Asset Management

Why ESG is a material issue in contemporary financial analysis

April 2019

Read Time: 6 minutes

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, it was 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 financial returns or for better understanding portfolio risk.

The term ESG was first coined in 2005 in a landmark study entitled “Who cares Wins” by the UN Global Compact. ESG investing is a type of ‘sustainable investing’ which is an umbrella term for investments that while seeking positive returns, also consider and evaluate the long-term impact that business practices have on society, the environment and the performance of the business itself. Strong ESG policies and practices can protect brand reputation, help recruit and retain talent, foster customer loyalty and reduce the risk of lawsuits against companies. 

Today, evidence is increasingly piling up that ESG performance is correlated with financial performance. Almost 30% of global assets are managed under SRI (Socially Responsible Investing). This number has risen to USD 30.6 trillion in 2018 compared to USD 13.6 trillion in 2012.  

ESG tends to deliver superior returns

High ESG-rated companies tended to show higher profitability, higher dividend yield and lower tail risks. These companies are more likely to show less systematic volatility, lower values for beta and higher valuations. Research evidence supports the fact that ESG investing is delivering superior returns and that companies with strong sustainability scores show better operational performance and are less risky. Investment strategies that incorporate ESG issues outperform comparable non ESG strategies. 

As per a Bank of America Merrill Lynch study, stocks that ranked within the top third by ESG scores outperformed stocks in the bottom third by 18% percentage points in the 2005-2015 period. More interestingly, if investors had used above-average ESG scores to guide their stock picking they would have avoided 15 of 17 corporate bankruptcies between 2008 and 2016.

Ignoring ESG issues can have material consequences

Mainstream investment firms have been snapping up ESG specialists in a bid to better understand and meet demand in this rapidly growing area. Swiss Re, the world's second-largest reinsurer, for instance, has begun shifting its entire USD 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 that the ESG market is poised for a mainstream breakthrough within the next couple of years.

The revenues of a firm can be materially impacted by a negative ESG event that affects the reputation of a firm (i.e. violation of emission regulations, pollution, etc.) or forces a long drawn out litigation event.  Purchasing decisions and the company’s ability to recruit and retain talent can also be influenced meaningfully by corporate reputation. Companies that have a history of accidents or strikes, or that caused environmental damage (oil spills into oceans) may have problems attracting talent. We saw a few years ago that a leading global automobile company violated emission regulations, which not only led to a sharp fall in the stock price and massive reputational damage but was also followed by years of litigation and expensive lawsuits.  We also had a case recently where poor corporate governance at another large global automobile company resulted in the ouster of the company’s CEO and a sharp decline in the company’s stock price.  The examples amply demonstrate how ESG factors can impact a company’s performance and, as a corollary, its valuations. Evidence suggests that companies with strong ESG profiles are better at managing risks and opportunities.   

Several pension schemes and insurance companies are now using ESG policy benchmarks for their portfolios, in effect using ESG ratings as a risk screening tool for their investments. This trend is likely to continue until it becomes a "strategic component at a top level" among investors.

ESG ratings can also be integrated into the financial analysis of companies to ensure model valuations 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. In fact, several ESG indices run by ratings agencies have consistently outperformed their standard benchmarks in recent years. 

Business Responsibility Report (BRR)

In India, the Business Responsibility Report (BRR) is a key enabling requirement placed by the Securities and Exchange Board of India (SEBI) on the 500 largest listed companies.  There is a global macro trend of assets increasingly being managed with SRI strategies and this means that (a) global asset managers will look for similar opportunities in India since it is a growing economy (b) Indian asset managers will create funds to attract foreign investors (mirroring the global trend).

Indian firms have begun disclosing information as per the required Business Responsibility Report. This enabling disclosure policy has created a framework for companies to engage in dialogue with their stakeholders. As companies improve their BRR reporting, asset managers using SRI strategies will leverage it more and more. ESG considerations for investment and sustainable profitability are becoming inevitable, primarily because of evolving social, economic and political trends. 

Regulations in each country are set to increasingly compel companies and investors to embrace ESG. There is mounting global pressure on countries to enact legislation around climate change, resource depletion, pollution, human rights.  Regulation is increasingly pushing companies and investors to assume their responsibility towards society and the various stakeholders.

Investors are increasingly demanding ESG investment solutions

Demographic shifts are driving a rapid change in investor profiles and investment preferences. Almost 67% of millennials and 36% of baby boomers believe investments are a way to express social, political and environmental values. Over 90% of affluent millennials and 76% of wealthy non-millennials have said they were interested in realizing high returns while also promoting positive social and environmental outcomes.  

Carbon risk management and climate change are becoming compelling issues today. Institutional investors are concerned about the long term value of their assets and have started to engage with and even divest from companies in carbon dependent industries. 

Energy sources are evolving. Shifts in the dynamics of oil market and fossil fuels have made natural gas cheaper than coal. Renewable energy sources are becoming cheaper and scalable.  ESG investing will compel companies to embrace these shifting dynamics. 

Against this backdrop we can safely say that ESG matters because following a robust framework can give investors a window into the intersection of big macro trends and the companies’ ability to navigate them.   

ESG is no longer a choice. It is becoming a requirement. 

Author: Abhay Laijawala, Managing Director, Avendus Capital Public Markets Alternate Strategies LLP

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