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MSCI ESG research reveals companies with higher ESG ratings tend to show improved performance

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A new report from MSCI entitled Foundations of ESG Investing : How ESG Affects Equity Valuation, Risk and Performance, authored by Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltan Nagy and Laura Nishikawa seeks to understand how environmental, social and governance (ESG) characteristics have led to financially significant effects.

The authors write that many researchers have studied the relationship between companies with strong ESG characteristics and corporate financial performance.
“A major challenge has been to show that positive correlations — when produced — provide explanations for the behaviour. As the classic phrase used by statisticians says, ‘correlation does not imply causation.’

“Instead of conducting a pure correlation-based analysis, we focus on understanding how ESG characteristics have led to financially significant effects. This way, we avoid the risk of data-mining and we can differentiate between correlation and causality.”

For the report, the team examined how ESG information embedded within companies is transmitted to the equity market.

“Borrowing the language of central banks describing how monetary policy can affect asset prices and economic conditions, we created three “transmission channels” within a standard discounted cash flow (DCF) model. We call these the cash-flow channel, the idiosyncratic risk channel and the valuation channel. The former two channels are transmitted through corporations’ idiosyncratic risk profiles, whereas the latter channel is linked to companies’ systematic risk profiles.

These three transmission channels are based on the following rationales:

• Cash-flow channel: High ESG-rated companies are more competitive and can generate abnormal returns, leading to higher profitability and dividend payments.
• Idiosyncratic risk channel: High ESG-rated companies are better at managing company-specific business and operational risks and therefore have a lower probability of suffering incidents that can impact their share price. Consequently, their stock prices display lower idiosyncratic tail risks.
• Valuation channel: High ESG-rated companies tend to have lower exposure to systematic risk factors. Therefore, their expected cost of capital is lower, leading to higher valuations in a DCF model framework.”

The authors tested each of these transmission channels using MSCI ESG Ratings data and financial variables. For the two idiosyncratic transmission channels, high ESG-rated companies tended to show higher profitability, higher dividend yield and lower idiosyncratic tail risks.

“We also found that high ESG-rated companies tended to show less systematic volatility, lower values for beta and higher valuations, which verifies the valuation channel.

“Finally, we provide empirical evidence for a causal relationship between ESG and financial performance by looking at the extent to which changes in ESG ratings predicted changes in financial variables. We found that the ESG rating change may be a useful financial indicator in its own right, which we call ESG momentum.”

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