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ESG integration

Renaissance Capital

14 January 2019

ESG

ESG integration has a shorter track record to assess and is less clearly defined than SRI screening. Implementing ESG can include using ESG as a risk analysis tool, as a corporate engagement and proxy-voting tool, as a tool for analysts to understand potential future investment costs, as a tool for adjusting a company’s cost of capital in traditional discounted cash-flow models and as an overlay tool to tilt overweights and underweights. As a result, there is no overwhelming consensus in studies.

Surveys suggest that investors believe full ESG integration is likely to provide the strongest impact on returns (followed by engagement/active ownership, positive screening and then risk factor-based screening).

The theory is that companies scoring well on ESG metrics are likely to be those achieving strong financial results over the cycle, and thus with a potential to outperform. Arguments for this include that such companies typically have better internal processes, information flow, are more forward looking and have the management information systems, risk management focus and strategies to position the business not only for current but potential future regulation and changes in societal norms. Such companies also tend to have better control over their supply chains, and stronger alignment between remuneration and performance, in addition to well-developed and operationally independent risk management and internal audit systems. But as one study importantly showed, outperformance would need to assume that these factors are being incorrectly understood by the market in order to provide a pricing inefficiency, and to be sure that excessive focus on ESG metrics does not compromise long-run financial returns vs peers. Another study showed that buying the top-performing stocks on eco-efficiency metrics could add to performance.

That said, there is plenty of work being done to promote ESG and plenty of studies attempting to show that investments can incorporate ESG without sacrificing returns, although much of the work done so far is back-testing of how strategies would have worked, with relatively few longer-term real-life demonstrations of outor under-performance.

One major positive turning point for ESG integration came after a 2015 Harvard Business School analysis, which found that “firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholdervalue enhancing”. In other words, there was a way to incorporate ESG without sacrificing returns. This was followed by a 2015 study of 2,200 pieces of research which concluded that 90% found a non-negative relationship between ESG and corporate financial performance. We still believe that the performance ‘proof’ for ESG integration is still very much in its early days, with a body of real-world evidence yet to be created.

It is clear from surveys (see Figure 53) that investors are prioritising governance issues when it comes to ESG. Arguments for this include ease of measurement, strong disclosure, ease of engagement and low barriers to improvement within a reasonably short investment timeframe. By contrast, bringing about change in carbon emissions can take decades and considerable investment.

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Renaissance Capital

14 January 2019

ESG

Figure 58: How would the following disclosures about a prospective investment affect your investment decision?

	Rule out investment immediately		Reconside investment		No change in investment plan

Risk from climate change

Absence of a direct link between ESG initiatives and business strategy to create value in the short, medium and long term

Risk from resource scarcity - e.g. water

Risk or history of poor environmental performance

ESG risks in supply chain unmanaged

Limited verification of data and claims

Human rights risk from operations

Risk or history of poor governance

0

10

20

30

40

50

60

70

80

90

100

Source: EY Climate Change and Sustainability Services 2017 investor survey

Our conclusion is that we do not know for sure whether ESG strategies will outperform or not over the long term in the real world, though we can see good arguments for it: we can envisage that: 1) a better understanding of a company’s ESG risks and strategies can help give investors better all-round understanding of a company; 2) there may be an increasing trend globally to reprice ESG underperformance, e.g. social media exposing companies with poor ESG performance, carbon and pollution pricing, tougher requirements on recycling/recyclability, increasing penalties on companies that fail to protect personal data, greater pressure on companies to eliminate gender pay gaps and provide greater protection to workers in the gig economy, and from governments on global corporates’ tax optimisation strategies, as well as higher penalties for breaching money laundering or sanctions legislation; and 3) growing ESG AuM can help push up the stock prices of companies doing well on such metrics via weight of money.

In the following section, we look at the data on ESG performance (with the caveat that our sample is necessarily limited) and shed more light on this question.

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Putting ESG to the test, pt. 1

ESG and performance: The evidence

Renaissance Capital

14 January 2019

ESG

Does ESG outperform ‘traditional’ investing? If we look at the performance of the MSCI World ESG Leaders Index vs the MSCI World Index, we see almost no difference between them in terms of performance. This is not indicative of much – by design, the MSCI ESG Leaders indices are supposed to match the factor exposures of their parent index.

