3.
1 ESG: Analysis and Valuation
[Introduction]
In this concept, we will look at how the ESG fundamentals can be integrated into both investment analysis
and valuation. We will also consider the commercial applications available to investors from vendors such
as MSCI. We will conclude and review by investigating the positive decision-making impact ESG has on
investment analysis and decision-making.
Before we begin, let’s refresh our understanding of the traditional investment decision-making process.
Asset managers allocate capital on behalf of clients to meet their risk return objectives (i.e. the investment
decision). Using the utilities sector as an example, the decision-making process will typically follow three
steps:
1. Research and analysis: Researching, collating and assessing data obtained from a company's
financial reports, government strategy, and regulatory reports to calculate financial ratios and cash
flow projections
2. Investment valuation: Using information from the analysis stage allows us to predict the future
performance of a company's cash flow and any risks likely to occur
3. Investment decision-making: Based on the valuation stage, we would now allocate capital to
maximize return to match the given risk tolerances of clients
As we shall see, integrating ESG into this process does not require a fundamentally new approach. Rather
each stage is complemented by considering ESG factors.
[Integrating ESG into Investment Research]
Material ESG data
We noted in the introduction that the research stage requires the creation of "useful" information for
further analysis. By useful we mean, "material" an auditing term which ensures we only look at information
likely to have a significant effect, with a high probability of occurrence, on key metrics, in this case, risks
and returns.
Using our earlier utilities sector example, we will now extend our research to incorporate an assessment of
the environmental, social, governance factors and the impact it can have on a utility business. Click on the
flashcards to learn more about each factor.
Each of these factors can impact the returns and risk of a utility business. This is just a sample of the wide
range of ESG issues and opportunities that face any sector. The challenge is creating a successful structure
that supports the effective analysis of available data, so that we can focus on the material factors relevant
to analysis and valuation.
[ESG Research]
Nature and sources of data
First, let's look at the nature of the data. This can be split into qualitative and quantitative ESG research.
- Qualitative ESG research: This involves gathering non-numerical data to gain an understanding of a
company's aspirations, strategy, management style and risk culture. Typical sources of such information
include the financial statements and, in the case of our utility company, a review of its risk management
policies.
- Quantitative ESG research: This involves gathering numerical information to gain an understanding of
relative or absolute metrics. Typical sources again include company financial statements and in the case
of our utility company, measurement of carbon emissions, waste and effluent volumes.
Next we can explore the sources of data, primary and secondary ESG research:
- Primary ESG research: Self-conducted research undertaken in-house or commissioned. For example,
surveys on the diversity of management boards or investment proposals for a new technology.
- Secondary ESG research: Use of existing published reports and ratings. For example, MSCI ESG ratings
for companies and sectors.
ESG ratings agencies
Most asset managers, even the largest, do not have sufficient internal resources to conduct their own
primary research and will instead, rely on third parties to provide market data, for example:
ESG ratings agencies Services provided
Sustainalytics Company ESG ratings, ESG data, Carbon analytics
MSCI Company ESG ratings, ESG indices
Carbon scope data, e-disclosures, environmental
CDP
management assessment
SASB Sustainability standards, materiality maps
Most ESG agencies provide a broad range of information, some focus on a specific area (CDP) and others,
like the Sustainability Accounting Standards Board (SASB), provide frameworks and guidance on best
practice for disclosure and analysis.
In the following section we will consider the approaches taken by two leading ESG agencies providing
information, metrics and analysis for asset managers and business owners.
Credit rating agencies (CRAs)
CRAs such as Fitch Ratings, S&P and Moody’s do not provide ESG ratings scores. They do, however, consider
ESG factors when making their credit rating decisions. Indeed, they have always done this, because
governance in particular, has a significant impact on the estimation of the probability of cashflows being
paid by the issuer and therefore their credit rating.
Fitch Ratings provide ESG Relevance Scores, indicating how ESG factors impact credit rating decisions.
