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Renaissance Capital

14 January 2019

ESG

Armed with our ESG scores, we can also look at selected financial and valuation characteristics of high-scoring ESG stocks:

Figure 74: Top/bottom EM ESG scores by sector

		Top quintile	2nd quintile	3rd quintile	4th quintile		Bottom quintile	Sample median	Top vs bottom
									quintile
Non-financials
RoE (5yr average)	17.4		14.8	12.1	11.9	9.8		12.9	7.6
Debt to equity (5yr average)		61.8	69.0	65.1	72.8		69.0	69.0	-7.2
Assets to equity (5yr average)	2.4		2.5	2.3	2.4	2.3		2.4	0.1
EBITDA margin (5yr average)		21.2	21.2	22.7	23.6		19.7	21.6	1.5
Revenue growth (5yr average)	4.5		2.6	3.0	2.5	2.8		3.2	1.7
Debt to EBITDA (5yr average)		1.1	1.4	1.3	1.9		2.0	1.5	-0.9
12M fwd P/E (current)	15.4		14.7	15.4	13.1	12.4		13.8	3.1
12M fwd div yield (current)		2.9	3.6	3.4	3.6		4.1	3.6	-1.3
EV/EBITDA (current)	11.0		9.3	7.7	7.4	7.3		8.4	3.7
MktCap, $bn (current)		9.6	15.6	11.9	10.5		11.1	11.5	-1.5
Financials
RoE (5yr average)		10.4	9.6	11.2	12.2		9.8	11.4	0.7
12M fwd P/E (current)	10.0		8.6	9.2	9.2	9.1		9.9	0.9
12M fwd div yield (current)		5.8	4.6	4.9	4.3		5.4	5.2	0.4
P/B (current)	1.2		0.9	1.0	1.1	0.8		1.3	0.4
MktCap, $bn (current)		16.7	14.4	10.2	11.4		7.9	21.7	8.8
								Source: MSCI, Bloomberg, Renaissance Capital

High-scoring non-financial ESG stocks tend to have higher RoE, higher revenue growth, higher margins, lower leverage (on debt/equity and net debt/EBITDA), and higher valuations on 12-month forward P/E and EV to 12-month forward EBITDA basis; they also tend to be smaller in market cap (with the caveat that the variation in the top quintile is considerable). For financial stocks, top-scoring companies show higher RoE, higher valuations on 12M forward P/E and trailing P/B, and higher dividend yields; they also tend to be larger in market cap.

What about the change?

Our first test of ESG’s ability to outperform relied on taking ESG scores based on data from 2013-2014, using these data to create composite scores and portfolios, then comparing the performance of top and bottom quintiles for each factor. We can also look at the performance of companies that improved their ESG rating.

Figure 75: Change in ESG performance across MSCI ACWI, $

Performance: Top quintile vs bottom quintile (2014-date, total return, $)

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20

15

10

5

0 -5 -10 -15 -20

RenCap ESG Score

RenCap E

RenCap S

RenCap G

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

Source: MSCI, Bloomberg, Renaissance Capital

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Renaissance Capital

14 January 2019

ESG

Overall, companies that improved their ESG rating outperformed only marginally.

Breaking things down further, we find that companies that improved their environmental ratings outperformed, while companies that improved their governance ratings underperformed.

What could explain this pattern? For the underperformance of changes in governance, a big part of this could be our relatively short window – changes in the structure of the board, or executive compensation, or ownership structure may not have an immediately positive outcome on the share price, as investors need time to understand the new system; furthermore, there could also be an adverse selection problem, as companies are more likely to change governance structures as part of a larger restructuring or in response to regulatory or legal problems (which are not usually positive for shareholder returns).

As for why companies with improving environmental scores should outperform, perhaps this should be expected, given the attention that has been placed on reducing emissions in recent years. A closer investigation shows that the companies that saw the least amount of emissions reduction per dollar of sales were in energy sectors – this is perhaps unsurprising given the fall in energy prices since 2014. Assuming a constant relationship between volume of output and emissions, a halving of the price would lead to a doubling of emissions per sales (of course, the reality is more complicated than this, so the relationship may be weaker), so perhaps the outperformance of companies with improving environmental scores could also reflects the underperformance of energy vs financials, IT and healthcare (which have seen the most improvement in emissions per dollar of sales).