However, an often-quoted result in EMs is that the EM ESG Leaders Index has outperformed the EM Index substantially since inception, with a relative outperformance of 48% since 30 September 2007.

Figure 59: MSCI World ESG Leaders vs MSCI World, $	Figure 60: MSCI EM ESG Leaders vs MSCI EM, $
MSCI World ESG Leaders	MSCI World	MSCI EM ESG Leaders	MSCI EM
150		170
140		160
130		150
		140
120
		130
110
		120
100
		110
90		100
80		90
70		80
		70
60
		60
50
		50
40
		40
30		30
Sep-07 Apr-08 Nov-08 Jun-09 Jan-10 Aug-10 Mar-11 Oct-11 May-12 Dec-12 Jul-13 Feb-14 Sep-14 Apr-15	Nov-15 Jun-16 Jan-17 Aug-17 Mar-18 Oct-18	Sep-07 Apr-08 Nov-08 Jun-09 Jan-10 Aug-10 Mar-11 Oct-11 May-12 Dec-12 Jul-13 Feb-14	Sep-14 Apr-15 Nov-15 Jun-16 Jan-17 Aug-17 Mar-18 Oct-18
Source: MSCI, Bloomberg, Renaissance Capital		Source: MSCI, Bloomberg, Renaissance Capital

Looking at a sample of 15 country and aggregate indices with ESG counterparts, we see that ESG beat the standard index in South Africa, Taiwan, India, Brazil, China, EM, Mexico, Canada, the Eurozone and Japan; it was flat against the US, Australia and the overall DM index, and it lagged for Korea and the UK.

Figure 61: MSCI ESG Leaders indices vs standard indices, 10yr annualised net total returns

ESG outperformance vs parent index (10yr annualised net $ total returns), ppts

5.0

4.0

3.0

2.0

1.0

0.0 -1.0 -2.0

South Africa

Taiwan

India

Brazil

China

EM

Mexico

Canada

Eurozone

Japan

US

Australia

World

Korea

UK

Source: MSCI, Bloomberg, Renaissance Capital

On the face of it, this suggests that ESG strategies work much better in EM than in DM. However, there are a few nuances here. First, while the index starts from September 2007, the actual launch date was July 2013 – data prior to this date are back filled. For the EM index, annualised outperformance drops by around two-fifths after the index went ‘live’. Of the sample considered, Canada, the eurozone, and Korea saw the ESG index’s

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Renaissance Capital

14 January 2019

ESG

outperformance improve once ‘live’ data was used. Mexico saw the most dramatic change, as ESG went from outperforming in the backtest to underperforming after the launch.

Figure 62: MSCI ESG Leaders indices vs standard indices, annualised performance preand post-launch ($)

16%				Outperformance prior to launch						Outperformance post-launch
14%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
	Mexico	Brazil	Taiwan		China	South Africa	EM	India		Canada	Japan	Australia	UK	Eurozone	Korea

Source: MSCI, Bloomberg, Renaissance Capital

China saw the highest ESG outperformance post-launch, followed by Taiwan and India; indeed, ESG’s outperformance in China, India and Taiwan has been a main factor in the overall index performance, given their weights.

With our sample of ESG and standard indices, we attempted to test whether there was a statistically significant alpha in favour of the ESG Index. Our results showed that alphas were significant (at the 5% level) for the EM index, and for China, South Africa, Taiwan and Canada.

Figure 63: MSCI EM ESG indices – alpha estimates and t-stats

			World		EM		China		India		Brazil	South Africa		Korea		Japan		Taiwan		Mexico		Australia		Canada		Eurozone	UK		US
	Estd. alpha		-0.1%		3.5%		5.9%		3.2%		3.9%	4.2%		-1.2%		0.3%		5.0%		4.5%		0.4%		2.3%		1.1%	-0.6%		-0.3%
	T-stat	-0.25		3.37			2.81		1.69		1.87	2.56	-0.55			0.59		2.89	1.69			0.29	2.34			1.69	-0.43		-0.52
																								Source: MSCI, Bloomberg, Renaissance Capital

What about ESG funds?

