Global Research & DataHub

ESG Proposition & Profitability

It’s a debatable and enduring question whether the adoption of ESG practices of a company positively correlates with its performance. Conventionally, studies have found that companies with lower ESG scores had a higher cost of capital and volatility due to controversies and other incidences such as spills and fraud. Meanwhile, companies with higher ESG scores generally displayed outperformance than companies that scored lower in ESG integration in general [1]. (Figure 1)

Figure 1: Gross profitability of ESG quintiles (Note: 01= worst ESG quintile and 05=Best ESG quintile) [2] (Source: MSCI, 2021)

How to evaluate the ESG performance of a company?

With the trend of ESG making a significant impact on the global market, there are many products developed by financial institutions such as MSCI and Bloomberg to assess the ESG performance. They have set different standards and criteria for investors and other stakeholders to integrate ESG considerations into the investment process.

However, some research studies stated that there are uncertainties about the current ESG score frameworks on explaining corporate financial performance. Not only does each ESG metric weighting scheme account for different weighting and indictors, but FTSE Russell has found that external factors like size, sector, and country play significant roles in ESG scores [3]. Therefore, it is noted that we have to review the specific industry with a horizon perspective across different metric weighting schemes and consider external factors for a holistic analysis approach.

Take sector effect as an example; some activities in the specific sector are more exposed unfavorably to those ESG issues that tend to report more to compensate an image deficit, such as oil and gas extraction, and mining activities. FTSE Russell also adopted the ICB classification (Level 3) to distinguish various sectors in average ESG scores distribution. Construction-related sectors like Real Estate Investment and Services had the lowest ESG scores compared to other industries. (Figure 2)

Figure 2: Distribution of ESG scores by ICB level 3 [3] (Source: FTSE Russell, 2020)

How about the corporate financial performance of the real estate investment and services sector? Let’s look into the European market in this case study; evidence in Figure 3 showed that a higher ESG completeness score (indicated by sBPR Award grading) was not associated with superior returns [4]. But if we control other variables (e.g., company size and leverage), the company stock returns had a positive and significant effect on ESG completeness.

Figure 3: Scatter plotting total returns versus ESG completeness scores (Note: Green = sBPR gold awards winners, Yellow = sBPR silver award winners and Red = sBPR bronze awards winners) [4] (Source: EPRA, 2020)

Despite the fact that the report demonstrates the positive correlation between the stock returns and ESG performance initially in this sector, the limitation on current ESG data availability and accuracy to capture the complex social and environmental systems can only regard as a reference for us to review [5]. It is beforehand to tell whether the substantial performance on companies' ESG proposition results in stock outperformance.

References:

[1]: Giese, G. (2017). Has ESG affected stock performance? Retrieved from MSCI Inc. web site:

https://www.msci.com/www/blog-posts/has-esg-affected-stock/0794561659

[2]: MSCI. (2021). ESG and Performance: How has integrating ESG considerations into the investment process affected performance? Retrieved from MSCI Inc. web site:

https://www.msci.com/esg-101-what-is-esg/esg-and-performance

[3]: Ratsimiveh, K., Hubert, P., Lucas-Leclin, V. & Nicolas, E. (2020). ESG Scores and beyond (Part 1) Factor control: Isolating specific biases in ESG ratings. Retrieved from FTSE Russell web site:

https://content.ftserussell.com/sites/default/files/esg_scores_and_beyond_part_1_final.pdf

[4]: Brounen, D., Marcato, G. & Veld, H. O. (2020). Measuring the ESG Impact on Listed Real Estate Performance: An Analysis of EPRA’s sBPR Database. Retrieved from European Public Real Estate Association (EPRA) web site:

https://prodapp.epra.com/media/EPRA-academic-research-paper-Measuring_the_ESG_Impact_on_Listed_Real_Estate_Performance_1601283359522.pdf

[5]: Howard-Grenville, J. (2021). ESG Impact is hard to measure - But It's Not Impossible. Retrieved from Harvard Business Review web site:

https://hbr.org/2021/01/esg-impact-is-hard-to-measure-but-its-not-impossible