Does ESG Outperform? It’s a Challenging Question to Answer

September 23, 2021

Source: Bloomberg; Companies ranked by sector; Data as of Aug. 31, 2021 Source: Bloomberg; Companies ranked by sector; Data as of Aug. 31, 2021

Currently, there is a general trend identifying environmental, social and governance (ESG) variables as urgent and important. But does ESG outperform? ESG brings nonfinancial variables into investing, and investors are increasingly applying ESG criteria in their analysis process.

Likewise, companies are increasingly adopting sustainability and ESG in their corporate profiles and, while not mandatory, including ESG disclosures in their annual reports. Ernst & Young LLP, for example, has for the first time used sustainability reporting standards developed by the World Economic Forum in its fiscal year 2021 global annual report.

The environmental criteria of ESG assess how a company performs as a steward of nature in relation to its peers. Some examples of environmental standards include climate change, greenhouse gas emissions, deforestation and pollution. According to the United Nations Office for Disaster Risk Reduction, the number of floods has more than doubled in the last 20 years.

The social criteria of ESG assess the company’s business relationships with its employees, customers, supply chain and community. Some examples of social factors include working conditions such as child labor, along with safety and donations. Many people have been personally impacted by shortages and shipping delays as supply chain issues rippled across the globe due to the COVID-19 pandemic.

The governance criteria of ESG focus on a company’s policies and practices, and the connection and responsibilities between directors, executive teams, and investors and shareholders. Some examples of governance are executive pay, board diversity, tax strategy, transparency and corruption. In early 2020, Airbus, a Netherlands company headquartered in Toulouse, France, made history when it agreed to pay US$4 billion in fines, one of the largest global settlements in history, to settle bribery charges.

While socially responsible investing has been around longer, the term ESG was coined in 2005 in the “Who Cares Wins” report, a joint initiative of 20 financial institutions invited by United Nations Secretary-General Kofi Annan to develop guidelines and recommendations for how financial actors can better integrate environmental, social and corporate governance issues.

Despite the relatively short history, ESG has gained traction in the last decade. This is partly due to various reports in the early 2010s concluding that companies with sustainability practices tend to have better operational outcomes and therefore financial performance. Another reason is that millennials and other younger investors tend to have a more global mindset than previous generations, leading them to more actively incorporate social responsibility and environmental into their investing considerations.

According to a Bloomberg Intelligence report in February, ESG has been growing at a pace of approximately 30% in the past five years to $35 trillion in assets under management (AUM), with ESG AUM projected to account for a third of all AUM by 2025.

An ESG rating is not about categorizing companies as good or bad, but more of an assessment of a company’s resilience to long-term ESG risks. The theory is that a better consideration of environmental, social and governance factors will lead to more robust and resilient investment markets. Some research has found that better ESG is valued by employees and investors alike, and reflected in stronger market performance.

So that brings us back to the question, does ESG outperform? It is challenging to answer. As demonstrated in this week’s chart, a very basic comparison of top- and bottom-50-ranked ESG companies by sector shows that highly ranked ESG companies have not performed better. But this is an overly simplistic comparison, with several immediate issues.

For starters, the ESG rankings were as of the day of the comparison (Aug. 31). A company might have had different rankings previously. Another issue is the relatively short history for meaningful comparison. Additionally, reporting of ESG data is non-mandatory, which means data is not necessarily audited, and availability is limited and non-standardized. A little under half of the companies reviewed had to be excluded from the comparison simply because they did not have Bloomberg ESG ratings. But that does not indicate whether they are or aren’t incorporating ESG practices.

There is no consensus on the list of ESG issues and no universal standards. ESG companies in different industries are impacted by varying regulations and may focus on different ways of incorporating ESG principles. Even with advances in technology and more sophisticated analysis tools available now than before, different opinions on what is relevant and which frameworks should be used to disclose the data make it difficult to measure and compare companies.

For my simple comparison, I looked at ESG rankings by Bloomberg. However, different research firms such as Sustainalytics, Morgan Stanley Capital International (MSCI) and Refinitiv, just to name a few of the many ESG rating providers, each has its own metrics and processes.

Some studies have found that the same company, such as Apple or Facebook, were rated anywhere from high to low depending on the rating provider. Currently, various institutions are working toward defining a universal standard.

Key Takeaway

Even though evaluating ESG performance is challenging, and there is not enough evidence to support ESG as a performance indicator or as a factor, it does not appear to be a soon-fading trend. As more data becomes available and more standardization is achieved in ESG reporting and ratings, perhaps we can better answer the question of whether ESG outperforms.

Until then, we can still benefit from the other facets of investing with ESG criteria. First, with increased social awareness, globalization and urgent environmental concerns, the pressure on companies to incorporate ESG principles is higher than ever, allowing more opportunities for investors to align their investments with their values.

Second, there does not appear to be a clear financial cost to companies incorporating ESG considerations. Some studies, such as the work of George Serafeim, Bob Eccles and Ioannis Ioannou, are showing that ESG integration leads to positive operational performance, while other studies show that ESG criteria can help investors avoid companies with risk exposures due to practices leading to scandals, lawsuits and fines.

Additionally, when a company embraces certain ESG drivers, there may be positive intangible outcomes such as brand reputation, healthy culture and employee satisfaction. As consumers are increasingly seeking products and services that are greener, cleaner, healthier and smarter, ESG valuation and investing represent a way for investors to identify which companies are adapting and staying relevant with changing markets.

Tags: ESG | ESG investing | environmental standards | social factors | COVID-19 pandemic

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