With research claiming that companies with high ESG standards make better investments, are sustainable strategies on the verge of a mainstream breakthrough?
It sounds too good to be true. Companies who avoid the “do anything to make money” mantra in favour of adopting better corporate behaviour could be more profitable and ultimately boost shareholder value.
This is the conclusion of Foundations of ESG Investing, a paper published by index and analytics specialist MSCI that looks at how a healthy environmental, social and governance (ESG) policy affects valuation, risk and performance.
It has widely been accepted that companies scoring high on ESG benchmarks carry lower risks. Now, however, it seems there is evidence that those adopting practices, such as providing greater transparency to shareholders, employing a more diverse workforce and removing climate change risks from their operations could generate higher longer-term profits too.
“Companies with good ESG ratings are significantly more profitable and pay higher dividends,” concludes Guido Giese, executive director, applied equity research at MSCI.
He adds that this could appeal to long-term investors. “Knowing that companies with good ESG characteristics in the long run are good dividend payers is definitely a motivation for pension funds to look into ESG,” Giese says.
Newton Investment Management’s investment director, Jon Bell, is not surprised by MSCI’s findings. “We have long believed that a good ESG policy is part of being a successful company,” he says.
Invesco Perpetual’s head of ESG, Cathrine De Coninck-Lopez, says stocks with an improving ESG performance, also often have improving valuations. “Furthermore, the opportunity related to sustainability of future earnings is potentially better for companies that produce in an innovative, less resource intensive manner; or provide solutions for the world’s problems,” she adds.
If proof were needed to support investor bullishness, the negative impact on share prices of poor ESG standards have been laid bare by scandals involving energy giant BP, car-maker Volkswagen and social media darling Facebook.
DON’T LOSE YOUR HEAD
This report has, unsurprisingly, been welcomed by those pushing the ESG agenda. Yet it is easy for cynics to dismiss the noise about ESG helping to make the world a better place if the financial returns and improving shareholder value are not there. So if MSCI’s conclusions prove correct, then could ESG be on its way to being considered a mainstream strategy?
But the man behind the report makes it clear that he is not saying that backing companies with high ESG ratings always means higher profits. “No investment approach guarantees outperformance,” Giese says.
He points out that traditional factors outperform on average for long periods as does the ESG signal on average in MSCI’s benchmark universe. Giese does, however, fire a warning to investors and trustees: “It doesn’t mean it outperforms every year and it doesn’t mean it outperforms for every single stock, of course.
“The key message that we have seen is that ESG is a tool to achieve better risk-adjusted returns,” he adds. Indeed, in the US $8.7trn (£6.5trn)of funds managed by professionals considered sustainable, responsible or impact investing factors when being put to work back in 2016, according to the US Forum for Sustainable and Responsible Investment. This bettered the $6.5trn (£4.9trn) reported in 2014. With so much already invested in companies with high ESG ratings, could this research be the catalyst that moves ESG into the mainstream from being just a niche for religiously-minded or ethically-focused investors.
While it is unlikely that on the basis of one report pension schemes, insurers and other institutions will start moving all of their portfolios over to an ESG mandate, this could be the start of a long journey to being an established investment style. One investor believes that MSCI’s findings will not be a game changer for ESG investing; but regulation could.
“Research tends to evolve over time and change behaviours gradually,” says Tim Manuel, Aon’s UK head of responsible investment. “What we haven’t seen is that one piece of ESG research that really changes perceptions,” he adds. “It is more about an acumination of research over time that gradually brings people round to the idea that this is a material concern and can make a difference to their portfolios. “It will help contribute to the debate, but it will take a lot more than one piece of research to shift perceptions,” Manuel adds.
ESG is core to Newton’s approach and a lot of people are already following that, Bell says. “Sustainable strategies will become much more common, but it will not happen overnight.
“There are still a number of asset owners who don’t want to restrict their investment universe, and they believe that the best chance of success comes from having the widest possible opportunity set,” Bell adds. “There are strong arguments to suggest that investing along ESG lines can help the environment, help the world but also help your returns.”
For some the arrival of ESG as a mainstream market feels a lot closer. Jeannette Andrews, corporate governance manager at Legal & General Investment Management (LGIM), believes that momentum in this space is growing. “It is something that we have been looking at for many years,” she says. “We are committed to it under the stewardship code, under our obligations under the Principles of Responsible Investment (PRI). It is something that our clients ask us about. They expect us to be doing it. “We are getting the data points now, we are seeing the research coming through demonstrating the materiality of it, so we are well on the road to it becoming a mainstream discussion,” she adds.
Another investor seeing ESG on its way to becoming a major investment class is Candriam Investors. “People are looking in that direction more and more because it is making more sense to do things this way,” global head of consultant relations Fawzy Salarbux says.
