Evidence links ESG performance to better investments

ShutterstockBrent Hofacker
ESG and financial performance go together like...

When the concept of measuring companies by their environmental social and governance (ESG) performance first started to emerge in financial circles over a decade ago, such factors were widely ignored by mainstream investors. Back then, the pervading view in the financial sector tended to paint ESG as merely philanthropic or ethical window dressing, and certainly not a serious framework for delivering big business returns or better understanding portfolio risk.

Fast forward 10 years and while some detractors remain, the evidence showing that ESG performance can be correlated with financial performance never has been more compelling.

A raft of ESG-based investment strategies has been launched by U.K. asset managers in the past year or two in response to increasing demand from consumers and pension scheme providers for transparency about what their money is helping to fund. Meanwhile, mainstream investment firms have been snapping up ESG specialists in a bid to better understand and meet demand in this rapidly growing area, and Swiss Re  the world's second-largest reinsurer — last year began shifting its entire $130 billion portfolio towards ESG indices.

The financial sector, it seems, finally appears to be taking environmental and ethical performance factors far more seriously, with surveys suggesting the ESG market is poised for a mainstream breakthrough within the next couple of years.

Yet, according to new research by investment analyst MSCI, there has been little empirical proof that strong ESG performance is actually a causal factor in delivering better financial performance and lower risk. Until now, that is.

According to Guido Giese, MSCI's executive director of applied equity research and an author of the report, to date there has been a major gap in analyses of ESG performance. "The problem is that in the existing research we found, they do all sorts of correlation studies and backtests to find some outperformance or risk reduction, but they are not able to explain where it has come from," Giese said. "That has been quite frustrating for asset owners or asset managers who are interested in investing in ESG, because as long as they don't understand why ESG should really matter, then they are not really believing in it."

The new paper, "Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance," explained that across the thousands of research reports investigating the relationship between ESG characteristics and financial performance there has been little consistency to the analysis methodologies employed, meaning the results overall have been inconclusive, albeit with the majority finding a positive correlation. Even those finding a positive correlation have failed to provide evidence that positive ESG performance is the cause, rather than the effect, of positive financial performance, it added.

"What's the economic process by which ESG can really affect risk and return figures, and so on? We wanted to explain the mechanism," Giese said. "There have been other studies saying that ESG creates better risk-adjusted performance, but they didn't really explain how. This is the 'how' and 'why' piece."

For instance, one can argue that companies with high ESG scores are better at managing their risks, leading to higher valuations, the report explained. But it also can be looked at from the reverse point of view — that companies with higher valuations might be in better financial shape and therefore able to invest more in measures that improve their ESG profile, thereby leading to higher ESG scores.

MSCI's report therefore took a different approach to previous studies, using historical MSCI ESG ratings data to look at the impact of ESG on cash flow and profitability, company-specific risk management and exposure to systemic risk factors. The results are unequivocal, said Giese.

High ESG-rated companies tended to show higher profitability, higher dividend yield and lower business-specific tail risks. Moreover, these firms usually displayed less systemic volatility and higher valuations, the research found, suggesting ESG rating changes for a company may be a useful financial indicator in its own right.

"We found strong evidence that companies with strong ESG profiles are really better at managing risks and opportunities," said Giese. "For example, we've seen that companies with high ESG profiles have a much lower risk of suffering from incidents like the Volkswagen case [often dubbed 'dieselgate'], or the BP case [the Deepwater Horizon disaster]. This explains why high ESG ratings make for better investments — it is because they are better managed companies."

Giese believes the pervading view of ESG among asset managers has improved a great deal compared to 10 years ago, and that the new "empirical evidence" that strong financial performance is in part caused by high-ESG ratings can help to push environmental, social and governance considerations even further into the mainstream.

More pension schemes and insurance companies are using ESG policy benchmarks for their portfolios, he pointed out, in effect using ESG ratings as a risk screening tool for their investments. He expects this trend to continue until it becomes a "strategic component at a top level" among investors.

The report recommended that ESG ratings be integrated into the financial analysis of companies to ensure model valuation are in line with stock market valuations — a move that could spell bad news for fossil fuel companies and investors that fail to take climate change risk into account.

"We have seen the first asset owners changing their policy benchmark to an ESG benchmark, and when you do that you are basically saying that the ESG perspective is what you consider the standard," he explained. "Over the next five to 10 years we would expect a large number of asset owners to have done that, and then ESG becomes the new standard."

Several ESG indices run by ratings agencies consistently have outperformed their standard benchmarks in recent years. As evidence clearly has pointed to both how and why this might be the case, more asset managers will be forced to view environmentally and financially sound investments as one and the same thing.

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