Impax blog

Demonstrating the value of ESG analysis

22 Jul 2015 - by Lisa Beauvilain

We are often asked how our ESG analysis is integrated into the investment process, how it adds value for our investments and how to measure its value.

Our listed equities investment process integrates a deep ESG analysis for every company that appears to be a contender for investment.  We seek to ensure that companies have appropriate governance structures in place and look for effective management systems and processes to address material risks.  Effective corporate governance cannot be taken for granted.  Smaller companies and those based in developing regions tend to require more detailed research.  

We have been undertaking this analysis and rating system for many years.  It gives us valuable insight and we can now demonstrate that it has been a clear indicator of long term performance.  This work is firmly embedded in our investment process – it can, and does, stop us from investing in a company.

Analysis by region and by sector

Governance structures and transparency are effectively analysed from a regional perspective and we look for potential outliers. We scrutinise companies’ policies and processes with regard to the most material environmental and social (E&S) risks they face by sector.  

We analyse a wide range of company disclosures to determine what and how information is disclosed and the overall level of transparency.  An important objective of our analysis is to establish the “character” of a company.   We look for evidence of:

  • Good transparency
  • Strong accountability structures
  • Performance alignment
  • Strategic approach versus struggling with short term operations.

Assigning an ESG score

External ESG research providers, such as MSCI ESG Manager (1) and Sustainalytics (2) also provide useful data and support our analysis. However we do not use the results of analysis by external research firms per se as we place significant importance on viewing and analysing company disclosures ourselves to ensure we understand a company’s overall approach to ESG and its implementation. Only then do we establish an ESG score for each company, based on governance structures, and E&S processes, as well as taking note of any controversies and overall corporate behaviour.  Company ESG analyses and ratings are reviewed annually, or more frequently if a material change or event occurs

Our ESG rating system is on a scale of five:

We have also established an additional governance analysis for Chinese and Hong Kong-based companies, in order to take account of cultural and structural differences.  For example, many companies in this region are managed by their founders who often remain as dominant shareholders, and they may have family and friends on the board and complex related party transactions potentially leading to conflicts of interest.  Our detailed additional work has enabled us to avoid many weak and subsequently underperforming companies in the region.

Analysis and engagement

ESG analysis gives us greater insight and understanding of the way in which companies are run; it often enables us to identify potential weaknesses before controversial issues arise.  When the analysis unveils risks, concerns or missing information, we frequently engage with the company to try to extract more information or effect change.  Effective engagement can encourage investee companies to improve their practices over time.

Correlation between ESG score and long term performance

We have analysed the long-term share price performance and ESG scores of more than 300 companies. The companies that were rated “Excellent” and “Good” have clearly and consistently outperformed the weaker ESG over the last ten years. 

Source: VIPER Analytics, FactSet. (3)

These results do not represent actual results. All returns presented are hypothetical and back-tested. Actual results may significantly differ from the theoretical returns being presented.  The results reflect performance of a strategy not [historically] offered to investors and do NOT represent returns that any investor actually attained.  The back-tested data was derived from the retroactive application of a model with the benefit of hindsight including the ability to adjust the method for selecting securities. PAST HYPOTHETICAL PERFORMANCE IS NOT A GUARANTEE OF FUTURE RETURNS.

We have tested the robustness of this data and have found that factors such as company size (market cap) and sector could not explain the outperformance of the stronger ESG rated companies.  The “Excluded” bucket is very small and dominated by Asian companies. The other categories are relatively large and outperformance cannot be explained by geographic factors.  

Identifying “future makers”

The correlation between the highest ESG scoring companies and their long term performance is clear and almost certainly reflects better management, transparency and a company’s ability to be a strategic, i.e. a “future maker”.  These findings are also strongly supported by recent large-scale academic research projects by Oxford University and Harvard Business School (4), reaching similar conclusions.

 

(1) MSCI Intangible Value Assessment (IVA) and Impact Monitor (IM)

(2) Sustainalytics quarterly UN Global Compact screen of the investable universe

(3) The underlying data depicts the NAV-growth of the companies in the various ESG-score “buckets”. When an ESG-score is entered or changed into the universe database, it is updated in the underlying data set and graph. The data therefore provides a current snapshot of the performance and ESG-scores. Companies are market cap weighted. Data from January 2007 to March 2015.

(4) University of Oxford, “From the Stockholder to the Stakeholder, How Sustainability Can Drive Financial Outperformance”, September 2014. Harvard Business School: Corporate Sustainability: First Evidence on Materiality, http://www.hbs.edu/faculty/Publication%20Files/15-073_8a7e13e5-68c5-4cc3-a9a0-a132bbef3bc7.pdf, January 2015

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