Forward-looking international investors evaluate all risks, especially those that are knowable yet ignored by the market. These metrics can be leading indicators of future financial performance – if intelligent investors are willing to analyze them.
The metrics of impact, sustainability, and ESG (environmental, social, governance) provide intelligent investors with extra insight about future risk and opportunities. Today, ESG reporting by corporations around the world is at the highest level ever. Asset4/Thomson Reuters, one of the leading sources of sustainability data, covers 4,500 publicly listed companies globally. According to Thomson Reuters’ Corporate Responsibility and Inclusion Report in 2014, its analysts collect data on over 200 ESG key performance indicators from publicly available sources – company annual reports, sustainability reports, websites, as well as information published by NGOs, like Carbon Disclosure Project, which inventories voluntary reporting of companies about energy, water, and land usage.
We analyzed MSCI country indexes from 38 countries (3,000 public corporations representing close to $38 trillion in market capitalization) to analyze the ESG performance of the companies listed in each country. More than three-quarters, 31 of the 38 indexes, had more than 80% of their market capitalization covered.
The question that arises next is why, in a world with such high ESG coverage, did it take a threat of a shareholder resolution for the world’s largest fossil fuel companies to consider reporting on potentially crippling climate change risks? The answer lies in understanding transparency and performance beyond simple inclusion in the ESG coverage universe.
New Risk Factors: E, S, and G
The corporations that form part of the ESG coverage universe are diverse in their size, industries, geographic origins, management styles, shareholder composition and the impact they have on the world. What brings them together is the progress they have made, on different scales, towards providing an increased level of insight into their operations, often beyond what is legally mandatory. The diversity, however, implies that there is no one-size-fits-all solution to ESG transparency and performance. The situation is further complicated by the varying focus of stakeholders’ interests in different aspects of ESG performance. These dynamics often lead to a lack of balance between transparency on environmental, social and governance issues.
E is for Environment: Low levels of transparency on an aspect of ESG performance is an indicator of future risk – and possible poor future performance financially. A look at reporting levels on ESG metrics across these countries showed that environmental issues have the lowest level of transparency and performance across the globe, with more than 50% of index constituents in eight countries not reporting any information on environmental usage, risks or performance.
In the US, the Securities and Exchange Commission has already said that Environmental issues – including climate change – are material. "We are not opining on whether the world's climate is changing, at what pace it might be changing, or due to what causes. Nothing that the Commission does today should be construed as weighing in on those topics," said SEC Chairman Mary Schapiro in 2010. "Today's guidance will help to ensure that our disclosure rules are consistently applied."
All material risks should be reported. However, risks related to climate change are not yet consistently mandated in the US for publicly listed companies. Leading firms are disclosing, but most laggards are not. According to CDP (Carbon Disclosure Project), from the time period 2011-2013, leaders in disclosure outperformed laggards in disclosure by a 67% premium at half the volatility, which would drive alpha higher.
S is for Social: Transparency on Social metrics is challenging due to the difficult task of quantifying performance. Additionally, these metrics have received the lowest level of investor and academics’ attention in terms of their material impact on financial performance. However, as people are commonly called the most valuable asset, and metrics on employee performance are available, this can be a significant way to evaluate the future risk and performance of holdings in your portfolio. Intangibles, like human capital, comprise 84% of stock market value of the S&P500.
G is for Governance: Governance issues, due to their relevance across sectors and geographies, have received the highest level of visibility and transparency due to their widely studied links with investment performance. This makes the G in ESG the usual starting point for transparency efforts. For example, the majority of stock exchanges around the world incorporating ESG metrics into their listing rules have focused exclusively on governance metrics, and gender diversity of the Board has been shown to correlate with stronger financial performance – and Credit Suisse analysis (of factors like Women on the Board of Directors) agrees.
What Drives ESG Transparency and Performance
Academic studies investigating drivers of corporations’ ESG performance focus on firm, industry and institutional level characteristics such as scale of operations, industry practices and legal systems. One such study published by the Harvard Business School found that for publicly listed firms across 42 countries: at the firm level, larger scale of operations and higher visibility increase ESG performance; at the industry level, higher levels of competition improve standings on ESG metrics; and at the institutional level, legal and labor market institutions are strong determinants of ESG performance.
Another Harvard Business School study of 58 countries on the impact of mandatory corporate social responsibility found that mandatory disclosure improves both transparency and performance on ESG metrics. This impact is larger for developed countries with stronger enforcement mechanisms.
An analysis of the most recent ESG scores using the ratings framework of HIP Investor across 38 countries and firm-, industry-, and country-level variables show that market capitalization (scale) at the firm level was one of the main determinants of transparency and performance on HIP metrics. Higher national income level did not substantively increase average ESG performance when controlling for firm and industry level variables. Regulations mandating different levels of ESG reporting or a higher percentage of companies covered in the index did not improve HIP Rating scores in this framework, showing that while regulatory reform is the first step towards better performance, it does not guarantee it.
Do you know all the future risks in your portfolio? ESG scores can provide additional indicators of future risk and return potential for forward-looking, intelligent investors.
How do you evaluate ESG in your investment portfolio? Share your commentary and suggestions in the comments section below, and come back next week to read part three of this four-part series.
By Hummayun Javed and R. Paul Herman
Hummayun Javed is an impact investment analyst, with a Masters in Global Policy Studies from the LBJ School at the University of Texas at Austin; R. Paul Herman is CEO, CIO and an investment adviser representative (Series 65) of HIP Investor Inc. and CEO of investment ratings firm HIP Investor Ratings LLC (More info at http://www.HIPinvestor.com)
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