As we pointed out earlier, ESG investing is by no means a new thing. That said, the bulk of the asset growth in EM ESG/SRI funds has come in the past three years, with AuM rising from $2.9bn in January 2014 to $21.4bn as of October 2018. Using a sample of 24 EM ESG/SRI funds from 2013, we see that while the EM ESG Index outperformed the EM Index, our sample of funds underperformed both the EM ESG Index and the MSCI EM Index as a whole.

Figure 64: EM ESG fund average vs MSCI EM and MSCI EM ESG (total return, $)

ESG fund average (total return)		MSCI EM total return ($)		MSCI EM ESG total return ($)

180

160

140

120

100

80

60

Apr-13

Jul-13

Oct-13

Apr-14

Jul-14

Oct-14

Apr-15

Jul-15

Oct-15

Apr-16

Jul-16

Oct-16

Apr-17

Jul-17

Oct-17

Apr-18

Jul-18

Oct-18

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17

Jan-18

Source: MSCI, Bloomberg, Renaissance Capital

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Renaissance Capital

14 January 2019

ESG

If we try to look at longer time horizons, it is difficult to use only EM funds, as the number of funds with more than 10 or 15 years of performance data is quite low. In addition, earlier vintages of funds are not necessarily ESG as it is understood today, operating on a principle of e.g. excluding ‘sin’ stocks, targeting low greenhouse gas emitters, and so forth.

Figure 65: ESG fund average total return relative to benchmark

Long-term ESG funds average relative total return vs fund benchmark

125

120

115

110

105

100

95

90

85

80

75

90-Jan 91-Jan 92-Jan 93-Jan 94-Jan 95-Jan 96-Jan 97-Jan 98-Jan 99-Jan 00-Jan 01-Jan 02-Jan 03-Jan 04-Jan 05-Jan 06-Jan 07-Jan 08-Jan 09-Jan 10-Jan 11-Jan 12-Jan 13-Jan 14-Jan 15-Jan 16-Jan 17-Jan 18-Jan Source: MSCI, Bloomberg, Renaissance Capital

Our longer view shows the average relative total return of ESG/SRI funds relative to their respective benchmarks. There is a small degree of underperformance overall, but very little. This might suggest ESG and SRI strategies imposes a small cost on performance, but the results are hardly conclusive.

In the next section, we will look at the performance of stocks by selected ESG metrics to see if we can find further insights into whether ESG outperforms and why.

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Putting ESG to the test, pt. 2

An ESG experiment – the results

Using a database of c. 3,000 EM and DM stocks, covering c. 150,000 ESG datapoints, we find that ‘good’ ESG stocks tend to outperform ‘bad’ ones by around 5 ppts pa (total return, $ terms), supporting the theory that ESG can help managers outperform. However, breaking this down further, we see that the bulk of this has come from the outperformance of better-governed companies vs their less wellgoverned peers. Using just environmental or social scores, there is some (albeit statistically insignificant5) outperformance.

Figure 66: ESG performance across MSCI ACWI, $

Performance: Top quintile vs bottom quintile (2014-date, Total Return, $)

35

30

25

20

15

10

5

0

RenCap ESG Score

RenCap E

RenCap S

RenCap G

Note: Equal-weighted total return of portfolios formed by ranking stocks by score and taking the average of each quintile, then comparing the top quintile with the bottom quintile

Source: MSCI, Bloomberg, Renaissance Capital

5 At 5% significance level

Renaissance Capital

14 January 2019

ESG

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Renaissance Capital

14 January 2019

ESG

What else did we learn?

Finland, the Netherlands and Israel top the rankings for overall ESG, while India, China, and Indonesia perform worst. On average, DM outperforms EM, particularly on environmental scores; for governance, DM is some way ahead, while for social both are equal. By sector, healthcare, IT and communications score best, while utilities, energy and materials score worst.

