ESG Investment

New research is strengthening the case for organisations to invest more in their Environmental, Social and Governance (ESG) skills and to view them as a key asset in driving higher returns and long-term, sustainable performance.

Academic evidence linking investment returns and ESG capabilities has been mixed over the years, partly because of inconsistencies in ESG data across companies and sectors, and due to a lack of a universally accepted framework for ESG reporting.

Also, investment markets have been slow to incorporate ESG data into valuation methodologies. Only one in 10 global investment professionals have been formally trained on considering ESG data in their analysis, according to a 2015 CFA Institute study.

Less than a quarter of investment professionals consider ESG information in their investment decisions, according to a 2015 Ernst & Young survey.

However, evidence is growing that strong ESG practices and reporting lead to better analysis of companies, more accurate valuation forecasts, and higher shareholder returns over time.

Macquarie Group in June analysed the impact of employee trends that are disclosed through corporate reporting of ASX-listed companies. It created a dynamic portfolio of companies with leading scores on employee indicators and a second portfolio with companies that had weaker returns on employee indicators. (Source: Macquarie Wealth Management, ‘ESG Employment Indicators’, June 7, 2016).

Macquarie’s Employee Engagement Survey considered issues such as industrial relations, staff turnover, employee absenteeism, remuneration and productivity, workplace diversity, and occupational health and safety – data that high-performing boards are across.

The survey found the first portfolio of companies with engaged workforces consistently outperformed the second portfolio over nine years. The relative outperformance was 6.6 per cent annually over the past three years and the gap is growing as more ESG data is reported.

Importantly, a change in a company’s employee engagement was found to be a predictor and signal for future share price performance.

It is no surprise that companies with engaged workforces achieve higher returns than those without them. Even so, a key takeout from Macquarie’s research is the influence that this data is having on company valuations and future share price performance.

International studies confirm benefits of ESG practices

Others confirm the influence of strong ESG practices on company valuations. A recent meta-analysis on the link between ESG and company returns – the most exhaustive review in this area of its kind – found a positive ESG impact on corporate financial performance over time.

The authors of the recent German study, ‘ESG and financial performance: aggregated evidence from more than 2,000 empirical studies’, wrote: “Based on this sample, we find clear evidence for the business case for ESG investing. This is contrary to the common perception among investors [which] may be biased due to findings of portfolio studies, which exhibit, on average, mixed neutral/mixed ESG-Corporate Financial Performance relation.”

They added: “Based on this exhaustive review effort, our main conclusion is: the orientation toward long-term responsible investing should be important for all kinds of rational investors in order to fulfil their fiduciary duties and may better align investors’ interests with the broader objectives of society.

“This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors.”

Another review of empirical academic studies, ‘Corporate Investment in ESG Practices’, published in 2015 in the Harvard Law School Forum on Corporate Governance and Financial Regulation, found that corporate investment in ESG:

  • Enhances the organisation’s marketing and accounting performance.
  • Lowers the organisation’s cost of capital.
  • Is a means of engagement with key stakeholders.
  • Improves business reputation.
  • Channels production innovation that fosters new growth.

The authors said corporations, although investing more in ESG practices in the past decade, tend to respond to immediate ESG business needs rather than invest in strategic, cohesive sustainability programs that enhance the long-term value of intangible ESG assets.

They wrote: “While empirical research on the link between corporate investment in ESG and firm performance is far from undisputed, several studies led by respected institutions have shown that a company can be rewarded for adopting these practices: higher profits and stock return, a lower cost of capital, and better corporate reputation scores are the key benefits enjoyed in return for this type of investment.

“As companies continue to adhere to harmonised reporting standards and verified data becomes more readily accessible, researchers will be able to continue this course of investigation and find the definitive proof that ESG-related corporate expenditures pay off.”

ESG data improving

The key, it seems, is for listed companies to collect and report more ESG data to the market, and help the investment community understand initiatives in this area. Boards have an increasingly important role in explaining the organisation’s ESG strategy to long-term investors, such as industry superannuation funds.

There continue to be improvements in sustainability reporting among ASX-listed companies. About 90 per cent of companies provided some level of sustainability data in their latest public disclosure, according to a June 2016 study by the Australian Council of Superannuation Investors (ACSI). The report, now in its ninth year, found the amount of “leading” sustainability reporters had tripled since 2009.

The implications for boards are: strong ESG practices can help drive better performance and shareholder returns over time. And, further, organisations that deliver ESG results - and report them - may achieve a higher return on their governance investment.