The Value of ESG in Investing
By Aitana Arriaga, Batchelor of Business Administration Student at Hult Business School.
Why do investors, business leaders and analysts seem to care so much about environmental social governance (ESG)? Enhanced investor awareness and a philosophical desire on the part of consumers to be more sustainable drive superior stock returns for firms with a strong ESG proposition and have improved their public standing.
Since the 1990s, growing investor interest in ESG data has increased the value created by disclosing non-financial information and externalities caused by business operations. The creation of the Principles of Responsible Investing (PRI) in 2006 was a key milestone. Its signatories are committed to incorporating ESG issues into their investment analysis, ownership policies, and practices. PRI’s assets under management (AUM) surpassed $100 trillion in 2020. ESG integration was the fastest-growing investment strategy in 2018, growing by 60% from 2016 to 2018 with a total of $193 trillion under ESG management globally (1). Europe is the region with the most capital allocated to responsible strategies, reaching $14.1 trillion in 2018, followed by the US with $11.6 trillion. Over 2/3 of these assets were managed on behalf of institutional investors and 1/3 on behalf of individual investors with a record of €25trn invested sustainably in Europe jointly. The UN differentiates between three types of ESG screening in investment portfolios: negative, best in class, and norms-based screening. Negative screening is the “weakest” form of screening and excludes certain sectors, companies, or practices based on specific ESG criteria. Positive/best-in-class screening involves investing in sectors and companies with better ESG performance than industry peers and was the fastest-growing strategy with 19 percent between 2016 and 2018 (2). Norms-based screening has minimum standards of business practise based on international norms such as the UN Global Compact Principles or the Universal Declaration of Human Rights. Over 100 agencies provide ESG data and scores including Thomson Reuters, MSCI, and Sustainalytics. At the core of the rise of ESG are enhanced consumer awareness and societal shifts and government regulation.
Especially the environmental factors have become an integral aspect of international policymaking. The Paris agreement, the 2030 agenda for sustainable development, and recent EU policies aiming to reduce carbon emissions are only some of the examples of how policymakers globally have joint forces to mitigate the repercussions of this issue. Nonetheless, the OECD predicts that should the nationally determined contributions to 2030 be achieved, global warming would still reach around 3°C (2). Therefore, policymakers have set ambitious national goals, striving for a circular economy and eventually, carbon neutrality. Road transport is at the core of current policymaking. Hence, the government stimulates innovation and technology development. The private sector must take action and contribute to meeting climate targets to successfully capitalize on the opportunities resulting from innovation in terms of operational and product portfolio improvements beyond the benefits resulting from risk mitigation of fines and penalties resulting from non-compliance with regulations. Getting “ahead” of the curve with a strong ESG proposition is a driver of competitive advantage and investors have recognized the opportunities resulting from discovering such firms early on, allowing them improved access to capital (3). Investors are concerned about a firm’s environmental impact from overall carbon emissions to its product environmental value proposition. Markets often misprice the risk premia allocated to firms with low disclosure, making it less attractive to investors. Therefore, improving transparency through enhanced disclosure has become the most salient issue for firms.
These aspects hold especially for industries that are systemically exposed to ESG risks such as transportation and energy. Both are crucial to our every-day lives, but both have been undergoing major shifts in regulatory, and market environments including access to capital and consumer demand (4). While a strong ESG proposition mitigates the risks of asset mispricing in financial markets, it also decreases operational risks such as restrictions in production and distribution of vehicles. As investors and financial institutions account for these operational risks, access to capital becomes limited and more expensive. The EU incentivized lenders to favour sustainable firms in their practices and thereby influenced firms’ access to capital based on the sustainability of their practices. Since passenger cars are responsible for around 12% of total CO2 emissions in the EU, the automobile industry focused on reducing carbon dioxide emissions from vehicles produced as The EU is committed to attaining an environmentally sustainable economic system to meet EU climate and energy targets by 2030 (5). Achieving low-carbon transport is one of the key targets of the EU energy and climate policies which have disrupted traditional norms and practices in the sector. The Union seeks 55% lower emissions from transport (excluding international waterborne transport) by 2030, compared to 1990. In 2020, the EU implemented strict emission targets with high penalties for non-compliance.