• 1 means ESG factors have no impact on the rating
• 5 means ESG factors are highly relevant
[Sustainalytics]
Sustainalytics are a leading ESG agency providing amongst other resources, ESG risk rating metrics. These
metrics are designed to measure the degree to which ESG factors may impact a company's economic
value.
Three dimensions of risk rating
1. Total risk: How much ESG risk is the business exposed to before any mitigation?
2. Manageable risk: What ESG risks and to what extent can management mitigate ESG risks?
Within this, management gap is the manageable risks that are not managed, which may be either:
• Deliberate: reflecting costs and resources
• Passive: management have simply not considered the risks
3. Unmanageable risk: ESG risks which are beyond management’s control, for example aspects of climate
change.
Companies with good risk management policies and corporate governance structures will have lower
unmanaged risks than their peers.
We should note that Sustainalytics' risk scores are absolute and are not normalized for each industry sector,
therefore an IT company may have a similar risk score to that of a company operating in the financial
sector.
[MSCI]
Risk and opportunity
MSCI are employed by both asset owners and managers when creating index funds and benchmarking their
services, and more recently their ESG resources. MSCI provides ESG scores for individual companies by
assessing ESG risks and opportunities arising from both large scale trends, as well as factors specific to the
nature of the company’s operations.
Shell
Let’s consider Shell, a company operating in the oil sector. All companies in the sector are impacted by ESG
factors. Some are particularly important for this sector, for example, carbon emissions. MSCI considers
these factors and looks at how they affect the individual business. We see to the left that the MSCI ESG
score for Shell reflects that it is a leader in corporate governance and toxic waste management. The result
is an overall weighted score of A, which is average relative to peers in the oil and gas sector. The
Sustainalytics absolute ESG score for Shell is 75/100, reflecting the high environmental and social risks
associated with the sector.
Risk
A risk is material when it is likely that companies in a given industry will incur substantial costs in
connection with it.
For example, regulation leading to curtailment of activities. Social media companies benefit from the use of
their platforms, but the social consequences of data recording and use has already led to legislation
modifying their use of data and engagement protocols.
Opportunity
An opportunity is material to an industry when it is likely that companies could capitalize on it for profit.
For example, demand for battery technology is increasing as eCar production increases. Tesla has taken
advantage of its battery manufacturing capabilities by servicing a range of clients beyond the automotive
industry.
MSCI
MSCI assesses material risks and opportunities for each industry through a quantitative model derived from
assessing companies using the following framework:
To create the score for industries and companies, "key issues" are assigned relevant to exposure. Carbon
footprint will be important for utilities but not for IT companies.
Final MSCI ESG ratings are then derived by the weighted averages of the key issue scores. These scores are
aggregated, and companies’ scores are normalized by their industries.
Each company’s final industry-adjusted score corresponds to a rating between best (AAA) and worst (CCC).
These assessments are not absolute but are intended to be relative to the standards and performance of a
company’s industry peers.
Given that MSCI’s definition of materiality is based on judgment and that their approach to scoring is
normalized, Sustainalytics and MSCI will generate different scores for the same company, causing
challenges with comparability for asset managers. Using guidance from the Sustainability Accounting
Standards Board (SASB), let's investigate the challenges of conducting a materiality assessment.
[Materiality Assessment and Risk Mapping]
Critical ESG factors
Given the vast range of data available, it is important that our materiality assessment focuses solely on
critical ESG factors. It should be noted that ESG factors that are material to one industry sector, e.g. water
usage to a utility company, will be immaterial to another, e.g. a financial services company.
Determining materiality is not an exact science and there is no agreed standard, so investment
professionals need to make their judgment on what they feel to be material. Ultimately, investment
professionals must develop their own views on what is most material.
Frameworks such as materiality maps provided by the SASB, offer guidance on the creation and
development of bespoke approaches relevant to individual asset managers.
Materiality map of high level sectors
- High level sectors: The SASB materiality map categorizes the general issues affecting each industry
sector.
- Grading: SASB assign a grade that reflects the importance of each issue and the significance of its
impact.
