Is "best-effort" the next frontier of ESG analysis?
Over recent years, we’ve experienced mounting pressure over ESG integration from stakeholders; and whereas the reasons behind this might vary (i.e. fiduciary duty, regulation, alignment of values...), most of them acknowledge that financial performance/alpha generation should remain part of the equation.
That was the beginning of the race to quantify this new source of value-creation. Now that it has been demonstrated that ESG integration brings positive alpha, the next goal is to optimise this signal...
From theory... When our SRI research team began its ESG integration analysis in 2012, we found little enthusiasm among investors (i.e. what ‘financial’ added value could there be other than ethical, marketing or philosophical positioning?). Back then the idea was to provide investors with warning flags on companies that rated poorly on ESG performance, and to reassure them about investing in companies that rated well. Our theory was that companies with strong ESG policies and good structures in place are less likely to produce unwelcome surprises. Such companies should inspire greater investor confidence and so be preferred over the long run.
... to practice. Traditionally, investors have used Environmental, Social and Governance ratings in a “defensive” way to mitigate portfolio risk, but the ESG model portfolio we have been running over the past five years has consistently outperformed the Stoxx600 index. So clearly ESG may not just be used for defensive purposes but also for positive alpha generation. In this article we go one step further to see whether companies that are improving their ESG ratings could further outperform.
Does it work? Yes, as shown below, the top 30% ESG rated companies would have outperformed the STOXX600 over our reference period by more than 9%. However, if investors had bought the positive-ESGmomentum companies, i.e. those that improved on the ESG rating by more than 10% YOY, they would have outperformed the STOXX600 by 23.5%.
How did we do it? To rate stocks, based on our “SRI: Beyond Integration” methodology and publications, we use a mix of qualitative, quantitative and engagement-based approaches. We firstly identify material ESG themes for each sector and assign weights to the key indicators based on their materiality, we then run our Quant tool which will give us an ESG score that can then be combined with our analysts’ financial recommendations. This Quant score will then be supplemented by more qualitative input. In this post, we focus only on the quantitative aspect—scoring each company on environmental, social and governance indicators to calculate their overall ESG rating.
In detail, for each sector we focus on 15-20 material indicators based on relevant themes. We try to avoid a generalist approach that might take all universally available indicators into consideration given the need to understand their relevance within the sector. Nowadays, there are hundreds of indicators available across ESG rating/data providers to analyse the ESG rating of companies. However, we find it better to focus on a small number of relevant indicators for each sector to avoid losing sight of what really counts from a financial perspective.
Sector example: by way of illustration, we have here broken down the ESG rating evaluation of the Aerospace & Defense sector. In this sector, we qualitatively select and analyse the 17 most material indicators based on four relevant ESG themes and weight each indicator between 1-3 based on its degree of materiality. We rate each KPI from 0 to 100 and, based on the weights assigned to each indicator, we then assign each company an overall ESG rating between 0-100.
ESG rating evaluation: Aerospace and defence
|CORPORATE GOVERNANCE||BUSINESS ETHICS||CLIMATE CHANGE||HUMAN RESSOURCES MANAGEMENT|
|Board Remuneration Disclosure (1)||Bribery & Corruption Policy (1)||GHG Reduction Programmes (3)||LTIR Trend (2)|
|Board Independance (2)||Bribery & Corruption Programmes (3)||Renewable Energy Programmes (1)||Employee Incidents (3)|
|Separation of Board Chair & CEO Roles (1)||Whistleblower Programmes (2)||Renewable Energyuse (2)||Scope of Social Supplier Standards (2)|
|ESG Governance (2)||Business Ethics Incidents (3)||Clean Technology Revenues (3)||Customer Incidents (3)|
|"Controversial" Weapons (3)|
Source: SG Cross Asset Research/ESG, Sustanalytics, Companies, Media - 03/05/2019. Note: numbers in brackets are weights of the KPIs in ESG rating
“Best-in-class” or “Best effort”: In detail... We found that the positive momentum stocks within the top 30% of the ESG-rating universe generated a cumulative outperformance of +23.5% vs. STOXX600 between Mar. 2013 and Jan. 2019. This is much higher than the performance of the top ESG-rated 30% of stocks from each sector (+9.4% vs. STOXX600), or those that do not meet the positive momentum criterion (+6.1% vs. STOXX600).
- Turnover: the turnover of the top 30% of stocks is 33% on average for the 2013-18 period. Also, the turnover of stocks with improving ESG ratings within the top 30% would be close to 100% as this list is made up of companies that are improving their ESG rating on an annual basis. For this reason, a company that appears on the list one year due to a 10% positive change in its ESG rating has a lower chance of appearing again the following year with a consecutive change of +10%.
- Sector and country breakdown: a deep dive into each sector or country is quite difficult, as the number of companies that have positive ESG rating momentum is low.
- Market cap: there were no conclusive results when we analysed the positive momentum companies based on market cap.
Yannick joined SGCIB in March 2007. He has a deep understanding of investor needs in Sustainability research, having worked for more than 16 years in the field, with global coverage and responsibility (including exercising voting rights). Prior to working at SGCIB, Yannick was Product Manager / RFP Analyst at BNP Paribas Asset Management (2000-2002) and Senior ESG analyst at BNP Paribas Investment Partners (2003-2007) in France. He graduated from the École Supérieure de Gestion de Paris (ESG) and from INSEAD.