What metrics were most important?

There are almost as many ESG metrics to choose from as there are providers. For our analysis, we chose 10 indicators that are simple, measurable and unambiguous, allowing them to be applicable across a wide variety of sectors and markets.

For environmental, we focused on greenhouse gas emissions per dollar of revenues. For social, we looked at the percentage of women in the workforce, the ratio of women in management to women employees (the insight being that if a company could employ women as the majority of its workforce but have no female managers), employee turnover, employee unionisation (while unions are not an unambiguously positive force, companies which employ union members would be more likely to take issues of worker compensation and safety more seriously than otherwise), and lost time incident rate (reflecting the frequency of worker safety incidents). For governance, we chose state ownership (as many companies with a high degree of state ownership have historically been associated with corruption and the pursuit of political goals), board size (with the idea being that large boards are often associated with cronyism, while a smaller board can more effectively supervise and safeguard shareholder rights), the percentage of independent directors on the board, and ISS governance scores.

Carrying out a similar procedure for testing the overall ESG scores, we looked at portfolios formed by ranking each of these metrics, and compared the performance of the top-scoring quintile to the bottom-scoring quintile.

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Renaissance Capital

14 January 2019

ESG

Figure 76: Performance of top quintile minus bottom quintile, $

Performance, top quintile - bottom quintile

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-10

-20

Govenrment ownership

Board Size

Women employees to management ratio

Independent directors, %

ISS score

GHG/revenue

Employee turnover, %

Lost time incident rate

Women employees %

Employees unionised %

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

Source: MSCI, Bloomberg, Renaissance Capital

The best-performing variable (in terms of the largest gap between the top and bottom quintile) was government ownership: companies with low degrees of government ownership significantly outperformed companies with high shares owned by the state. Almost as effective were companies with small boards vs companies with large boards, followed by the ratio of women managers to employees, suggesting that focus on these areas is key for investors. Unionisation of employees did not result in outperformance – this is partly to be expected, as a greater share of company profits going to labour would tend to mean a lower return to capital, while simply focusing on the percentage of women employees did not, in and of itself, outperform.

Of course, this is only one approach. The SASB highlights the following issues as ones that companies should focus on, and have developed a ‘materiality map’ (see Appendix A) highlighting which issues are likely to be material for which sectors.

Figure 77: SASB sustainability topics and issues

Source: SASB

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The ‘science’ behind the scores

Renaissance Capital

14 January 2019

ESG

Perhaps a better title for this would be ‘the method behind the madness’. To construct our ESG scores, we took an initial sample of 2,791 stocks across MSCI DM and MSCI EM, then collected data on 24 separate metrics from 2013 to date. From there, we pared the database down to our chosen 10 metrics. In choosing our metrics, we went for the most widely available metrics that exhibited high correlation to the metrics that were less comprehensive – e.g. for environmental, GHG emissions to sales had a high correlation to other measures of environmental performance, but covered vastly more companies. Where possible, we dealt with missing values through a combination of imputation using regressions with sub-industry level dummies. We then normalised the variables to transform to lie on the interval (0-100).

With our final set of metrics obtained, we constructed two scores: the first to gauge the absolute performance of a company, the second to judge the performance of a company against its sector peers. We then combined these into a single score, then further aggregated the scores on each metric into a composite score, giving us a final ESG ranking. To construct the country scores, we took the average for each metric then applied the same normalisation as for stocks, the idea being that the country’s score is proxied by the average performance of its companies. To avoid issues of small sample bias, we calculated country averages only for countries with at least five companies with data per category.

To measure the performance of each factor, we first sorted all the stocks that had data into quintiles, then took the average performance of each quintile. Finally, we measured the difference between the top quintile’s performance and that of the bottom quintile, the idea being to capture the outperformance of stocks that score ‘well’ on our metrics vs stocks that score ‘poorly’.