Figure 67: ESG scores by country

		Environmental	Social	Governance	Overall
	Netherlands	90%	72%	98%	87%
	Finland	72%	84%	95%	84%
	Israel	70%	91%	70%	77%
	UK	90%	49%	74%	71%
	Norway	64%	99%	47%	70%
	Sweden	91%	46%	64%	67%
	Korea	64%	87%	48%	66%
	Switzerland	83%	29%	84%	65%
	Australia	54%	49%	92%	65%
	Brazil	63%	78%	52%	64%
	South Africa	71%	65%	56%	64%
	Spain	72%	81%	36%	63%
	Singapore	68%	38%	81%	62%
	US	66%	35%	81%	61%
	Germany	77%	59%	41%	59%
	Italy	78%	62%	33%	58%
	France	88%	62%	23%	57%
	Denmark	92%	16%	64%	57%
	Belgium	64%	66%	20%	50%
	Canada	46%	23%	77%	49%
	Taiwan	29%	96%	18%	48%
	Ireland	59%	0%	74%	44%
	Greece	11%	91%	14%	39%
	Chile	49%	6%	58%	38%
	Malaysia	23%	78%	9%	37%
	Russia	25%	73%	11%	37%
	Turkey	48%	31%	31%	36%
	Mexico	34%	10%	61%	35%
	Japan	68%	24%	7%	33%
	Philippines	4%	34%	51%	30%
	Thailand	12%	53%	3%	23%
	Hong Kong	20%	21%	27%	22%
	Indonesia	16%	10%	39%	22%
	China	14%	31%	16%	20%
	India	17%	3%	25%	15%
	DM	71%	50%	59%	60%
	EM	32%	50%	33%	38%
	Health Care	78%	55%	62%	65%
	Information Technology	79%	49%	63%	64%
	Communication Services	81%	47%	56%	62%
	Consumer Staples	74%	53%	57%	62%
	Consumer Discretionary	78%	49%	57%	61%
	Real Estate	70%	54%	60%	61%
	Financials	93%	36%	54%	61%
	Industrials	74%	52%	55%	60%
	Materials	57%	56%	59%	57%
	Energy	59%	54%	58%	57%
	Utilities	55%	54%	52%	54%
				Source: MSCI, Bloomberg, Renaissance Capital

For environmental, Denmark, Sweden and the Netherlands score best, with the Philippines, Greece and Thailand scoring worst. South Africa is the best country in EM for environmental, while Hong Kong is the worst country in DM. One reason South Africa performs well is that it has very few energy and utility companies in the index – adjusted

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Renaissance Capital

14 January 2019

ESG

for sector composition, South Africa is merely middling (contrast this with Brazil, where while the index is tilted towards high-emissions sectors, the companies are generally better on average than their industry peers). Hong Kong suffers from a high proportion of utility and land development companies with high levels of emissions per sales, which drags down its score.

For social, Norway, Taiwan and Greece score best, while Ireland, India and Chile score worst. Some interesting points here are:

▪Taiwan, Greece and Korea do best in EM, as their companies show a strong presence of women in management roles and in the workforce more widely, high rates of unionisation and relatively low rates of time lost to injury; moreover, their companies tend to be ahead of industry peers on these metrics.

▪India, Ireland and Chile are the polar opposite – women are underrepresented in both management and in the workforce, unionisation is low and lost time to worker injuries are high both on absolute and relative levels.

For governance, the Netherlands, Finland and Australia score best, while Thailand,

Japan and Malaysia score worst. Some interesting points:

▪It is perhaps unsurprising, given the number of corporate scandals in Thailand, Japan and Malaysia, that these countries screen worst on our governance scores. Low proportions of independent directors, over-sized boards, low ratings from Institutional Shareholder Services (ISS) on corporate governance and a high proportion of state-owned corporations are features these three countries share; with Russia, Greece and China not far behind.

ESG top-down vs ESG bottom-up

Comparing our ‘bottom-up’ scores to our ‘top-down’ scores (Thoughts from a Renaissance man – Reclaiming ESG in EM and FM, published 19 October 2018) we find that top-down factors account for roughly 40% of the variation of bottom-up scores. By category, governance scores show the closest relationship, with a correlation of 51%; social scores have a correlation of 21% and environmental scores are almost unrelated, with a correlation of just 2%.

