pollution abatement starts to become a cost burden for firms. The firm's credibility and reputation can be damaged if they start to think about cost savings instead of their negative environmental impact (Hart & Ahuja, 1996).

Harvard Business Review published in October 2007 a special edition about the climate. The edition contains a collection of several articles written by some of the world’s leading management scholars and practitioners. Businesses that do not mitigate carbon emissions and find it as a business problem will lose compared to those companies who do not. The articles published in the month’s forethought purpose is to help firms address climate issues by for example framing strategy, protecting reputation, engaging customers, employees, and markets (Stewart, 2007).

Businesses that take more responsible decisions towards a better climate will gain competitive advantages. The strategy is going to provide more opportunities for business, increase profits and be good for society (Porter & Reinhardt, 2007). According to Porter & Renhardt (2007) the business leaders are playing an important role for the company's approach to the climate. There are two ways to look at a firm's impact on the climate, inside out and outside in. The inside out approach is the firm’s own activities impact on the climate. The outside in approach is how climate change for example regulatory affects the business (Porter & Reinhardt, 2007).

Esty (2007) argues for the importance for companies to meet different stakeholder expectations.

Companies are today expected to for example release public reports on greenhouse gas

(30)

20

emissions, meet emission targets and improve their energy efficiency. If they do not, the company's reputation and image will be harmed. It can lead to big business consequences. Esty (2007) means that greenhouse gas emissions are costly and associated with a big risk for the business.

Reinhardt (2007) discusses which firms will gain and which will lose from the current climate trend. He suggested where to find these clues as an investor. A lot of information is provided in the company’s balance sheets. To succeed, investors should not focus on the short-term balance sheet effects or efficiency initiatives. The answer behind which company who will succeed in a carbon-constrained world is determined by its innovation, management, and leadership (Reinhardt, 2007). From an investor's point of view, it is more important that the company is aware of climate change, sees the opportunity and not get left behind (Roosevelt IV & Llewellyn, 2007). Investors should focus and bet on the long-term future they want, because business leaders will focus on the long-term future that will favor their company.

(Reinhardt, 2007). When the greenhouse gas emission prices will increase the only way to attract investors is with green capital. Companies must share the same view of the climate and the importance of the change as investors to succeed (Roosevelt IV & Llewellyn, 2007).

King & Lenox (2011) made a longitudinal study on 652 manufacturing industries in the US over the time period 1987-1996. The purpose with the study was to investigate the hypothesis if it pays to be green. Previous studies have provided that higher environmental performance will lead to a better financial performance. The authors mean that these studies often lacked the longitudinal data that is needed and cannot be trusted. Evidence from King & Lenox (2011) study is that there exists a relationship between firm environmental and financial performance, lower pollution leads to a financial gain. Furthermore, there is no evidence that firms that move to cleaner industries improved their financial performance (King & Lenox, 2011).

ESG in Focus: the Australian evidence is a study made by Galbreath (2013). The study examines ESG performance on firms in the Australian Securities Exchange (ASX) 300 in an 8- year period between 2002-2009. The results showed that firms were improving their ESG performance during the timeframe. Galbreath (2013) means that institutional forces for example the United Nations Global Compact, the Global Reporting Initiative and Carbon Disclosure project are key drivers for companies to improve their ESG performance. One hypothesis from the study was not confirmed. The hypothesis was that high impact industries were predicted to demonstrate a higher ESG performance compared to medium or low industries. Interesting finding because high impact industries are more exposed and facing a higher institutional pressure to respond to ESG issues (Galbreath, 2013).

From the stockholder to the stakeholder is a report conducted by Clark, Feiner & Viehs, (2015).

The report gives an overview of the current research on ESG performance. From a meta-study based on 200 different academic sources they found a positive correlation between companies’

sustainability business practices and economic performance. From an investors point of view the findings from this study are interesting. Companies with high ESG scores generate higher profits and are less risky, also investment strategies that take ESG issues into account outperform compared to strategies that do not (Clark et al., 2015). According to Clark et al.

(2015) sustainability has become mainstream and that all investors should incorporate sustainability considerations in their decision-making process.

Buffo et al. (2020) has investigated how investors can use the E pillar and the derived ESG score in order to consider the environmental and climate risk into their portfolios. The study aims to examine how well the E of ESG score measures emissions that have a negative effect

Sustainable Investing: On the relation between sustainability rating and greenhouse gas emissions