- Specific industries: The grading structure is also used to highlight issues of significant materiality to a
particular industry, e.g. greenhouse gas emissions will be considered immaterial to the financial
services sector but will be material to the extraction and mineral processing sector.\
- Contrasts: Product quality will also vary in its materiality between industry. For example, the product
quality will be material to the food and beverage sector but immaterial to the extraction and minerals
processing sector.
[ESG Scorecards and Screens]
ESG Scorecards
Faced with a wide range of qualitative and quantitative data, an analysis now needs to sort and assess the
relative ESG credentials of potential investments. This is achieved using ESG scorecards, available from ESG
agencies.
The process for developing a scorecard is outlined in the diagram shown here. We note that the key
determinant is a decision on what factors to measure, again the output from the materiality assessment.
Let’s look at an example from Verbund AG in the utilities sector.
• ESG factors material to sector: Ecological impacts
• Indicators to material ESG factors: Surveys or reports from CDP
• Scoring: 0 equals high exposure to ESG factors; 5 equals low exposure
• Assess company: Verbund AG based on third party research is scored at 4
• Aggregate all scores for Verbund AG
• Compare these scores against relative benchmark for the utilities sector or absolute benchmark for
investment universe
Based on this high score, a fund with the objective of investing in companies with good ESG performance,
may then include Verbund AG in the selection of stocks for further analysis.
ESG screens
Provided with quantitative data and ESG scores, the investment analysts can now identify which companies
merit further research, using a screen to filter out stocks which do not match the investor's ESG criteria.
Click on the tabs to learn more.
- Negative ESG screens: The first ESG screens were negative, excluding "sin stocks" which derived their
profits from gambling, weapons or tobacco. Negative screens can now be used to exclude ESG
"laggards".
- Positive ESG screens: Positive ESG screens are used to identify stocks which are leaders in their sector.
[Integrating ESG into Valuation Models]
Valuation models
Armed with the results of our ESG research, we can now extend our analysis by assessing the impact our
research has on the valuation of selected stocks.
Most asset managers employ a fundamental valuation model, which calculates the present value of future
cash flows using the discount model. The valuation can be considered alongside other techniques such as
the relative valuation model.
The value of the business is assessed by multiplying a key valuation driver, such as earnings per share
(EPS), by a relevant multiplier, in this case Price/Earning (P/E) ratio.
Financial analysis
Our formula to determine the value of a company we are assessing is as follows:
Target P/E ratio times Company EPS equals Target company value
For example, Company ‘Good E’ with an EPS of 1.5 US dollars, is judged to have a high ESG rating. Analysts
believe this justifies a higher relative valuation to its peers. If the industry average P/E ratio is 10, we may
add a premium of 2 to assess the target value of Good E. Using our formula, we get the following:
(10 plus 2) times 1.5 US dollars equals 18 US dollars equals Target value of Good E
If in fact Good E is trading at less than 18 US dollars, the manager will have an incentive to buy and hold
until this target price is met.
ESG factors that affect either future cash flows or the discount rate will impact the business valuation. In
the case of the relative valuation model, a company with a comparative ESG advantage may attract a higher
multiple.
Example: Volkswagen and BMW
Let us consider Volkswagen (VW) and BMW, two companies operating in the automobile sector. If we
review the MSCI ratings for these stocks, we note that BMW is more highly rated than VW. Recall that MSCI
ratings are normalized for the industry, so we are comparing relative scores. Click the arrows to scroll
between the two images.
All other things being equal, we may believe that BMW should warrant a higher relative valuation than VW,
as investors will be attracted to a company with a superior ESG rating. This higher relative valuation may be
because investors think the company will have lower relative risk and/or better opportunities.
P/E as a metric
We can now turn our attention to the price to earnings ratio (P/E ratio) as a metric for the relative
valuations of these two companies. The P/E ratio tells us how much investors are willing to pay for each
USD1 of earnings a company generates.