Figure 68: ESG bottom-up vs ESG top-down

Figure 69: Environmental bottom-up vs environmental top-down

RenCap ESG Bottom-Up (y-axis) vs ESG Top-Down (x-axis)

100%

90%

Netherlands

80%

Finland

Israel

70%

South Africa

UK

Norway

Brazil

Korea

Australia

Sweden

Switzerland

60%

US

SpainSingapore

Germany

50%

Italy

France

Denmark

Canada

Belgium

Taiwan

Ireland

40%

RussiaTurkey

Malaysia

Greece

Chile

Mexico

Japan

30%

Philippines

Thailand

Hong Kong

20%

China

Indonesia

India

10%

0%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Source: MSCI, Bloomberg, Renaissance Capital

RenCap Environmental bottom-up (y-axis) vs Environmental top-down (x-axis)

100%

Denmark

90%

Netherlands

Sweden

UK

France

80%

Switzerland

Germany

Italy

70%

Finland

Spain

South Africa

Israel

US

JapaSingapore

Korea

NorwayBelgium

Brazil

60%

Ireland

50%

Australia

Chile

Canada

Turkey

40%

Mexico

30%

Taiwan

20%

Russia

Malaysia

Hong Kong

China

India

Indonesia

Thailand

10%

Greece

0%

Philippines

40%

50%

60%

70%

80%

90%

100%

110%

Source: MSCI, Bloomberg, Renaissance Capital

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Renaissance Capital

14 January 2019

ESG

Why is there such a large difference between our environmental scores? The main reason would be that in measuring emissions on a per-person basis, less-developed economies would tend to look better than more developed economies, as they lack the industrial base and technology that leads to high emissions. However, just because they are not large polluters does not mean their industries cannot improve in terms of emissions – indeed, one would hope that new investments made in low-income countries would use the latest technologies to ensure lower emissions than their high-income peers had at the same level of development.

Figure 70: Social bottom-up vs social top-down

Figure 71: Governance bottom-up vs governance top-down

RenCap Social bottom-up (y-axis) vs Social top-down (x-axis)

100%

Norway

Taiwan

90%

Israel

Greece

80%

Korea Finland

Malaysia Brazil

Spain

70%

Russia

Netherlands

South

Africa

Belgium

60%

FranceItaly

Germany

50%

Thailand

Australia

Sweden

UK

40%

Singapore

US

Switzerland

30%

Philippines

China

Turkey

Japan

20%

Hong Kong

Canada

Denmark

10%

Indonesia

Mexico

India

Chile

0%

Ireland

20%

30%

40%

50%

60%

70%

80%

90%

100%

RenCap Governance bottom-up (y-axis) vs Governance top-down (x-axis)
100%						Netherlands
90%						Australia Finland
80%						Switzerland
					US	Singapore
						Canada
70%				Israel		IrelandUK
60%	Mexico					DenmarkSweden
			South Africa	Chile
	Brazil
50%
	Philippines			Korea		Norway
40%	Indonesia					Germany
				Spain
			Italy
30%	Turkey
						Hong Kong
	India
20%					France
					Belgium
	China				Taiwan
			Greece
10%	Russia
			Malaysia
					Japan
		Thailand
0%
0%	20%		40%	60%	80%	100%

Source: MSCI, Bloomberg, Renaissance Capital

Source: MSCI, Bloomberg, Renaissance Capital

The difference between the top-down and bottom-up social and governance scores is also interesting and suggests that there may be companies which are lagging the developments in the economy as a whole, or conversely, that some countries – e.g. South Africa, Israel and Brazil – have companies that are more socially responsible and bettergoverned than the country in aggregate.

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Renaissance Capital

14 January 2019

ESG

Top of the charts

Our ESG scores shows Natura Cosmeticos, the Brazilian cosmetics giant famed for its sustainable practices, as the top ESG company in EM, followed by Lojas Renner and China State Construction and Engineering.

