By Toby Belsom, Director Investment Practices, PRI and Laura Lake, former CIO, Breckinridge Capital Advisors
Asset flows into ESG funds have been a notable feature of capital markets in the last 12 months and this is likely to continue. According to some forecasts, in the next five years half of professionally managed investments may include an ESG mandate. Responsible or sustainable investing has moved from a niche product to a mainstream investment offering. Given both the asset flows and strong performance of ESG funds in 2020, we have reviewed 30 recent industry research publications on the connection between ESG rankings or ratings and risk adjusted listed equity returns.
This blog summarises our key findings and includes links to the industry research we reviewed. These findings point to an increasing body of industry research which supports the proposition that there are correlations between ESG rankings and risk adjusted equity returns. However, these correlations are nuanced and complicated by factors such as geography, market capitalisation, industry sector, relative & absolute rankings and ranking changes. To explain these correlations and relationships further research into explanatory or causal factors is a necessary and important next step.
Listed equity returns and sustainability ranking
At an index and single asset level, there is a wide range of research that identifies correlations between overall ESG performance or ranking and listed equity returns.  Deutsche bank’s review of the empirical evidence in 2016 was probably the most comprehensive survey but more recent studies from a range of industry participants support its broad findings. This growing body of research shows various correlations between a listed security’s absolute or relative ESG rankings (and rate of change) and shareholder returns & volatility.  Based on evidence from these industry reports, investors might expect companies with higher ESG rankings, and portfolios comprised of companies with these rankings, to have had superior risk adjusted returns relative to their peers. However, there is nuance and results are easy to oversimplify. Research indicates that absolute scores are not the only important determinant. For example, research by Credit Suisse found that individual securities with improving sustainability scores, often linked to improving disclosures, are shown to record outperformance relative to their peers with static or falling sustainability scores. This correlation ought to encourage management teams to improve corporate disclosures on ESG issues.
Listed equity returns in relation to a E, S or G factors
Much research has also attempted to disaggregate certain aspects of ESG performance. In an early seminal piece, Paul Gompers et al. demonstrated that companies with better governance and shareholder rights outperformed on a range of metrics. More recent research supported this early work and governance is a well-established metric in many investment processes.
Beyond governance, research has also focused on establishing evidence of correlations between returns and environmental or social metrics. These correlations often seem to vary over time and between industry sector. For example, research on social factors seems to show an increasingly strong correlation with equity returns. This correlation is shown to vary between geographic regions. Differences in correlations between listed equity returns and ESG rankings between industrial sectors also records interesting results. For example, research shows governance metrics are of more significance in the financial sector; environmental factors show a strong significance in the energy and materials sectors; and social factors are important in consumer discretionary business.
Equity performance in relation to sector, size, quality and geographical factors
To add another complicating factor, geography and market capitalisation are both correlated to ESG rankings. Large corporations and regions with elevated disclosure requirements and high ESG rankings tend to record better ESG rankings - maybe due to greater financial and human capital resources dedicated to ESG related disclosures. FTSE Russell reviewed ESG scores after controlling for geography, sector and size demonstrating that there is connection between ESG ratings and market capitalisations, sector classification and country specific laws and regulations.
Industry research also identifies a connection between ESG risk management and rankings and factors such quality. Quality businesses are often characterised as having attributes such as consistent profitability, conservative balance sheets and strong cash flows. Research seemed to indicate combining analysis of characteristics of quality businesses and non-financial sustainability indicators in an investment strategy or asset selection process can lead to a more holistic view of the company and improved equity returns.
These correlations and connections between factors such as geography, market capitalisation, quality & industry sector and ESG rankings raises questions as to disaggregate such factors. Reviewing industry research shows that normalising data, disaggregating factors and reviewing changes over time are all important steps in analysing and assessing correlations. Though many of these correlations would seem to make intuitive sense and align with the Sustainable Accounting Standards Board’s (SASB) materiality map, this type of research highlights the need to identify explanatory hypotheses or causation.
Reviewing research on causation
Our review indicates that industry research into causation or explanatory factors is less developed. In the research we reviewed there were several attempts to identify explanatory factors by attempting to identify transmission channels, and considering ESG factors & economic moat.
ESG and transmission factors
To isolate how ESG rankings translate into corporate financial performance, MSCI looked at the following transmission channels: cash-flow, idiosyncratic risk and systemic risk. The cash flow channel attempts to explain that companies with strong ESG profiles are more competitive than their peers. This enables them to generate more sustainable profit and cash flow and therefore improves relative and absolute risk adjusted returns and dividends relative to their peers. The idiosyncratic risk channel shows that highly rated ESG companies have superior risk management practices, lower risk of material incidents and therefore less downside tail risks. The systemic risk channel demonstrates that companies with strong ESG profiles will be less vulnerable to disruption from external regulatory or market changes and, therefore, benefit from a lower cost of capital, leading to a higher valuation.
ESG and economic moat
Taking a slightly different direction, research also linked the concept of ESG rankings and economic moat. The concept of moat is a measure of a company’s competitive advantage and ability to defend returns - leading to better shareholder returns. In 2016, Credit Suisse developed a checklist to evaluate a company’s moat but how does this link with sustainability or ESG rankings?
SustainAnalytics / Morningstar reviewed the connection between ESG risk factors, economic moat analysis and shareholder returns. They identified that companies with low ESG risks tend to share at least one of the five sources of wide economic moats (cost advantages, intangible assets, economies of scale, network effects and high switching costs). Investments (and therefore portfolios composed of securities with these characteristics) that combine both wide economic moats and ESG factors might be expected to show improved relative risk adjusted returns.