Currently, passenger cars sold by mass-manufacturers over a year must not surpass 95g of CO2 per km driven on average, and 147 g/km phasing for light-commercial vehicles for 95% of vehicles in 2020 with 100% in 2021 (6). This caused major shifts in automakers’ product portfolio including the launch of new products and fading high-emitting fuels, focusing on carbon neutrality through hybrid and alternative fuel vehicles (predominantly electric vehicles) as well as “pools” amongst automakers such as Fiat Chrysler Automobiles (FCA) and Tesla (7). These pools allow FCA to avoid large fines for non-compliance with upcoming EU emissions regulations. FCA agreed to pay Tesla hundreds of millions of euros so Tesla’s electric vehicles are considered part of its fleet to offset CO2 emissions from its cars against Tesla’s, reducing FCA’s average CO2 emission figure per car sold to the allowed level. From next year, the EU’s target for average CO2 emissions from cars is 95g per kilometre.
Besides government regulation, shifting social norms create a measurable value resulting from increased consumer demand for sustainable products and investor preference for socially responsible firms. Considering a stock price as the weighted average of investor preferences, investor preferences will further enhance their stock performance. Nonetheless, informational asymmetry resulting from a lack of transparency presents a barrier to entry for investors (8). Therefore, reducing informational asymmetry between managers and investors through enhanced disclosure benefits firms and enhances their market value. Current ESG ratings do not provide an informational advantage to investors since they rely on public information. Hence, ESG integration in corporate valuation requires thorough firm-specific analysis. Analysts should consider focusing on only one element of ESG as to not fall subject to the “average” effect. For instance, despite its superior environmental performance, Tesla has an average single “A” ESG score due to poor employee management. This might reduce the value created by its competitive advantage in the “E” category.
Therefore, a firm-specific analysis must be conducted and the different areas for adjustment investigated. Operational figures can be adjusted for ESG factors such as projected cash flows and operating expenses. Since studies suggest a strong correlation between resource efficiency and financial performance, firms with a strong ESG proposition can capitalize on enhanced resource efficiency, reducing their operational costs. Better resource efficiency, lower energy consumption, and pollution contribute to the reduced cost of capital. Therefore, a firm’s cost of capital can be adjusted for ESG aspects considering the correlation between ESG performance, operational risk, and access to financing. Investors attribute lower risk premiums to firms with a strong ESG proposition. Credit rating agencies are committed to ESG incorporation as part of their risk analysis. A recent S&P survey of 194 credit risk professionals confirmed the importance of including ESG factors in credit risk analysis. 86% of respondents agreed that heightened investor demand is driving that need. Thus, investors have realized that ESG impacts credit risk (9). S&P forecasted that credit and portfolio risk considerations involving ESG will increase by 10% between 2019 and 2021 to 34% with environmental factors being the most critical factor for investors.
Findings from the Carbon Disclosure Project where S&P 500 firms voluntarily disclosed carbon emissions data for 2006-2008, reveal that on average, for every additional thousand metric tons of carbon emissions, the firm value decreases by $212,000 (10). Hence, investors take into account environmental factors and attribute lower value to firms with high emission levels. The S&P study also suggests that the median value of firms that disclose their carbon emissions is approximately $2.3 billion greater than the value of comparable non-disclosing firms. Since MSCI ESG scores are based on firm disclosure, it implies that firms with better disclosure achieve superior ESG scores and valuation. The London Stock Exchange Group conducted similar research and concluded that ESG-related information became a ‘core’ part of investment and risk analysis (11). Nonetheless, no pro forma ESG adjustment based on ESG scores can be made to the WACC. The main reason for this is the fact that ESG scores are based on public information and therefore, do not provide an informational advantage. For instance, Volkswagen’s and BP’s CDS spreads spiked only after the information about the scandals these firms were involved in went public (see figures 1 and 2). Therefore, ESG integration in portfolios and consideration of such factors in corporate valuation are crucial but cannot rely solely on ESG scores but on thorough firm-specific analysis.
