MSCI: How does ESG impact the performance of companies?

Report into ESG from the index provider

Tom Eckett
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MSCI report researches ESG factors in various companies
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MSCI report researches ESG factors in various companies

MSCI has published new research highlighting how environmental, social and governance (ESG) characteristics affect corporations' valuations and risk profiles.

Its report, Foundations of ESG Investing, focused on understanding how ESG characteristics have a financial impact on investments through three "transmission channels": cashflow, idiosyncratic risk and valuation.

Cashflow

The "cashflow channel", the report said, would be generated by companies with high ESG ratings being more competitive than their peers in areas such as innovation, human capital development and implementing long-term business plans. 

It said this competitive advantage would enable companies to generate stronger returns, which in turn leads to higher profitability and ultimately higher dividends.

What has been driving the boom in passive ESG product launches? 

But Guido Giese, executive director of applied equity research at MSCI and co-author of the report, noted: "The competitive advantage of high ESG-rated companies cannot be readily observed.

"Therefore, our empirical analysis focuses on the second and third steps of the cashflow channel - ie higher profitability and higher dividends.

"High-dividend yields play an essential role in our analysis because sustainability investors typically have a long-time investment horizon. 

"Therefore, the apparent tilt of high ESG-rated strategies toward high dividend-paying companies may have helped enhance medium- to long-term improvement of risk-adjusted returns."

Idiosyncratic risk

Meanwhile, the "idiosyncratic risk channel", the report said, focuses on how well ESG-rated companies manage their business and operational risks.

It found firms with high ESG ratings tend to have stronger risk control and compliance standards across the company.

Giese said this would result in better risk control standards, meaning companies would be affected less by fraud, corruption or embezzlement issues, which can impact the value of a company.

These instances occur less frequently, he said, and mean there is less stock-specific downside or tail risk in the individual firm's stock price.

Giese said: "The analysis of companies' exposure and management techniques in relation to environmental, social and governance risks is the backbone of MSCI ESG Research's framework.

"To score well on a key issue, management needs to be commensurate with the level of exposure: a company with high ESG-risk exposure must also have very strong management, whereas a company with limited exposure can have a more modest approach.

"Over the past ten years, higher ESG-rated companies showed a lower frequency of idiosyncratic risk incidents, suggesting high ESG-rated companies were better at mitigating serious business risks."

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