- If company ABC has a P/E of 10, this means investors are willing to pay USD10 for each USD1 of
earnings generated by ABC
- If company XYZ, in the same business sector as ABC, has a higher P/E of say 15, then all other things
being equal, this implies that the market values XYZ more highly than ABC
This may be because the market thinks XYZ has lower risk and/or better opportunities for growth in the
future as indicated by the higher ESG score.
We noted that the MSCI score for BMW was higher than that for VW so what about the P/E ratios? Click the
arrows to scroll between the two images.
In the tables above we note that BMW does indeed have a higher P/E score (15.86) compared to VW
(12.51).
Is this a result of the higher ESG score? Possibly. It is evidence of a positive correlation between ESG scores
and relative valuation in this single example, but it is not evidence of causation. There will be many other
factors investors will consider when valuing BMW relative to VW.
Nevertheless, research has shown that companies with good ESG scores do have lower volatility of
earnings, in other words less risk, than companies with poor ESG scores. Everything else being the same,
then investors will value the lower risk business more highly than a similar, but higher risk business.
[Challenges to ESG Research and Analysis]
Disclosure, data-related challenges & comparability difficulties
There are currently few compulsory requirements for corporates to disclose ESG data in their report and
accounts. However, there are frameworks in most developed countries and standards of best practice
supported by organizations such as SASB. The consequences are as follows:
• Management has flexibility in what it chooses to report
• There may be a problem of over-disclosure ("greenwashing" where companies paint a picture of
good ESG policies)
• Lack of disclosure, which could be an indicator of poor ESG management
• Even when revealed, ESG disclosure might be unaudited, incomplete or not comparable
For example, carbon pollution can be measured by: Amount of fuel purchased, electricity usage and carbon
emissions. Many companies will provide data on the first two not the third, which is estimated to account
for more than 50 percent of the world’s carbon pollution impact.
Comparability difficulties: Although there are more than 20 ESG ratings agencies all producing scores and
data on very similar ESG factors, they will use their own techniques and assessments to do so. For example,
Sustainalytics provide absolute risk numbers, whereas MSCI offer ratings normalized for each industry. As a
result, it is often difficult to make accurate comparisons as illustrated in the research by Schroders.
Even if the data is comparable, judgments on ESG materiality may differ between analysts, differences
which can be magnified with cultural or regional biases. Finally, where materiality can be judged, it can be
hard to assess the level of impact.
ESG data analysis challenges
As we have previously established, ESG research and analysis is a subjective process, based upon opinions.
Where an asset manager is attempting to integrate ESG across both the firm and asset classes, many of the
following challenges will arise:
• Many quantitative ESG factors are not concrete: Scoring and materiality is subjective
• ESG factors are difficult to integrate globally across large firms: Assessment of ESG factors is
impacted by culture and experience
• ESG integration is different across asset classes: Equity is significantly impacted by E and S factors,
while fixed income analysts often only consider G factors as material
• Materiality is subjective and different investors weight materiality differently
The resulting consequence is a lack of comparability or differences of opinion, even within asset
management firms.
The challenges associated with research and analysis are being addressed by a move by organizations such
as the PRI and SASB to provide an overarching framework, whilst the regulators move to standardize ESG
disclosure requirements. It is hoped that these measures will help to address the issues around
comparability and subjectivity, which impact on the successful integration of ESG within the investment
industry.
[recap]
Integrating ESG does not require a new investment process. Instead, it requires the analyst to consider
material ESG factors alongside traditional financial factors within the research, analysis and valuation stages
to improve investment decision making.
The range and scope of ESG factors is very broad and analysts draw on materiality mapping frameworks
from organizations, such as the SASB, and ESG ratings from agencies, including MSCI and Sustainalytics, to
facilitate their analysis. However, challenges associated with the management and assessment of ESG data
remain, creating issues with comparability and inconsistent disclosures from corporates.
These challenges will be resolved as the investment profession moves towards consolidated reporting
frameworks similar to those now widely adopted within traditional corporate financial reporting.