Figure 1. Credit Spread VW 2010-2020
(Data Source: Bloomberg Terminal, 2020)
Figure 2. BP Credit Spread 2007-2020
(Data Source: Bloomberg Terminal, 2020)
What do you think? Let us know in the comment section below!
Interested in writing for us? Click on the 'Write For Us' button at the top of the page!
1. Global Sustainable Investment Alliance (2018). 2018 GLOBAL SUSTAINABLE INVESTMENT REVIEW. http://www.gsi-alliance.org/wp-content/uploads/2019/06/GSIR_Review2018F.pdf
2. Sloggett, J. (2016). A Practical Guide To ESG Integration For Equity Investing. PRI. https://www.unpri.org/download?ac=10
3. McKinsey. (2019). Five ways that ESG creates value. McKinsey & Company. https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/five-ways-that-esg-creates-value
4. McKinsey (2014). Electric vehicles in Europe: gearing up for a new phase? https://www.mckinsey.com/~/media/McKinsey/Locations/Europe%20and%20Middle%20East/Netherlands/Our%20Insights/Electric%20vehicles%20in%20Europe%20Gearing%20up%20for%20a%20new%20phase/Electric%20vehicles%20in%20Europe%20Gearing%20up%20for%20a%20new%20phase.ashx Mulder, S., Stegink, R., & Venkatanarayanan, D. (2020). Incorporating an ESG lens in business valuations. KPMG. https://assets.kpmg/content/dam/kpmg/nl/pdf/2020/services/incorporating-esg-lens-in-business-valuations-final.pdf
5. McKinsey. (2020). The ESG premium: New perspectives on value and performance. McKinsey & Company. https://www.mckinsey.com/business-functions/sustainability/our-insights/the-esg-premium-new-perspectives-on-value-and-performance
6. European Commission (2018) Action Plan: Financing Sustainable Growth. https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52018DC0097
7. European Parliament (2019). Electric road vehicles in the European Union. https://www.europarl.europa.eu/RegData/etudes/BRIE/2019/637895/EPRS_BRI(2019)637895_EN.pdf
8. Miller, J. (2020). Carmakers breathe easier after emissions targets dash. Financial Times. https://www.ft.com/content/7f6a400f-5252-406e-a7f5-d62f7211aefe?shareType=nongift
9. PWC. (2020). Mind the gap: the continued divide between investors and corporates on ESG. https://www.pwc.com/us/en/services/assets/pwc-esg-divide-investors-corporates.pdf
10. S&P Global Market Intelligence. (2019). The S&P Global Market Intelligence 2019 ESG Survey. https://pages.marketintelligence.spglobal.com/rs/565-BDO-100/images/S%26P-Global-MI-2019-ESG-Survey-Report-16-lowres.pdf?aliId=eyJpIjoiZ09ib3NkanNFXC9jbHBlOEwiLCJ0IjoiNDdjTDV5RDNuRnVvbFpaWG5ldiszdz09In0%253D Matsumura, E. M., Prakash, R., & Vera-Muñoz, S. C. (2014). Firm-Value Effects of Carbon Emissions and Carbon Disclosures. Accounting Review, 89(2), 695–724. https://doi-org.hult.idm.oclc.org/10.2308/accr-50629
11. London Stock Exchange Group (2018). Your guide to ESG reporting. https://www.lseg.com/sites/default/files/content/images/Green_Finance/ESG/2018/February/LSEG_ESG_report_January_2018.pdf