Figure 72: Top/bottom 10 EM stocks by ESG scores

Ticker	Name	Country	Sector	MktCap, $mn	Overall ESG score
NATU3 BS	Natura Cosmeticos Sa	Brazil	Consumer Staples	4,708	80.1
LREN3 BS	Lojas Renner S.A.	Brazil	Consumer Discretionary	7,212	78.3
601668 C1	China State Construction -A	China	Industrials	36,012	77.0
032830 KP	Samsung Life Insurance Co Lt	South Korea	Financials	15,170	76.4
ISA CX	Interconexion Electrica Sa	Colombia	Utilities	4,777	76.0
BSAN CC	Banco Santander Chile	Chile	Financials	14,473	75.7
SANB11 BS	Banco Santander Brasil-Unit	Brazil	Financials	41,991	73.8
8299 TT	Phison Electronics Corp	Taiwan	Information Technology	1,495	72.0
LPPF IJ	Matahari Department Store Tb	Indonesia	Consumer Discretionary	1,036	71.9
DELTA TB	Delta Electronics Thai Pcl	Thailand	Information Technology	2,629	71.8
817 HK	China Jinmao Holdings Group	China	Real Estate	5,056	32.4
SMGR IJ	Semen Indonesia Persero Tbk	Indonesia	Materials	4,862	32.2
TITK GA	Titan Cement Co. S.A.	Greece	Materials	1,890	31.8
002380 KP	Kcc Corp	South Korea	Industrials	2,655	31.1
SIME MK	Sime Darby Berhad	Malaysia	Industrials	3,738	30.3
2002 TT	China Steel Corp	Taiwan	Materials	12,119	30.1
ACEM IS	Ambuja Cements Ltd	India	Materials	5,695	29.7
GAIL IS	Gail India Ltd	India	Utilities	10,481	29.3
2610 TT	China Airlines Ltd	Taiwan	Industrials	1,859	27.2
				Source: MSCI, Bloomberg, Renaissance Capital

On the other end of the spectrum, we find China Airlines, Gail India and Ambuja Cement.

Looking by sector, we find the following in EM:

Figure 73: Top/bottom EM ESG scores by sector

Ticker	Name	Country	Sector	MktCap, $mn	Overall ESG score
TIMP3 BS	Tim Participacoes Sa	Brazil	Communication Services	7,324	64.5
LREN3 BS	Lojas Renner S.A.	Brazil	Consumer Discretionary	7,195	78.3
NATU3 BS	Natura Cosmeticos Sa	Brazil	Consumer Staples	4,697	80.1
010950 KP	S-Oil Corp	South Korea	Energy	10,630	57.3
032830 KP	Samsung Life Insurance Co Lt	South Korea	Financials	15,176	76.4
LHC SJ	Life Healthcare Group Holdin	South Africa	Health Care	2,655	51.1
601668 C1	China State Construction -A	China	Industrials	36,018	77.0
8299 TT	Phison Electronics Corp	Taiwan	Information Technology	1,496	72.0
CMPC CC	Empresas Cmpc Sa	Chile	Materials	8,324	58.0
RDF SJ	Redefine Properties Ltd	South Africa	Real Estate	3,896	65.6
ISA CX	Interconexion Electrica Sa	Colombia	Utilities	4,836	76.0
MAXIS MK	Maxis Bhd	Malaysia	Communication Services	10,049	34.3
MM IS	Mahindra & Mahindra Ltd	India	Consumer Discretionary	12,190	47.5
600887 C1	Inner Mongolia Yili Indus-A	China	Consumer Staples	19,856	33.7
ROSN RX	Rosneft Oil Co Pjsc	Russia	Energy	67,904	32.6
DHBK QD	Doha Bank Qpsc	Qatar	Financials	1,918	35.0
2196 HK	Shanghai Fosun Pharmaceuti-H	China	Health Care	9,197	42.8
2610 TT	China Airlines Ltd	Taiwan	Industrials	1,860	27.2
2337 TT	Macronix International	Taiwan	Information Technology	1,153	36.2
UTCEM IS	Ultratech Cement Ltd	India	Materials	14,312	26.1
817 HK	China Jinmao Holdings Group	China	Real Estate	5,056	32.4
GAIL IS	Gail India Ltd	India	Utilities	10,439	29.3
				Source: MSCI, Bloomberg, Renaissance Capital

Brazil manages to have three companies at the top of their sectors with Tim Participacoes, Lojas Renner and Natura Cosmeticos. South Africa boasts two companies at the top of their respective sectors (Life Healthcare and Redefine Properties), as does Korea.

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