Growing awareness on the relationship between ESG criteria and financial returns has made disclosure on how companies manage their ESG risks more crucial – to enable investors to make informed decisions.
However, the exact mechanism behind performance in ESG related areas and financial outcomes remains unclear even if there is evidence for a relationship between the two.
A research paper by MSCI Inc.,a renowned provider of research and insights for institutional investors, has attempted to highlight the “link between ESG information and the valuation and performance of companies, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk).” The aim of the paper is to analyse the various transmission channels from ESG to financial performance in order to provide a fundamental understanding of how ESG characteristics affects corporations’ valuation and risk.
Two idiosyncratic risk and one systemic risk transmission channel was identified, namely: cash flow channel, idiosyncratic risk channel and valuation channel.
The economic rationale behind the channels are as follows:
1.Cash flow channel- High ESG rating companies are more competitive due to more efficient use of resources, human capital development and better innovation management. This leads to abnormal returns – higher profits and higher dividends.
2.Idiosyncratic risk channel- High ESG rating companies tend to better manage risk and have better corporate governance standards. Less frequent outbreak of risk incidents leads to a lower tail risk in the company’s stock price.
3.Valuation channel- High ESG rating companies are less vulnerable to systematic market risks such as commodity prices. Lower systematic risk means investors demand a lower required rate of return. This implies a lower cost of capital which translates to a higher valuation.
An examination of the causality in the systemic and idiosyncratic risk channels, led to the conclusion that ESG downgraded companies experienced a relative increase in both systematic and stock-specific risk compared to companies whose ESG rating was upgraded.
Finally, they provide empirical evidence for a causal relationship between ESG and financial performance by looking at the extent to which changes in ESG ratings predicted changes in financial variables. They found that the ESG rating change may be a useful financial indicator, which was termed as ESG momentum.
It was observed that an improvement in ESG characteristics led to increase in valuation over time.Thus, ESG ratings and ESG momentum are both financially important indicators which can be used for portfolio or index construction. The effects of changes in ESG initiatives are long-term and take time to realise.
Most importantly, the paper provides evidence that ESG ratings have a financially material impact on valuation, profitability and risk and should be taken into account in financial analysis.
FAQs
Cash flow channel- High ESG rating companies are more competitive due to more efficient use of resources, human capital development and better innovation management. This leads to abnormal returns – higher profits and higher dividends.
How does ESG affect stock performance? ›
ESG performance improves stock price synchronicity by reducing information asymmetry. The “noise reduction” effect of ESG performance is significantly lower in non-state-owned enterprises and enterprises with low investor trust.
How does corporate ESG performance affect stock liquidity evidence from China? ›
Corporate ESG performance in China is found to increase stock liquidity by lowering corporate risk and gaining stakeholders' support.
Can ESG indices improve the enterprises stock market performance an empirical study from China? ›
Research on the economic consequences of ESG performance of Chinese firms is in the preliminary exploration stage, and the current findings basically support that ESG performance can positively affect enterprise value, for example, some studies have shown that ESG has a significant role in improving corporate ...
Does ESG improve investment performance? ›
9 in 10 asset managers believe that integrating ESG analysis into their investment strategy will improve long-term returns, and a majority of institutional investors have reported that their ESG products have outperformed traditional counterparts.
Do ESG stocks outperform the market? ›
Some studies suggest that companies with high ESG scores tend to outperform the market, while others indicate no significant difference. The relationship between ESG factors and stock performance may vary based on the time horizon, sector, and region. Q: How can I identify ESG stocks?
Do ESG stocks underperform? ›
Funds that invest using environmental, social, and governance, or ESG, criteria underperformed for a second consecutive year.
Does ESG certification improve price efficiency in the Chinese stock market? ›
Empirical findings identify that stocks included in the ESG lists have relatively better pricing efficiency performances.
How ESG ratings affect stock liquidity risk evidence from the Chinese market? ›
ESG rating significantly improves stock liquidity in the Chinese stock market. This effect is more pronounced in firms with less political connection, weaker corporate governance, and less transparent information environment. Investor attention is an important channel between ESG rating and stock liquidity.
Does China require ESG reporting? ›
China stock exchanges have announced new sustainability (ESG) reporting guidelines for listed companies, requiring larger-cap and dual-listed issuers to begin mandatory disclosure on a broad range of ESG topics starting in 2026.
ChinaSIF estimates that the size of China's ESG market in 2022 was RMB 24.6 trillion (US$3.57 trillion) growing from RMB 18.4 trillion in 2021.
What are the arguments against ESG investing? ›
Critics of ESG — such as a group of Republican states that banned Blackrock and other “ESG friendly” asset managers from their state pension plans — argue that considering environmental and social factors violates the fiduciary duty that asset managers have towards their clients.
Can ESG investing beat the market and improve portfolio diversification evidence from China? ›
Overall, we find that investing in ESG equity indices can increase risk- adjusted returns and improve portfolio diversification for the case of China.
Why do ESG stocks perform better? ›
Investors increasingly believe companies that perform well on ESG are less risky, better positioned for the long term and better prepared for uncertainty. Companies that realign to the stakeholder capitalism agenda may have a competitive advantage over those that try to return to business as usual.
Do companies with high ESG scores perform better? ›
High ESG scores indicate that a company is effectively managing environmental, social, and governance risks, which can lead to better financial performance and lower investment risk.
How ESG improves portfolio companies? ›
ESG & company stock returns
High-scoring ESG stocks tend to have lower volatility and betas (i.e., systematic risk) than lower-scoring ESG stocks. Companies in both developed and emerging markets with higher ESG scores generally experience lower costs of capital when compared to those with poorer ESG scores.
Do ESG funds outperform the S&P 500? ›
By the fourth quarter of 2021, the S&P 500 ESG index began to steadily outperform the S&P 500 by four points on average. During the coronavirus pandemic, the technology sector was one of the best-performing sectors in the market.
How does ESG benefit shareholders? ›
The Bottom Line. ESG investing focuses on companies that follow positive environmental, social, and governance principles. Investors are increasingly eager to align their portfolios with ESG-related companies and fund providers, making it an area of growth with positive effects on society and the environment.
Does ESG affect financial performance? ›
While ESG data collection and reporting is the first step of a company's ESG journey, it does not by itself lead to financial improvement. According to McKinsey, studies show that strong ESG performance is positively correlated with higher equity returns and reduction in downside risk.