Full quintile performance for each variable is available below:

Figure 78: Metric performance by quintile, $

					Top	2nd		3rd	4th	Bottom	Performance,
	Variable		Type								top quintile -
					quintile	quintile		quintile	quintile	quintile
											bottom quintile
	Government ownership (lower = "better")		G		73.1	86.2		91.3	43.9	37.1	36.0
	Board Size (lower = better)		G	72.8		54.9	57.9		46.4	39.0	33.8
	Women Employees to Management Ratio (higher = better)		S		58.2	37.0		34.2	49.7	32.1	26.2
	Independent Directors, % (higher = "better")		G	67.6		49.3	46.3		53.6	58.5	9.1
	ISS (lower = "better")		G		49.1	53.4		49.3	47.5	44.0	5.1
	GHG/Revenue (lower = "better")		E	48.7		49.5	41.2		38.8	44.1	4.6
	Employee Turnover, % (lower = "better")		S		33.5	42.6		29.7	29.7	30.7	2.8
	Lost Time Incident Rate (lower = "better")		S	41.2		46.5	36.4		39.1	47.0	-5.7
	Women Employees % (higher = "better")		S		41.8	51.0		40.0	40.7	48.6	-6.8
	Employees Unionized % (higher = "better")		S	51.3		29.8	33.0		57.3	62.4	-11.0
									Source: MSCI, Bloomberg, Renaissance Capital

How do our scores compare with those of other providers? Not well. Our score has a 16% correlation with Robeco ESG scores, and a 12% correlation with Sustainalytics ESG scores.

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Figure 79: RenCap ESG score vs Robeco ESG score

RenCap ESG vs Robeco ESG

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80
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0	10	20	30	40	50	60	70	80	90	100

Source: Bloomberg, Robeco, Renaissance Capital

That said, this is perhaps not a real surprise. According to the Government Pension Investment Fund of Japan, two of the largest ESG rating and index providers, MSCI and FTSE, exhibit very low correlation between their scores:

Figure 80: FTSE ESG ranking vs MSCI ESG ranking, Japanese rated universe

Renaissance Capital

14 January 2019

ESG

Source: GPIF

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ESG appendix A

History of ESG

ESG in one form or another has been with us for at least 3,500 years. Jewish law saw that ownership brought with it not only rights but responsibilities as an owner. Later, the Koran established guidelines to prevent exploitative gains – or usury – and ruled out investment in alcohol, pork, gambling and gold. By the eighteenth century, Methodists and Quakers were rejecting the slave trade, as well as investment in liquor, tobacco and gambling.

The 1960s saw campaigners opposed to the Vietnam war putting pressure on university endowments to divest from investments in the defence sector. The 1980s saw companies exposed to apartheid South Africa come under pressure to exit, while ecological disasters such as Bho Pal, Chernobyl and Exxon Valdez triggered greater environmental awareness. By the nineties onwards, corporate scandals such as Polly Peck, BCCI International, Enron, Tyco, WorldCom, Satyam, Olympus and Tesco added greater focus on corporate governance. In the 2000s, the gig economy, data protection, the impact of globalisation (as well as the aftershocks of the global financial crisis) have been added to the mix.

The first public offering of a socially-screened investment fund was the Pioneer fund, launched in Boston in 1928, which avoided investments in alcohol, tobacco and gambling companies on religious criteria. Political developments during the sixties led to the first modern 'ethical' fund, the PAX fund, launched in 1971 to exclude investments related to the Vietnam War (including manufacturers of Agent Orange). The Dreyfus Third Century Fund opened a year later, in 1972, to invest in companies that “show evidence in the conduct of their business, relative to other companies in the same industry or industries, of contributing to the enhancement of the quality of life in America.” Still by 1985, it was estimated that only $55mn of AuM in the US were invested under SRI. In the UK, Charles Jacob, an investment manager for the Methodist Church, tried to launch the UK's first ethical unit trust in 1973, which he named 'Stewardship'. Regulatory approval was refused several times, but the fund was finally launched by Friends Provident in 1984. By 2000, all UK pension funds were required to disclose their policies on social, environmental and ethical investing, and from October 2019, trustees who choose to disregard ESG will have to explain why this does not jeopardise investment returns. EU law requires all companies with over 500 companies to report on their policies in relation to environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, as well as diversity on company boards (in terms of age, gender, educational and professional background). In the US, 85% of S&P 500 companies are now providing ESG disclosure, up from just 20% in 2011. Some of the world’s largest pools of capital, including the $1.5trn Government Pension Investment Fund of Japan, the $1trn Norway Government Pension Fund, the $490bn Dutch ABP and the $350bn California Public Employees Retirement System (CalPERS) are now invested within an ESG framework.

