Socially Responsible Investment and Market Performance: The Case of Energy and Resource Companies.

• Author: Brzeszczynski, Janusz

1. INTRODUCTION

The global and national energy and environmental policy debates are increasingly shaped by the need to balance the competing objectives of economic efficiency, sustainability and afford-ability. Many energy and resource firms have noted the social and political changes in their environment and view the pursuit of profit for shareholders combined with social and environmental responsibility as part of their long-term corporate strategies. The recent developments in global climate agreements (e.g. COP21) and the emergence of the notion of 'stranded carbon' are examples of such contextual changes. The new operating environment represents a major departure from the "business-as-usual" conduct of business as these firms move from a production function of only private goods towards joint production of private and public goods.

From the theoretical point of view, firms undertake sustainable investments to improve their image, secure comparative advantage and maximise profits for their shareholders. This is particularly the case for energy and resource firms since they increasingly find themselves at the centre of the sustainability debate. However, empirical evidence about their performance in financial markets remains scarce. It is, therefore, worthwhile to examine whether the market rewards or penalizes this departure from the conventional profit maximisation model.

In order to achieve sustainable energy economy objectives, it is important to decouple energy use and its related emissions and environmental impacts from economic activity. Therefore, not only the governments but also energy and resource firms can have a crucial role to play through their actions and investments (see, e.g., IEA, 2014 and 2015). In recent years, many major companies have adopted Socially Responsible Investment (SRI) principles as a strategic tool and self-regulation mechanism for improving corporate image and gaining competitive advantage.

SRI has grown drastically over the past three decades. Forum for Social Investment reports that the assets invested in SRI companies in the US have increased by over 1260% to $8.72 trillion between 1995 and 2016 (a compound annual growth of 13.25%) representing nearly 22% of the $40.3 trillion total assets under management (USS1F, 2017). The number and value of SRI funds have also increased significantly, which has led to the creation of SRI indices, such as: Calvert Social Index, Domini400 Social Index, FTSE4GOOD Social Index and MSCI ESG Social Indices etc.

However, it is not clear from the literature whether investments according to the SRI principles provide higher, lower or similar returns in comparison with conventional stocks (see, e.g., the review studies by Margolis and Walsh (2003), Orlitzky et al. (2003) and more recently by Revelli and Viviani (2013). In particular, the literature about the effect of SRI on performance of energy and resource firms is remarkably scarce (see, e.g., Jenkins and Yakovleva (2006), Frynas (2009) and Zhao (2015) for rare exceptions) and the available findings are inconclusive.

Our paper contributes to the literature on SRI investments and firms financial performance in general and in the case of energy and resource firms in particular. To the best of our knowledge, this paper is the first such study to analyse SRI investments in energy and resource companies on a global scale using international data from several markets in different geographical regions covering all six continents. We present novel empirical findings on the performance of international energy and resource SRI stocks. The findings are important for energy market and financial market researchers. In particular, they are of relevance for energy policymakers and for the investors in energy and resource firms.

We analyse the performance of energy and resource SRI companies on the international stock market and we simulate an investment in portfolios of such firms. We calculate raw returns of the energy and resource SRI stocks portfolios and analyse their performance using Fama-French (1992, 1993) and Carhart (1997) multi-factor models. Furthermore, we control for changes in the oil price by including the crude oil price returns in our Fama-French and Carhart estimations. We also measure the performance of the portfolio using risk-adjusted techniques, such as the Modified Sharpe Ratio (MSR) and the Certainty Equivalent (CEQ) returns. Moreover, by evaluating the profitability of stocks portfolios in the variants with and without dividends, we can extract the effect of dividends on their total returns. Finally, we analyse the performance in individual sub-sectors and examine the relation between the investigated stocks returns and the changes in the levels of the crude oil price.

