The Data-Driven Case for ESG

With political debates raging over the incorporation of environmental, social, and governance (ESG) considerations into the investment process, is there a more constructive way to approach the subject? Look to the data, argues Mark Webster, Director, Institutional & Advisory ETF Distribution—which conclusively demonstrates that ESG integration enhances value-creation.

The debate surrounding responsible investing (RI) continues to be ferocious. Though the opposing poles may not be as wide apart as they were when climate denials were at their zenith, there has been a noted backlash against asset managers who integrate responsible investing criteria into their stock selection process. The most notable examples are in the U.S., where some state legislatures have gone as far as to forbit certain asset managers from managing state assets.

This is quite surprising because environmental, social, and governance (ESG) is a fiduciary risk management concept meant to provide insight to investors about business practices which could reasonably be expected to impair capital in the future.

If fiduciary responsibilities are not reason enough, there is expanding data to show high ESG-rated companies display more compelling market metrics and can access capital for less than their lower-rated peers. For those who disavow RI/​Sustainability/​ESG, consulting that data, rather than leaning on rhetoric, may provide a grounded argument to support ESG integration in investment management.

McKinsey identified five distinct areas where ESG commitment enhances value creation:¹

1. Top Line Growth: higher ESG scores expand opportunities in more markets because regulators are less concerned that business practices might result in costly interventions
2. Cost Reductions: more effective resources use can reduce variability in operating margins by 60%
3. Regulatory & Legal Interventions: according to McKinsey research, almost one-third of corporate profits can be at risk due to regulatory intervention
4. Improved Productivity: engaged employees who have a strong social commitment have been shown to be more productive. Companies with poor Governance, for instance, have higher incidences of strikes or worker disruptions
5. Investment & Asset Optimization: avoiding stranded assets may align capital with longer-term benefits

In another study, Deloitte found evidence that there is an ESG value premium.² Companies with higher ESG scores displayed 1.2 times higher enterprise value (EV)/earnings before interest, taxes, depreciation, and amortization (EBITDA) scores than companies with lower ESG scores. More significantly, companies with rising ESG scores showed 1.8 times higher EV/EBITDA. The authors concluded that superior ESG metrics were rewarded with additional value over and above net financial gains.

EV/EBITDA by ESG Score³

MSCI has more data to demonstrate a positive correlation between high ESG score and company performance.⁴ Examining ESG score, measuring its business practices, and its relation to company financial ratios, they see a distinct positive impact on valuation and performance.

Transmission Channels of How ESG May Affect Financial Performance and Risk

Interestingly, the positive impact was far more noticeable and more enduring at the cumulative ESG score level than it was for any of the individual components: environmental, social, or governance. This might be a testament to the more comprehensive nature of ESG in assessing overall business practice risks.

Financial ratio fundamentals were examined closely to address the critique that performance might be bolstered due to ESG crowding—that investment management firms might flock to higher rated companies to improve their own ESG metrics.

Using the formula below, MSCI dissected equity returns to parse the price-to-earnings (P/E) crowding effect from total returns:

• Total equity return = Earnings growth + P/E growth + dividend yield

Their study revealed that between May 2013 and November 2020, company outperformance was attributable to stronger earnings growth and marginally higher dividend growth.

The data was more pronounced in Developed Markets than in Emerging Markets, due to earlier regulatory impetus and radically different energy infrastructure (several Emerging economies remain heavily dependent on coal to expand industrial production, for example).

Interestingly, the study also found that companies with superior ESG scores displayed lower idiosyncratic risk, which makes sense, but also lower systemic risk.

The underlying fundamentals to explain why such highly rated ESG companies display lower risks are found in a more recent MSCI report entitled MSCI ESG Ratings and Cost of Capital, published in July 2024.⁵

Examining the cost of capital and associated risk metrics — beta for equities and credit spread for fixed income — the study demonstrated markedly different profiles for companies with differing ESG rankings.

The Cost of Capital Across MSCI ESG Quintiles

Unsurprisingly, there were noticeable differences across sectors, due partially to traditional capital structures in different industries but likely also attributable to the cyclicality, which is a particular risk for both Energy and Materials.

Average Cost of Capital by Sector

Always cognizant that data tends to be historical, MSCI explored whether ratings changes had any impact on future capital costs. Unsurprisingly, rising ESG scores lowered the cost to access capital.

Cost of Capital After a Substantial MSCI ESG Rating Change

Perhaps understood, given the trend in the data, companies with declining ESG scores faced higher capital costs than their highly ranked or appreciating peers in the same sector.

Conclusion

Rhetoric is divisive and unproductive for any debate. More constructive arguments are waged when data can be tabled for objective consideration and discussion, leading to better decisions and better policy.

Thorough data is available to demonstrate there is a sound thesis to support ESG’s integration into the investment process. Not only is ESG a core fiduciary concept and obligation, it appears to demonstrate a positive impact on company metrics and long-term performance.

To learn more about BMO’s suite of ESG ETFs or receive other trading insights, reach out to your BMO ETF Specialist at their email address or via telephone at 1−877−741−7263.

¹ Witold Henisz, Tim Koller, and Robin Nuttall, ​“Five Ways that ESG creates value,” McKinsey Quarterly, November 2019.

² Igor Heinzer and Andrea Mezzanzanica, ​“Does a company’s ESG score have a measurable impact on its market value?” Deloitte, 2022.

³ ​‘A’ score indicates excellent relative ESG performance and high degree of transparency in reporting material ESG data publicly. ​‘B’ score indicates good relative ESG performance and above average degree of transparency in reporting material ESG data publicly. ​‘C’ score indicates satisfactory relative ESG performance and moderate degree of transparency in reporting material ESG data publicly. ​‘D’ score indicates poor relative ESG performance and insufficient degree of transparency in reporting material ESG data publicly.

⁴ Guido Geise & Drashti Shah, ​“MSCI ESG Ratings in Global Equity Markets: A Long-term Performance Review,” MSCI, March 2024.

⁵ Jakub Malich and Anett Husi, ​“MSCI ESG Ratings and Cost of Capital,” MSCI, July 2024.