Aside from the research on understanding causation, another key area that we felt might value from further work is how modelling scenarios to reflect changing political, social, climate and demographic landscapes might be incorporated into listed equity analysis and research especially as debate on modelling climate scenarios is becoming an increasingly important.
In recent years, industry research has strengthened the argument that there is correlation between ESG rankings and listed equity risk adjusted returns. Industry research identified a series of correlations between better management of ESG issues and risks and corporate financial performance, cost of capital, market valuations and volatility. These arguments are becoming more widely accepted across industry. However, understanding the connections between geography, market capitalisation, sector, ‘quality’ factors & ESG rankings is important to understand the nuances in the correlations between ESG rankings and risk adjusted listed equity returns. Understanding and disaggregating these correlations requires further research into causation - an area that our review showed is less well established. Increasing fund flows and the rise of ESG makes further research into causation of these correlations increasingly important.
|Adding Value Through Active Engagement||UBS (Christopher Greenwald, Valeria Paini, Bruno Bertocci, Patrick Zimmermann)||2018||https://www.ubs.com/ch/en/asset-management/distribution-partners/insights/white-papers/2018/active-engagement.html|
|ESG and Financial Performance: Aggregated Evidence from more than 2000 Empirical Studies||Deutsche Bank||2016||https://www.db.com/newsroom_news/2016/ghp/esg-and-financial-performance-aggregated-evidence-from-more-than-200-empirical-studies-en-11363.htm|
|Sustainable Investing Research Suggests No Performance Penalty||Mornigstar (Jon Hale)||2016||https://video.morningstar.com/ca/170717_SustainableInvesting.pdf|
|Sustainable Reality: Analysing Risk and Returns of Sustainable Funds||Morgan Stanley||2019||https://www.morganstanley.com/pub/content/dam/msdotcom/ideas/sustainable-investing-offers-financial-performance-lowered-risk/Sustainable_Reality_Analyzing_Risk_and_Returns_of_Sustainable_Funds.pdf|
|ESG Investing, A social uprising||Hermes Inv (Lewis Grant)||2019||https://www.hermes-investment.com/us/insight/equities/esg-investing-a-social-uprising/|
|Corporate Sustainability: First Evidence on Materiality||Mozaffar Khan, George Serafeim, Aaron Yoon||2015||https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2575912|
|Assessing Risk through Environmental, Social and Governance Exposures||AQR (Jeff Dunn, Shawn Fitzgibbons, Lukasz Pomorski)||2017||https://www.aqr.com/Insights/Research/Journal-Article/Assessing-Risk-through-Environmental-Social-and-Governance-Exposures|
|Making an Impact: Earning Returns on Sustainable Terms||Credit Suisse (Tom Greenberg, Rick Faery, Eric Rattner, Charu Sharma, Austin Rutherford, Dash Enkbayar)||2019||Credit Suisse, Making an Impact: Earning Returns on Sustainable Terms, 2019|
|Corporate Governance and Equity Prices||Paul Gompers, Andrew Metrick, Joy Ishii||2003||https://www.researchgate.net/publication/24091808_Corporate_Governance_And_Equity_Prices|
|ESG Investing in Recent Years: New Insights from Old Challenges||Amundi (Angelo Drei, Theo le Guenedal, Frederic Lepetit, Vincent Mortier, Thierry Roncalli, Takaya Sekine)||2019||https://research-center.amundi.com/article/esg-investing-recent-years-new-insights-old-challenges|
|Deconstructing ESG Ratings Performance: Risk and Return for E, S, and G by Time Horizon, Sector and Weighting||MSCI (Guido Giese, Zoltan Nagy, Linda-Eling Lee)||2021||https://www.msci.com/documents/10199/7b77de78-0c6e-0a45-f4dd-e65025552bae|
|The Impact of Corporate Sustainably on Organizational Processes and Performance||Harvard Business School (Robert Eccles, Ioannis Ioannou, George Serafeim)||2014||https://www.hbs.edu/ris/Publication%20Files/SSRN-id1964011_6791edac-7daa-4603-a220-4a0c6c7a3f7a.pdf|
|Hermes: Industry ESG scores for small and mid-cap companies can be misleading||Hamish Galpin||2019||https://www.corporatesecretary.com/articles/esg/31709/hermes-industry-esg-scores-small-and-mid-cap-companies-can-be-misleading|
|ESG Scores and Beyond (part 1)||FTSE Russell (Kevin Ratsimiveh, Patrick Hubert, Valery Lucas-Leclin, Emeric Nicolas)||2020||https://content.ftserussell.com/sites/default/files/esg_scores_and_beyond_part_1_final_v02.pdf|
|Sustainable Companies for a Better Portfolio||Northern Trust (Jordan Dekhayser, Emily Lawrence)||2020||https://www.northerntrust.com/documents/white-papers/mutual-funds/financial-intermediaries/using-quality-and-esg-to-enhance-returns.pdf|
|Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance||MSCI (Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltan Nagy, Laura Nishikawa)||2019||https://www.msci.com/documents/10199/03d6faef-2394-44e9-a119-4ca130909226|
|Combining ESG Risk and Economic Moat||Sustainalytics (Hendrik Garz, Liam Zerter)||2020||https://connect.sustainalytics.com/combining-esg-risk-and-economic-moat|
|Measuring the Moat||Credit Suisse (Michael Mauboussin, Dan Callahan, Darius Majd)||2016||https://plus.credit-suisse.com/rpc4/ravDocView?docid=V6fkr51AF-WElY95|
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ESG and financial performance: aggregated evidence from more than 2000 empirical studies – Newsroom (db.com)
Credit Suisse, Making an Impact: Earning Returns on Sustainable Terms, 2019