DOES IT PAY TO BE ESG? An empirical analysis of sustainability in the Nordic countries from a risk and valuation perspective Corentin Arnou, Marcus Hammarstedt Department of Business Administration Civilekonomprogrammet Degree Project, 30 Credits, Spring 2021 Supervisor: Lars LindBergh [THIS PAGE WAS INTENTIONALLY LEFT BLANK] Abstract In the field of sustainable finance, Environmental-, Social- and Governance-ratings (ESG) have become an acknowledged measurement of a firm's sustainability performance. The increased awareness of sustainability issues in today's society is undeniable. However, based upon contradicting results from previous research, it was uncertain if investors were rewarding a firm’s sustainability efforts in the form of a lower cost of equity. The purpose of this thesis has therefore been to examine the relationship between sustainability, risk and valuation as well as stock-price behavior in times of crisis regarding large firms publicly listed in the Nordic countries. In order to fulfil the purpose, various multiple regression models have been conducted on quarterly data from the period between 2011 to 2020. The approach chosen to examine if ESG has a relation to the cost of equity has been to calculate the implied cost of equity inferred from consensus forecasts of future financial development and stock price at each point in time, also known as the ex-ante cost of equity. Since the independent variable ESG-score was not likely to be the sole variable to affect the independent variables in our multivariate regression models, we have followed previous studies in the choice of control variables. The empirical results of this study showed a significantly negative relationship between a firm’s ESG-score and the cost of equity. In addition, our results showed a significantly positive relationship between a firm’s ESG-score and both the price-to-earnings ratio as well as the price-to-book ratio while no significant relationship between a firm’s ESG- score and the enterprise value to earnings before interest and taxes ratio could be established. Finally, the results of this thesis showed that firms with a greater ESG-score generated excess- returns during the latest market turmoil of 2020 caused by the Covid-19 outbreak. This thesis challenges the value-destruction view of ESG-efforts since our results indicate that investors are pricing sustainability risk with a negative risk premium in line with the value- creation approach. No causality test has been performed during this study, however several possible mechanisms by which ESG impacts the valuation and crisis resistance have been discussed based upon previous research and the theoretical framework. We argue for the reduced cost of equity to reflect diminished information asymmetry, a larger investor base, improved growth and cash-flow opportunities as well as reduced risk for litigations as a consequence of a more sustainable business conduct. To the best of our knowledge, no previous study on the topic has been conducted on the Nordic markets. This study fills thus a research gap on the relation between sustainability, risk and equity market valuation and we sincerely hope to have contributed to academia with new approaches. Keywords ESG, Cost of equity, Sustainable finance, Price-to-earnings ratio, Price-to-book ratio, Enterprise value to earnings before interest and taxes ratio, Covid-19, Shareholder’s theory, Stakeholder’s theory, Information asymmetry. Acknowledgments We would like to thank our supervisor Lars Lindberg for his academic guidance and important feedback during the course of this study. We are thankful that Lars Lindberg gave us his insights, which definitely have helped us to develop this thesis. We furthermore would like to thank our family, close friends, and each other for the support during this tough semester. Umeå 10th of May 2021, Corentin Arnou and Marcus Hammarstedt. Table of contents 1. Introduction ---------------------------------------------------------------------------------------- 1 1.1 Problem Background ------------------------------------------------------------------------ 1 1.2 Purpose and Research Questions ---------------------------------------------------------- 4 1.3 Choice of the subject and preconceptions ------------------------------------------------ 5 1.4 Delimitations --------------------------------------------------------------------------------- 5 1.5 Target audience ------------------------------------------------------------------------------ 6 2. Theoretical point of reference ------------------------------------------------------------------ 7 2.1 Theoretical Framework --------------------------------------------------------------------- 7 2.1.1 Defining sustainability -------------------------------------------------------------- 7 2.1.2 ESG Investments - Preferences, risk and return in equilibrium --------------- 8 2.1.3 Shareholder’s theory --------------------------------------------------------------- 11 2.1.4 Stakeholder’s theory --------------------------------------------------------------- 11 2.1.5 Legitimacy theory ------------------------------------------------------------------ 12 2.1.6 Information asymmetry ------------------------------------------------------------ 13 2.1.7 Signaling theory -------------------------------------------------------------------- 14 2.1.8 The cost of equity capital --------------------------------------------------------- 14 2.1.8.1 Ex-Post Cost of Equity models ------------------------------------------- 15 2.1.8.2 Ex-Ante Cost of Equity models ------------------------------------------- 16 2.1.9 Price-based multiples -------------------------------------------------------------- 17 2.1.10 Market crashes ---------------------------------------------------------------------- 18 2.2 Previous research --------------------------------------------------------------------------- 19 2.2.1 The impact of ESG on firm’s operational and financial performances ----- 19 Line of reflections ---------------------------------------------------------------------- 20 2.2.2 The impact of ESG on firm’s cost of equity capital --------------------------- 20 Line of reflections ---------------------------------------------------------------------- 22 2.2.3 The impact of ESG on firm’s market valuation, stock return and volatility 22 Line of reflections ---------------------------------------------------------------------- 24 2.2.4 General conclusions of the previous research ---------------------------------- 26 2.3 Positioning of the thesis within the theoretical framework --------------------------- 27 2.4 Theoretical hypothesis --------------------------------------------------------------------- 28 3 Scientific methodology -------------------------------------------------------------------------- 30 3.1 Ontological assumptions --------------------------------------------------------------------- 30 3.2 Epistemological assumptions ------------------------------------------------------------- 31 3.3 Research design and methodological choice -------------------------------------------- 31 3.4 Research approach -------------------------------------------------------------------------- 32 3.5 Literature search and evaluation of sources --------------------------------------------- 33 3.6 Ethical considerations ---------------------------------------------------------------------- 33 4 Research Method --------------------------------------------------------------------------------- 35 4.1 Population and Sample --------------------------------------------------------------------- 35 4.2 Statistical hypothesis ----------------------------------------------------------------------- 37 4.2.1 Hypothesis connected to research question one -------------------------------- 37 4.2.2 Hypothesis connected to research question two -------------------------------- 37 4.2.3 Hypothesis connected to research question three ------------------------------ 38 4.3 Regression analysis ------------------------------------------------------------------------- 38 4.3.1 OLS - Ordinary Least Squares --------------------------------------------------- 38 4.3.2 GLS - Generalized least square regression ------------------------------------- 39 4.4 Regression models -------------------------------------------------------------------------- 39 4.4.1 Dependent variable ----------------------------------------------------------------- 40 4.4.2 Independent variable --------------------------------------------------------------- 42 4.4.3 Control variables ------------------------------------------------------------------- 42 4.4.4 Problem with chosen variables --------------------------------------------------- 45 5 Data ------------------------------------------------------------------------------------------------- 46 5.1 Descriptive statistics ------------------------------------------------------------------------ 46 5.2 Model diagnostics -------------------------------------------------------------------------- 48 5.2.1 Linearity of the regression model ------------------------------------------------ 49 5.2.2 Distribution and mean value of the error term --------------------------------- 50 5.2.3 All explanatory variables are uncorrelated with the error term. ------------- 51 5.2.4 Observations of the error term are uncorrelated with each other. ----------- 51 5.2.5 No heteroskedasticity -------------------------------------------------------------- 52 5.2.6 No perfect multicollinearity ------------------------------------------------------