Globally, the 2004 publication of Who Cares Wins by the UN Global Compact acted as a springboard for ESG: in 2005, former UN Secretary General Kofi Annan, wrote to over 50 CEOs of major financial institutions to create an initiative, launched in 2006 as the UN Principles for Responsible Investment (UN PRI). PRI now has over 1,900 signatories representing $82trn of assets. Signatories undertake to incorporate ESG in to their investment processes, be active owners, seek ESG disclosure from companies in which they invest, promote ESG, boost the effectiveness of ESG and report on ESG principles.

More lately, there have been moves to institutionalise and form standards and best practices around ESG. GRI was set up in 1997 and pioneered sustainable reporting standards, claiming that of the 92% of the world’s largest corporates that report their sustainability performance, 74% use GRI standards. The International Integrated Reporting Council (IIRC) is a global coalition of regulators, investors, companies,

Renaissance Capital

14 January 2019

ESG

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Renaissance Capital

14 January 2019

ESG

standard setters, the accounting profession and NGOs setting standards for integrated reporting (a concise communication about how an organisation’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term). The SASB was set up in 2011 and maintains sustainability accounting standards for 79 industries in 10 sectors (on average there are five topics and 13 metrics per sector, based on the definition of ‘materiality’ outlined by US securities law).

Figure 81: SASB Summary Materiality Map

Dimension	General issue category
Environment	GHG emissions
	Air quality
	Energy management
	Water & wastewater management
	Waste & hazardous materials management
	Ecological impacts
Social capital	Human rights & community relations
	Customer privacy
	Data security
	Access & affordability
	Product quality & safety
	Customer welfare
	Selling practices & product labelling
Human capital	Labour practices
	Employee health & safety
	Employee engagement, diversity & inclusion
Business model & innovation	Product design & lifecycle management
	Business model resilience
	Supply chain management
	Materials sourcing & efficiency
	Physical impacts of climate change
Leadership & governance	Business ethics
	Competitive behaviour
	Management of the legal & regulatory environment
	Critical incident risk management
	Systemic risk management
	Issue unlikely to be material
	Issue likely to be material for < 50% of companies
	Issue likely to be material for >50% of companies

For the detailed map covering 79 industries click here

Consumer goods	Extractives & minerals processing	Financials	Food & beverage	Health care	Infrastructure	Renewable resources & alternative energy	Resource transformation	Services	Technology & communications	Transportation

Source: Sustainable Accounting Standards Board

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ESG appendix B – ESG providers

MSCI

▪MSCI ESG research was launched in 2010, via MSCI's acquisition of RiskMetrics, which included sustainability pioneers KLD, Innovest and IRRC.

▪MSCI has over 170 research analysts rating over 6,400 companies (11,800 total issuers including subsidiaries) and more than 400,000 fixed-income securities globally.

▪37 data points are assessed using thousands of data points, focused on the intersection between a company’s core business and the industry issues that can create significant financial risks and opportunities for the company.

▪Companies are rated on a AAA-CCC scale relative to the standards and performance of their industry peers.

▪MSCI ESG Research is used by 46 of the top 50 asset managers and over 1,200 investors worldwide and forms the basis of MSCI's 1,000 Equity and Fixed Income ESG indices.

Sustainalytics

▪Sustainalytics was formed in 2008 from the consolidation of DSR, Scores and AIS

▪Sustainalytics’ ESG Risk Ratings universe covers 9,000 public and private companies and will expand to over 10,000 companies in early 2019. Morningstar acquired a 40% stake in 2017.