The people running the country have stepped in to help improve standards. The Environmental Audit Committee has asked the UK’s top 25 pension funds about how they are dealing with climate change and how they manage those risks. “It has shone a spotlight on the issue and it has really made those at pension funds take it seriously because their responses will be made public,” Manuel says. The Department for Work and Pensions (DWP) is planning to launch a consultation to roll that out to all pension schemes in the country. “That is the right end of the investment chain to start,” Manuel says. “If the asset owners take it seriously then their intermediaries will take it seriously, which then flows down to the companies themselves.”
APPLES WITH APPLES
MSCI is not alone in claiming to have found a positive connection between ESG standards and corporate performance.
Calvert Investments, in collaboration with George Serafeim, a Harvard Business School professor, found that a higher ESG performance correlates with greater management or business model quality. One of The Role of the Corporation in Society: Implications for Investors’ conclusions was that the valuations of firms with a better ESG performance reflect higher expected growth and a lower cost of capital.
Calvert-Serafeim’s research also found that firms with superior ESG qualities trade at higher valuation multiples in equity markets, while firms with better ESG performance also had the added benefit of lower credit default swap spreads.
Serafeim is not the only academic to contribute to the debate. A study by anthropologist Alex Edmonds, who is professor of finance at London Business School, found a positive link between how happy a company’s employees are and stock price movements.
There is also a paper from Elroy Dimsen called Active Ownership, which shows that successful ESG engagement has a materially positive impact on companies.
Other academic studies on the subject include the University of Hamburg, which studied 2,000 research papers in 2015. It examined the E, S and G individually and found a stronger correlation between them than when they are aggregated together. It makes sense because investors run the risk of averaging out when you aggregate something together.
Research from Harvard concluded that ESG factors lead to a lower cost of capital and better operational performance.
“They all look at the same issue but come back with slightly different conclusions,” Andrews says.
Giese didn’t find his research too taxing. He looked at companies in the MSCI World Index, where every company has an ESG rating. “It is amazing how straight forward it is within MSCI to link the ESG ratings to financial analysis because we have integrated our ESG ratings into our portfolio risk analysis tool,” he says.
“So every stock in the universe not only has standard measures like book value, market cap and volatility, but the ESG signal is also in the risk model. Therefore we can relatively easily run all sorts of risk analysis also using the ESG signal.” For others looking at ESG ratings is not so straightforward. Salarbux says that comparing apples with apples in an ESG basket is challenging. “Yes, some might use some common sets of data, but at the end of the day everyone comes at ESG from their own perspective,” he adds.
In the same basket, he adds, you will have an ESG strategy that is merely excluding tobacco and alcohol, and you will have an investor doing it from a much more engaged perspective. “In the same ESG basket there is a lot of dispersion, so to draw an overall conclusion and say “yes, ESG works” is difficult.”
GET THE MESSAGE
The main benefit of this research is the message it sends out to management and investors that ESG matters and, if done properly, could lead to improved risk-adjusted returns.
Salarbux adds that the research means that when an investor assesses a company they have to look beyond the traditional financial metrics.
The challenge is to have reliable and available data of non-financial risk to see which companies are exposed to long-term sustainable trends and the long-term macro perspective.
Whatever the conclusion that asset owners and senior managers read into this research, for Newton this is an investment trend that is unlikely to fall out of fashion. “Studies suggest that the next generation of investors are more interested in engagement in the environment and the impact that companies have on the world than the older generation,” Bell says. “As that comes through, you will see increasing pressure on asset owners and investment managers to take more account of these factors.”
Whatever conclusion institutions glean from MSCI’s findings, Giese believes that his report is a game changer. “A decade ago ESG was a difficult field, even five years ago it was considered niche. It has changed in the past few years. We have seen enormous in-flows going into ESG. For example, the assets tied to our ESG indexes, in terms of people tracking the ESG index or launching an ETF, have quadrupled in the past two years, so it is exponential growth.
“The reason for that is that there is now a lot of evidence that ESG can help performance. The evidence is not only there in terms of research papers but also our ESG Leaders Index has an eight-year track record,” Giese says. “With an eight-year track record people are comfortable to say that this works, ESG helps to make portfolio returns more resilient and now we see that flows are coming in.”
Whatever happens following the publication of MSCI’s report it is clear that change is in the air for ESG and the early adopters could be among the biggest beneficiaries of picking stocks on the financials alongside non-financial data. “It is called ESG now, but maybe in 20 years it won’t be called ESG it will just be called investing, because that will be the right way to do it anyway,” Salarbux says. “Mangers who have a framework today, we’ve had one for about 22 years now, will have a significant advantage in that respect.”
