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October 11, 2011
SRI in the Rockies: Moskowitz Prize Winner Presents Paper
    by Robert Kropp

Co-author Sadok El Ghoul explains how corporate social responsibility lowers cost of equity.

As reported previously at, the winner of the 2011 Moskowitz Prize for Socially Responsible Investing was a paper entitled Does corporate social responsibility affect the cost of capital? by Sadok El Ghoul, Omrane Guedhami, Chuck C. Y. Kwok, and Dev R. Mishra.

The Moskowitz Prize the only global prize awarded for outstanding quantitative research in the field of sustainable investment.

"The quality of academic work done in the field of social investing each year has become really exceptional," Lloyd Kurtz, Moskowitz Prize administrator, said. "We believe this sustained, serious analysis will ultimately bring great benefits, not just for social investors, but for society as well."

In a breakout session moderated by Kurtz at this year's SRI in the Rockies conference, El Ghoul presented his paper, explaining the work of a group of academic economists to a roomful of investment professionals, sustainable investors, and social activists.

Placing his work in context, El Ghoul described corporate social responsibility (CSR) as a concept that has gained increasing importance over the years with mutual funds and institutional investors. This interest has led to an expectation that public companies will report on issues of environmental, social, and corporate governance (ESG) importance.

Yet, despite the fact that CSR has become increasingly mainstream, the question of whether the practice of CSR is accurately reflected in the capital markets continues to be debated.

In an interview with, El Ghoul said, "In finance we have a quite established literature relating corporate governance to the cost of equity capital. This literature shows that well-governed firms that treat their shareholders well have lower cost of equity capital. One of the implications of our results is that social responsibility also leads to lower cost of equity capital."

Using data on 12,000 US firms compiled by the former KLD Research & Analytics (now part of MSCI), the paper concluded that firms with higher CSR scores do indeed gain a lower cost of equity capital. In particular, higher scores in the areas of employee relations, environmental performance, and product strategies had significant positive effect. The effects of outperformance in the areas of community, diversity, and human rights were less apparent.

"So it is also important to treat other stakeholders well to enjoy lower equity financing costs. Other stakeholders in addition to shareholders matter as well," El Ghoul said.

"Treating stakeholders well—that is, having a higher social responsibility score—leads to lower equity financing costs," he continued. "We find that three areas of social responsibility are particularly important. These are responsible employee relations, responsible environmental policies, and responsible product strategies."

On the other hand, the stocks of companies engaged in tobacco and nuclear power, excluded from the portfolios of many sustainable investors, turned out to have higher costs of capital.

"Those companies that are involved in tobacco and nuclear power have higher financing costs," El Ghoul said. "This is consistent with two theoretical positions. First, they have a narrower investment base, since not all investors are willing to buy shares of these companies. Second, these firms are riskier than others. Litigation costs are probably an important explanation for our results."

Making the report of El Ghoul et al of particular relevance is the fact that most papers studying the beneficial effects of CSR focused on past performance, such as realized returns. This year's prizewinning paper, on the other hand, shifted attention to forward-looking advantages, as the cost of equity capital implies a required rate of return for investors; the paper foresees a discount rate on future cash flows for high performing firms.

The paper defines cost of equity capital as "the required rate of return given the market's perception of a firm's riskiness," and it "represents investors' required rate of return on corporate investments." Therefore, the authors continue, "If CSR affects the perceived riskiness of a firm…then socially responsible firms should benefit from lower equity financing costs."

El Ghoul told, "The cost of equity is going to be higher if risk is higher. The cost of equity is defined as the discount rate that investors apply to firms' future cash flows, and the penalty is higher if the risk is higher."

One factor helping to decrease the cost of equity capital for high-performing companies is that they will attract the investments of both sustainable and neutral investors. Low-performing firms, on the other hand, will only attract the neutral investors, as sustainable investors perceive the heightened risk involved in investment in them.

The implications of the quantitative analysis employed by the authors reveal that the cost of capital for socially responsible firms will be two-thirds that of irresponsible companies.

"For example," El Ghoul told, "Our results show that socially responsible firms enjoy cheaper equity financing. We compare a socially responsible firm with six percent cost of equity with a socially irresponsible firm with nine percent cost of equity. If both firms have an investment opportunity that yields an 18% return, the spread of the investment return is going to be nine percent for the socially irresponsible firm and 12% for the socially responsible firm. So the profit in percentage terms is going to be higher for the socially responsible firm."


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