▪ESG ratings are categorised across five risk levels: negligible, low, medium, high and severe. Ratings scale is from 0-100, with 100 being the most severe. Nearly 40 industry-specific indicators are designed to give investors a stronger signal into company performance.

ISS

▪ISS was founded in 1985 to provide informed proxy voting and governance advisory services.

▪In addition to ISS's governance service, February 2018 saw the launch of the Environmental & Social QualityScore, a new component of its analysis, initially covering 1,500 companies most exposed to ESG lists, with 3,500 additional companies. E&S QualityScore encompasses 380 environmental and social factors (of which at least 240 apply to each industry group).

▪Scoring ranges from 10 (highest) to 0 (lowest) for aggregate Environment and Social, as well as sub-issues.

Bloomberg

▪Bloomberg collects ESG data for almost 9,500 companies in 83 countries (and executive compensation data for 5,600 companies in 69 countries).

▪Integration into Bloomberg terminal provides ease of access, terminal also provides access to RobecoSAM rank, ISS QualityScore, Sustainalytics Rank and CDP climate score.

▪Scoring 1-100, with 900 ESG indicators in total, 15,000 subscribers

Renaissance Capital

14 January 2019

ESG

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Renaissance Capital

14 January 2019

ESG

Figure 82: Responsible and ethical investment spectrum

Source: Responsible Investment Association Australia

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ESG appendix C – Detailed country scores

RenCap’s ESG country scores consist of both absolute and sector adjusted scores. Below, we show both of these scores for each ESG category:

Figure 83: ESG scores by country

Renaissance Capital

14 January 2019

ESG

	Environmental			Social			Governance			Overall
	Absolute		Sector-relative	Absolute		Sector-relative	Absolute		Sector-relative	Overall
Netherlands	91%		89%	74%		71%	98%		98%	87%
Finland	48%		96%	88%		79%	95%		95%	84%
Israel	93%		46%	91%		91%	70%		70%	77%
UK	89%		91%	47%		50%	73%		75%	71%
Norway	52%		76%	97%		100%	45%		48%	70%
Sweden	100%		83%	38%		53%	61%		66%	67%
Korea	74%		54%	79%		94%	50%		45%	66%
Switzerland	72%		93%	29%		29%	84%		84%	65%
Australia	46%		63%	53%		44%	93%		91%	65%
Brazil	54%		72%	82%		74%	52%		52%	64%
South Africa	83%		59%	65%		65%	55%		57%	64%
Spain	65%		78%	85%		76%	36%		36%	63%
Singapore	87%		50%	41%		35%	80%		82%	62%
US	59%		74%	32%		38%	82%		80%	61%
Germany	67%		87%	59%		59%	41%		41%	59%
Italy	76%		80%	76%		47%	32%		34%	58%
France	78%		98%	56%		68%	23%		23%	57%
Denmark	85%		100%	18%		15%	66%		61%	57%
Belgium	80%		48%	71%		62%	20%		20%	50%
Canada	35%		57%	26%		21%	77%		77%	49%
Taiwan	43%		15%	94%		97%	18%		18%	48%
Ireland	57%		61%	0%		0%	75%		73%	44%
Greece	15%		7%	100%		82%	14%		14%	39%
Chile	28%		70%	6%		6%	57%		59%	38%
Malaysia	33%		13%	68%		88%	9%		9%	37%
Russia	20%		30%	62%		85%	11%		11%	37%
Turkey	61%		35%	21%		41%	30%		32%	36%
Mexico	41%		26%	9%		12%	59%		64%	35%
Japan	70%		67%	15%		32%	7%		7%	33%
Philippines	9%		0%	44%		24%	48%		55%	30%
Thailand	2%		22%	50%		56%	5%		2%	23%
Hong Kong	0%		39%	24%		18%	27%		27%	22%
Indonesia	13%		20%	12%		9%	39%		39%	22%
China	4%		24%	35%		26%	16%		16%	20%
India	17%		17%	3%		3%	25%		25%	15%
							Source: MSCI, Bloomberg, Renaissance Capital

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