Respect and responsibility: How ESG is impacting valuations
10 November 2022
In recent years we have seen societal change across global communities influencing corporate values and therefore informing Environmental, Social and Governance (ESG) policies. As a result, ESG has become increasingly important for investors and related stakeholders, as we collectively commit to worldwide environmental sustainability.
The way that all three elements of ‘ESG’ interact with each other is important and establishes a dependency and interrelationship that cannot be ignored by policy-makers when determining the guiding principles that will carry a company’s success, sustainability and viability into the future. Further, an associated ripple effect is forming throughout supply-chains across a growing number of industries.
The following diagram shows the average ESG score by region across the globe:
However, it remains challenging to observe, measure and report related implications of ESG.
It is difficult to accurately measure and monitor the effect of ESG on a company. A number of organisations claim to score or rate companies in respect of their ESG behaviour, but with inconsistencies regarding the relative importance placed on each ESG factor which cause vastly different scores/ratings for the same company across various agencies. Over time it’s expected that the ratings and approach will come together to display some level of correlation between agencies.
Is not yet dictated, transparent or aligned. There are no rules, guidelines or accounting standards in place to ensure accurate, consistent and transparent disclosure. Again, as the industry evolves it is expected that we will see enhancements and developments to enable users of financial information to observe better reporting of company’s sustainability efforts in the future.
Notwithstanding the above, disclosure against ESG is increasing across corporations, and it has rapidly emerged as a focal element for investors, boards, advisers and stakeholders. Additionally, companies are making more mention of ESG in public disclosures and other documents such as IPO Prospectuses, etc. thereby creating an inherent public profile related to positive ESG behaviour.
We observe that whilst the Australian Securities Exchange Ltd (ASX) does not have a policy or guidance specifically around ESG, it has addressed a few of the ESG matters in the 4th edition of the ASX Corporate Governance Principles and Recommendations. For example, the recommendation 7.4, recommends listed entities to disclose any material exposure to environmental or social risks and how the entity manages or intends to manage those risks.
It goes to follow that at present ESG mainly impacts the intangible value of a company, such as:
Brand reinforcement and enhancement;
Human capital capture and retention and improved productivity, via a more compelling Employee Value Proposition; and
Customer attraction to the company’s goods and services. A study by Simon-Kucher & Partners found that globally, 85% of people indicate that they have shifted their purchase behaviour towards being more sustainable in the past five years. Additionally, on average, more than a one third (34%) of the population is willing to pay more for sustainable products or services, and those willing to pay more would accept a 25% premium on average.
Whilst the quantitative impacts are not easily isolated, studies linked favourable ESG ratings and financial outperformance.
In the future it is possible that ESG linked outperformance represents a market inefficiency that may erode, as eventually all companies will respond to the requirement for a robust ESG program. However, it is emerging as vitally important for companies to:
Fully understand the ESG issues relevant to their business operations and establish corresponding corporate values at the Board level;
Continually invest in ESG initiatives relating to their business operations and industry; and
Ensure accurate and transparent disclosure of relevant, material ESG matters.
ESG and Valuations
We note that outside Australia, The International Valuation Standards (IVS) have always implicitly required the consideration of ESG components within valuation, but no explicit standards exist.
Over the past few years, the explicit quantification of the components of ESG within the valuation process (including business valuation, financial instruments and tangible assets) has gained even greater prominence across all markets. This is in part due to renewed global commitments to environmental sustainability and net zero, the growing influence of intangibles on valuations, and greater investor regulatory and public scrutiny of ESG components within the valuation process.
Within the Australian market there is no specific guidance as to the inclusion of ESG into valuations, nor the most appropriate approach to do so. For example, can it be assumed that a company’s revenue or margins will be impacted by their ESG actions in the future, or is the impact of ESG better incorporated into the earnings multiple or discount rate?
Further, most, if not all Australian transactions now incorporate (in some shape or form) potential ESG impacts and build ESG considerations into M&A decision making. It therefore leads to the contemplation as to how ESG is incorporated into company valuations, and to the degree to which ESG factors are being considered within the valuation process.
We consider the potential impact of company ESG polices on the key elements of Valuation below:
Key valuation element
Investments today are assumed to eventuate in enhanced cash flows in the future i.e. a company may be able to increase prices or drive greater volumes or cost efficiencies from reduction in waste and lower energy consumption.