The performance of energy and resource SRI stocks portfolios is assessed by comparisons with major global benchmarks, including broad market indices as well as the energy market, the SRI market and the alternative energy market sector indices (S&P Global 1200, MSCI World Energy, FTSE4GOOD and FTSE ET50 Index). The study encapsulates bull and bear market phases and allows the assessment of the impact of those market conditions on the profitability of energy and resource SRI stocks portfolios. We identify bull and bear market periods using the concept of non-overlapping "bull" and "bear" phases based on major peaks and troughs in the stock market indices, presented in Gooding and O'Malley (1977) and in Woodward and Anderson (2009), i.e. based on the price variability of indices and their long-term trends. Our sample is composed of global energy and resource stocks, hence we rely on the examination of bull and bear market phases of the S&P Global Index and the MSCI World Energy Index.

The next section presents the conceptual framework of our study. Section 3 reviews the relevant literature, which relates mainly to market performance of stocks and portfolios within the context of social responsibility. Section 4 presents a theoretical discussion of the effect of limiting the size of stocks portfolio due to imposition of the stocks exclusion criteria. Section 5 provides an overview of the data and the methodology. Section 6 presents and discusses the empirical results. Section 7 concludes the paper.

(2.) CONCEPTUAL FRAMEWORK

The conceptual framework of our analysis relies on two competing theoretical views about the profitability of investments in the SRI stocks.

The literature pointing towards a negative relationship between SRI and stock returns proposes two possible explanations. First, the cost of social responsibility is an extra expense for firms that reduces profitability. However, the SRI supporters argue that, over time, this extra cost is traded off by gains in reputation. Second, focusing on SRI companies as a subset of stocks reduces benefits of diversification (e.g., when stocks of tobacco companies are excluded from portfolios), which may result in lower risk-adjusted returns. On the other hand, the proponents of SRI argue that the excluded companies are engaged in unsustainable products or services that will make them less profitable anyway over time. These arguments are supported by many empirical studies that do not find meaningful differences between the performance of SRI and non-SRI stocks (see, for example, the results in Revelli and Viviani, 2013).

There is also a stream of literature that advocates a positive relationship between SRI and stock returns. The conceptual argumentation in this case is related predominantly to the instrumental stakeholder theory and the slack resources theory. Instrumental stakeholder theory postulates that companies aim to satisfy various stakeholder groups and that the resulting stakeholder-management relationships serve as monitoring and enforcement mechanisms leading to various positive side-effects, such as the increased efficiency of the firm's adaptation to external demands as well as better overall financial performance (Freeman and Evan, 1990; Hill and Jones, 1992; Jones, 1995; Clarkson, 1995).

Slack resources theory argues, in turn, that positive financial performance allows companies to become more socially responsible because it provides them with additional resources necessary to engage in corporate social responsibility, which usually requires availability of substantial excess funds (see Ullmann, 1985; McGuire et al., 1988; Waddock and Graves, 1997).

Other theoretical and conceptual views postulate that socially responsible companies are likely to benefit from different "mediating effects ", such as improvement of reputation, better relations with financial institutions and investors as well as easier access to capital or even lower cost of capital (Spicer, 1978; Fombrun and Shanley, 1990). Further positive consequences of reputational effects, such as increase in employees' goodwill, may lead to improvement of the firm's financial performance (Davis, 1973; McGuire et al., 1988; Waddock and Graves, 1997).

There exist different channels through which financial performance of the SRI companies can be improved, for example through higher sales, better profitability or achieving lower cost of capital etc. Moreover, in the theoretical literature there are two other themes related to the conceptual discussions and their respective theoretical arguments that are tested empirically, i.e. the existing studies have also attempted to verify: (1) whether the socially responsible and ethical attitudes increase costs of firms' operations, which leads to negative impact on their financial performance and (2) whether social responsibility can be afforded by firms that already have good financial performance, which leads to feedback effects and further improvement of their financial situation.

In this study, we examine the main theoretical conjectures discussed in the above section. We empirically analyse the performance of portfolios composed of the...