Companies who better manage ESG risk see better annual returns: study

During a technical session for valuation experts organised by the Luxembourg Valuation Professionals Association, Carla Nunes from Kroll provided key findings from a study on ESG and global returns. Companies that were “leaders” in terms of managing ESG risks and opportunities earned more than “laggards.” But how much more?

The Luxembourg Valuation Professionals Association, in partnership with Kroll, held an online technical session on ESG and investor returns on 29 November 2023. The online event featured insights from Carla Nunes, managing director and global leader of the valuation digital services group at Kroll, who presented the results of a .

“There’s a lot of terminology out there, and it means different things to different people,” Nunes began. To name just a few, there are ESG, socially responsible investing, climate and environmental investing, impact investing and sustainable investing. It can be confusing. “What you actually measure--and what you actually incorporate, for example, in a valuation--depends on what you’re talking about in terms of ‘flavours’ of investing in the area of ESG.”

What I’m concerned about is if there are risks and opportunities out there related to these topics that will impact the value of this investment

Carla Nunes, managing director in the office of professional practice, Kroll

ESG is a term created by the United Nations in 2004, 2005, explained Nunes. The idea was to create an “investment framework” that would lead people think about how environmental, social and governance factors impact the financial bottom line. “So it’s no different than any other risk factor you look at,” she noted.

Sustainability, on the other hand, looks at how a company’s actions are impacting the world. “What you’re trying to measure is different.” But people often get confused and use the terms interchangeably, which can lead to problems down the road.

A third category--impact investing--refers to having certain investment objectives and value systems and using specific metrics to measure to which extent these goals are met. Talking about different value systems can get “political,” especially in the United States, Nunes cautioned. “What I’m concerned about is if there are risks and opportunities out there related to these topics that will impact the value of this investment.”

Relationship between stock returns and ESG ratings

The last few years has seen academic research and corporate studies that look at topics such as the impact of ESG on cash flow, the market performance of funds or ESG and the cost of capital, said Nunes. An issue, however, is the divergence in ESG ratings between different ratings providers. So when looking at all these studies, it’s important to keep in mind which methodology is being used.

Kroll’s study focuses on more than 13,000 companies across four geographic regions (world, North America, Western Europe, Asia Pacific) and 11 different industries during the 2013-2021 period, Nunes explained. It analyses the relationship between a company’s total stock returns (dividends plus capital appreciation) and its MSCI environmental, social and governance ratings. While no rating is perfect, she noted, the MSCI ratings provided the elements Kroll was looking for, including a long coverage period, companies around the world, stability and a composite rating. Portfolios were built and rebalanced monthly and adjustments, such as converting all amounts to US dollars, were done in order to compare “apples to apples.”

Even though the MSCI ratings system uses groups of letters like “AAA” or “BB,” Nunes added, it is not the same as a credit rating. In the study, “leaders” were categorised as companies that led in an industry in terms of managing ESG risks and opportunities (AAA, AA). “Average” companies had a “mixed” or “unexceptional track record” when it came to managing ESG risks and opportunities compared to peers (A, BBB, BB), while “laggards” were companies that lagged their industry based on high exposure and failure to manage significant ESG risks (B, CCC).

So what did they find?

$2.99 for leaders, $2.11 for laggards

If you invested one US dollar at the beginning of 2013 and held that investment--a buy-and-hold strategy--through the end of 2021, how much would you have made?

At the end of that period, “leaders” would have cumulatively earned $2.99, while “laggards” would have earned $2.11, said Nunes. “So there is clearly a difference.” The leaders would have even outperformed the MSCI All Country World Index, which would have earned $2.75 over the same period, and “average” companies would have earned $2.53.

Almost a 50% premium for leaders vs. laggards

“But as investors and valuation professionals, we don’t think about cumulative returns,” said Nunes. “We want to know the annualised returns, right? So that’s what we did. We converted this into compound annual returns.”

For the group of companies in the world portfolio, “what we found during this period is that leaders earned 12.9% in USD terms versus laggards, of 8.6%.”

“That’s almost a 50% premium for leaders versus laggards, which is something we weren’t expecting,” she continued. “From a cost of capital standpoint, if you really think that ESG strategies are less risky, you should earn lower returns. That’s in terms of expectations. But what actually happens is different.”

“You can generate alpha in all kinds of strategies. And so during this period, clearly, the companies that were ahead of the curve, they earned higher returns.”

Europe has more “leaders” than other regions

In North America, “the outperformance by leaders was clearly also around 50% more than laggards,” said Nunes. In Western Europe, “it is also true that leaders earn a higher return than laggards.” Asia-Pacific sees the same trend, she added, while Latin America could not be easily analysed as there was not enough company data.

“But what’s interesting here is that Western Europe is by far the region that has the most amount of leaders,” said Nunes. “It’s consistent with what we think about Western Europe: that they are ahead of the curve in terms of implementing ESG-related initiatives. Granted, a lot of them are based on the ‘E,’ but not just that.”

Looking at the number of companies categorised at the end of December 2021, 34% of European companies in the study were rated as “leaders.”

On the other hand, 10% of companies in North America were rated as leaders, while in the Asia Pacific region, only 6% of companies were leaders.

Regulatory changes to ensure investor protection

Data that is available and consistent is a challenge. The report also refers to the Carrots & Sticks project, a database of mandatory and voluntary policies related to ESG, noted Nunes. There are many accusations of companies portraying themselves in the best possible light. If reporting is voluntary, she pointed out, would companies show the stuff that makes them look bad? Probably not.

“In 2020, there were almost 600 sustainability reporting provisions globally and 60% were mandatory. But in 2023, they expanded the database to 130 countries. And the number of sustainability reporting provisions had increased to 2,400, and 55% were voluntary.”