Stockholm (NordSIP) – Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance (Part 1), a new report from MSCI, the provider of stock market indices and investor analysis tools, examines how ESG data accumulated by companies can be translated to equity markets.
The report, authored by Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltan Nagy and Laura Nishikawa, finds that companies that have integrated strong ESG characteristics have reaped tangible benefits from doing so.
In its investigation, MSCI created a model using three “transmission channels”, which take into account both stock-specific risks based on the business models of companies, and systematic risks, which have to do with exposure to a market environment, prices or regulatory change. The model leans on a “Discounted Cash Flow” notion borrowing from a concept used by Central Banks to suggest how monetary policy affects asset prices and economic conditions. The transmission models are as follows:
- A “Cash-flow” channel suggesting how companies that have a high ESG-rating become more competitive;
- An “idiosyncratic risk” channel, which points towards how companies with a high ESG-rating are less likely to suffer incidents that can impact share price;
- A “valuation” channel that suggests that companies with a high ESG rating often have a lower exposure to systematic risk, which can lead to higher valuations.
The report purports to demonstrate empirical evidence of a causal, rather than just correlational, relationship between ESG and financial performance, to the degree that a company’s ESG rating can be a financial indicator in its own right. The report terms this “ESG momentum”. The momentum itself, with an on-average three-year time lag, can point towards the value of ESG ratings in methodologies relating to portfolio construction.
“Instead of conducting a pure correlation-based analysis, we focused on understanding how ESG characteristics have led to financially significant effects,” wrote report author Guido Giese, Executive Director of Applied Equity Research with MSCI. “This way, we avoided the risk of data-mining and can differentiate between correlation and causality.”
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