An increasing number of asset managers globally are incorporating Environmental, Social, and Governance (ESG) factors in their investment strategies. Even as more and more investors embrace “responsible investing,” they are still looking to generate alpha. As a result, we’re seeing a growing number of tools that allow us to evaluate ESG portfolios. In this article, we set out to discover whether there is a correlation between ESG scores and company performance in the Asia Pacific region.
To explore the impact of ESG scores on companies’ performance across APAC, we leveraged MSCI’s key scores and factors. We limited the universe of companies in our analysis to the current constituents of MSCI All Countries Asia Pacific index, using return on equity (ROE) to measure each company’s performance in order to capture the return to the company’s shareholders.
We back-tested each of MSCI’s 10 ESG themes across Environmental, Social, and Governance pillars over the last seven years to evaluate whether a high ESG score is correlated with better performance. The companies in the universe were grouped into their respective sectors according to the GICS classification. This allowed us to identify which ESG factor is the most integral determinant of the sector performance.
MSCI ESG THEMES
Climate Change (E)
Corporate Behavior (G)
Corporate Governance (G)
Environmental Opportunities (E)
Human Capital (S)
Natural Capital (E)
Pollution & Waste (E)
Product Liability (S)
Social Opportunities (S)
Stakeholder Opposition (S)
The correlation between each ESG theme and the (subsequent) ROE of the company is represented by Spearman’s information coefficient (IC). This statistic measures the correlation coefficient between the factor rank and the return rank for all companies in the universe for a specific period. A high positive IC means that companies with high factor values yield high returns while a negative IC indicates that high factor values tend to yield low returns.
From the chart above, we can see that the top positive correlation comes from corporate behavior and its impacts on the consumer staples sector, with an IC score of 0.52. This means that an increase in the corporate behavior score can lead to a return increase of more than 50% for consumer staples constituents. Corporate behavior encompasses various governance key issues, which include business ethics and fraud, anticompetitive practices, corruption and instability, financial system instability, and tax transparency.
With many large conglomerates operating within the consumer staples sector such as AEON in Japan and Woolworths in Australia, the need to ensure a high standard of corporate behavior becomes highly important and carries a heavier weight. Any exposure to practices that hinder competition, such as monopoly or oligopoly pricing, will result in a lower corporate behavior score. However, the severity is judged based on whether the exposure is caused by a structural or nonstructural issue; the former would be something that has been recognized as a prevailing management practice while the latter is likely to be a one-off incident.
The profitability of the communication services sector seems to be highly correlated with the human capital score, demonstrated by an IC score of 0.31, the second highest IC score in our universe. According to MSCI, human capital includes key social issues such as human capital development, labor management, supply chain labor standards, and health and safety. Human capital development looks at the strategy and initiatives instituted by management to develop employees’ skills and increase their motivation and engagement. These initiatives can be in the form of specific on-the-job continuous training, work/life balance policies, Employee Stock Ownership Plan (ESOP), etc. The companies’ effectiveness in implementing these strategies is measured by a number of key indicators: employee turnover rate, employee productivity ($ profit per employee), external recognition as employer of choice, and percentage of female executive team members. The human capital score is assigned based on the companies’ performance on these key indicators.
Our analysis shows that higher scores for product liability boosted the ROE of utilities companies by 27%. Product liability considers the quality of the products produced by the companies. Scores are based on the exposure companies have to products that may harm public health and safety. Utility companies, which include electric and power companies, have immense responsibilities. Not only do they have to provide power to the entire country, they must properly ensure the safety of their workers as well the general public in the vicinity of their plants. Hence, the product liability score is crucial in determining the performance and continuance of the utilities sector. Other companies that face threats of product recalls because their products could jeopardize the public safety will also score low on this criterion, which may translate to lower profitability.
Now we move to the least influential ESG factors for companies in APAC, indicated by negative IC scores. These low IC scores tell us that a high score in the above ESG factors indicates an inefficiency in resource allocation for the companies within the corresponding sectors. For example, the environmental opportunities theme includes activities such as building and marketing opportunities for clean technology and supporting renewable power production. These activities are crucial for companies within the materials, industrials, and energy sectors, yet less relevant for those companies within the communication services, which should perhaps put more focus on improving its human capital, according to the chart above.
With an IC score of -0.63, the environmental opportunities theme is the least influential factor for communication services. A high environmental opportunities score has the potential to adversely impact the ROE of communication services companies. The next lowest IC score was for the social opportunities factor and its correlation with consumer discretionary with an information coefficient score of -0.54.
The third lowest IC score (-0.49) comes from the relationship between the stakeholder opposition theme and the consumer discretionary sector. The key issue under stakeholder opposition is controversial sourcing, which looks at the percentage of products made with raw materials that potentially come from regions of conflicts, e.g., tin, gold, and diamonds.
So, what does this mean for APAC investors? Our analysis shows that that high scores across certain ESG criteria are highly correlated with better performance in specific industries. For example, it is not surprising that a good corporate behavior rating correlates with strong performance in the consumer staples sector. However, the corporate behavior score has an inverse relationship with the performance of the utilities sector; companies within this sector that score high in corporate behavior are deemed inefficient in their resource allocation. This methodology gives us one set of tools that investors can use to define and implement an ESG strategy. One could easily extend this analysis to compare results across regions or within countries to identify market differences.
Jane Jian and Hiroyuki Takao also contributed to this article.