Finding the benefits of ESG integration

Rapidly accelerating macroeconomic trends, such as technological advancements, climate change and shifting socio-demographics are bringing us closer to an era that will be quite different from the present. As the world economy and society evolve, these changes can create new risks and present new opportunities for investors over the next few years.

The evidence is growing to demonstrate that companies that deal with non-financial environmental, social , and governance (ESG) threats such as working environment (including the modern-day slavery) as well as climate change and that are focused on good governance are also more successful in the long run.

As part of one of the biggest studies on this topic, Deutsche Bank and the University of Hamburg examined more than 2,000 research studies related to ESG integration and financial performance. They discovered it was true that ESG integration didn’t negatively impact investment returns in the majority of studied studies. And the majority of the time it actually added value.

Similar to that, MSCI ESG data demonstrates that businesses that have more ESG ratings typically have gross profit margins that exceed the overall market (see the chart above). A study conducted by MSCI goes even further and found that businesses with higher ratings for ESG generally had greater financial performance for their businesses (controlling for other variables like size, quality, and).

Additionally, the gap in return between the top and bottom ESG-rated firms appears to have been growing in recent years, being at or near 2.9 percent in the last five years (2015 through 2019).

In turn, the demand from pension schemes for investment in companies with robust ESG profiles is growing rapidly. For this reason trustees and consultants as well as asset managers are seeking a greater understanding of ESG elements that can have the greatest impact on the financial performance of an investment.

ESG integration aims to help support this. It is defined as part of the Principles for Responsible Investment (PRI) as “the explicit and systematic integration of ESG concerns in the analysis of investment and decision-making about investments” It helps investors by identifying and addressing ESG risks, along with other financial data, to measure the goals of strategy, management and quality of firms. This will impact the performance of companies and be correlated with equity returns.

The advantages of ESG integration can be described as follows:

* Improving the performance of corporates

The long-term financial advantage from ESG Integration at the corporate level is that more effective ESG practices will improve the company’s financial performance as well as financial value.

* Strengthening long-term future investment returns

ESG data and metrics can aid in portfolio building and decision-making about stocks. This could help to create more long-term value, and reduce ESG risk.

* Progression in ESG integration improves valuations as well as return on investment

Companies that invest in those with greater momentum ESG ratings are likely to experience more significant growth on their performance in the financials. This leads to better valuations and higher return on investment.

* Stronger resilience to extreme risk-related events and lower volatility

The real-world examples illustrate that not taking care of the financial risks arising from ESG issues can have a significant impact on the performance of a business and negatively affect the value of shareholders.

This means that ESG aspects are likely to play a growing and consistent function in the formulation of strategies for asset allocation, portfolio building and selection of managers. ESG considerations will also become crucial to support the long-term perspective of schemes and enhancing the traditional analysis of financials as a part of the decision-making process for investment.