The role of ESG in value creation
A corporate scandal can decimate share value, and not just in the immediate aftermath as the gory details hit the headlines. Shareholders in Volkswagen, Tesco, Toshiba and Rolls-Royce, all mired by significant wrong-doing, are still suffering damage some four years after the scandals emerged. The share price of all four companies is still 30-40 percentage points below their pre-crisis peak, underperforming the market significantly with the FTSE index rising by 15% over the same period. But this is a dent in ESG value as well as share value.
Increasingly investors are looking for indicators of long-term sustainability that will ensure their capital investment is protected from the damaging impact of corporate scandals. As such, investors are now actively seeking environmental, social and governance (ESG) indicators. Indeed companies such as Blackrock state that ESG is now a core part of their investment analysis. They are not alone, investment analysis that focuses solely on financial performance is increasingly regarded as insufficient. Instead, we now see more and more investors analysing ESG-related indicators alongside financial performance.
According to HSBC, $21 trillion of global investments now take ESG into account and this is expected to rise. The London Stock Exchange estimates that 60% of assets managed for EU investors incorporate sustainable investment strategies. The Stock Exchange also finds that ESG performance is now routinely used to draw conclusions about management quality. This includes exposure to business risk and the ability to leverage business opportunities, in order to gain a better understanding of a company’s future prospects.
In 2006, the UN-supported Principles for Responsible Investment (PRI) was launched. Today it has over 900 signatories in Europe and over 1700 signatories globally. This represents over $60 trillion in assets under management.
The good news for investors is that ESG factors are now seen as having a real and quantifiable impact on financial performance over longer periods. Investments in companies with strong ESG ratings are being seen to deliver good returns.
According to the MSCI Equity index, ESC-compliant companies in emerging markets generally outperform general market indices. The All-World index, which invests based on ESG factors, outperformed its parent index by 39 basis points over the 5-year period to June 2017.
A study by Oxford University and Arabesque Asset Management in 2014 found a ‘remarkable correlation’ (paywall) between responsible investment and performance. According to their report, ninety percent of the studies reviewed showed that the cost of capital is lower for companies with higher standards of sustainability practice.
It is clear that ESG indicators are having a significant impact on investment. Businesses seeking investment need to take a proactive approach to managing their ESG performance in order to access this rapidly expanding source of debt and equity funding. Investors increasingly require genuine commitment to ESG values and will become increasingly demanding of the quality and veracity of reporting ESG performance. Independent verification attracts a stronger weighting in ESG performance collected by indices and this is a sign of things to come.
Published May 2018