Companies with ESG policies and behaviours aligned to societal values will be assumed to be more attractive to investors, leading to likely reduction in their cost of capital (and associated increase in company value) and potential de-risking of specific company risk premiums in the future. These companies can access lower interest rates on loan and credit default swap spreads and higher credit ratings.
A correlation of company values with communities, investors and stakeholders is expected to result in favourable long-term growth rates. Additionally, the government will support sustainable businesses by providing subsidies or reducing regulatory requirements.
Whilst the approach and methodologies adopted to perform a valuation will not change, the availability of more consistent ratings and enhanced reporting will enable access to better information and therefore impact the inputs into valuations. We expect this to evolve over time, however, will enable more in-depth questions, research and analysis to be undertaken by valuation practitioners. We cannot be immune to the worldwide shift for society and corporates to take tangible actions for a sustainable and ethically responsible future - and how the impact of this flows into components and assumptions underlying valuations.
Furthermore, we can apply the basic economic concept of supply and demand to ESG. All else equal, a company with a strong ESG proposition will be in greater demand to investors, as compared to its peers. The higher demand will lead to higher prices and valuations. The greater demand for companies with a strong ESG proposition is driven by some investors seeking socially responsible companies, while no investors would be discouraged to invest in a company because they have a stronger ESG proposition. Thus, overall demand for a socially responsible company will be higher, leading to higher pricing and valuations.
A rise in sustainable funds
A new structural trend has emerged via ‘ESG investing’, and a rise in ESG-themed funds is among the industry’s fastest-growing trends.
Whilst ESG investments have existed for many years, in recent times the growth has been rapid both in Australia and internationally. The Australian bushfires in late 2019 put ESG investing in the limelight, as the effects of climate change came to the forefront globally. This growth was accelerated by the onset of the coronavirus pandemic in 2020, a pattern that continued into 2021. According to Morningstar’s Sustainable Investing Landscape for Australian Fund Investors report for Q2 2021, assets in Australian Sustainable Investments were AUD 33.42 billion on 30 June 2021, a 66% increase from a year earlier. Asset managers have seen this trend and launched ESG funds, thereby attempting to offer a compelling investment option to market participants.
Morningstar Direct data shows that there are 33 Australian-domiciled large-cap global equity funds with unique investment strategies classified as sustainable investment funds. Only 19 of the 33 funds have a three-year history, while only 14 of the 33 funds have a five-year history (as of 31 August 2021), therefore demonstrating how recent the growth in ESG funds is.
But, do these sustainable funds deliver superior performance? Morningstar’s empirical evidence showed that none of the 14 ESG global equity funds available to Australian investors five years ago has been able to deliver a higher return with lower risk than the broad market index (MSCI World ex-Australia). Results improved when analysing the same risk/reward analysis over a shorter three-year period, with seven of the 14 funds achieving higher returns with lower risk than the MSCI Index, and six funds with higher returns and higher risk (the remainder delivering lower returns).
The rapid growth of ESG investment options in recent years has made it challenging for fund selectors and investors who wish to build ESG portfolios. The breadth of different approaches undertaken by funds, combined with differing methodologies for defining ESG, can make it very difficult to ascertain which funds are delivering a valid ESG proposition for investment.
It appears that it’s still early days for ESG investing, as more money is allocated to the sector and differing investment approaches become available as the sector continues to evolve and mature. To date, the evidence is inconclusive that global equity ESG funds can improve returns or reduce risk (on average) - but similarly, there is no evidence to suggest that ESG funds make these features worse.
There is no doubt that social values and favourable sentiment for ESG across the globe is boldly shaping corporate policies, capital allocation and initiatives. For decades, companies have aimed to understand consumers in an attempt to tempt and promote their goods and services. We are now in a unique position where society ‘wants’ are being clearly enunciated.
For now, it remains to be seen how this will eventually flow into value creation, however it seems apparent that those companies ignoring the trend will be left behind and fail to survive. A focus on respect and responsibility is informing and prioritising factors of importance for all stakeholders. Sustainability for business encompasses all three elements of ESG and with increasing ESG disclosures and convergence of ESG ratings systems, ESG comparability across companies will be easier and more informative.
We are observing a pivotal trend around global community values, environmental initiatives, social norms and governing authority. We expect the outcome for companies that understand and capitalise on these factors – whilst also balancing sound business practice and economics - to have a sustainable presence, a positive experience for all and thereby ensure relevance in tomorrow’s world. If you would like to learn more about our Sustainability Strategy, please visit the website.