In recent years, the role of sustainable actions with low environmental impact has become crucial in financial markets, especially if we focus on the European market.
Recent findings provide evidence that highly rated companies in terms of environmental, social and governance scores report higher returns and lower volatility, which is supported by the assumption that environmental, social and governance (ESG) factors are considered, by market agents, as a good indicator of financial strength of companies.
According to Eurosif (2020), Sustainable and Responsible Investing (SRI) is an approach that combines fundamental analysis with the assessment of ESG factors in the process of researching, analyzing and selecting securities within an investment portfolio to better capture long-term returns for investors and benefit society by influencing the behavior of companies.
exist fundamental underlying factors that justify its attractiveness. For most companies, a growing demand for sustainable products can represent a business opportunity or a forced path and they have to face higher costs and manage a new range of risks, which, at this stage, are mainly driven by environment.
One thing to keep in mind is that sustainable consumption is catching on in western economies. Sustainable products grow 560% faster than conventional products and they represent more than half of the total growth of the market.
We can all remember the e2014 Volkswagen emissions scandal, which caused the carmaker’s share price to drop by 18% in one session (although the drop lasted 32% during the day). It took about two years to recover the previous levels, it is a solid example of how environmental regulations can affect the financial profitability of a company, through compliance with its environment and reputational risk.
What is required of an SRI company?
The ISR company must maintain a firm commitment to the local, national and global community in which it operates the company. It also encompasses the relationships between the community itself and the company, its attention to public welfare and its commitment to reducing the impact on the environment in terms of corporate infrastructure.
You must participate and respect human rights and the integrity of work Through, for example, respect for the worker, support for freedom of association and the exclusion of child or forced labor.
In relation to products or services sold, the social and environmental impact, including their design, management and development. It also reflects the contribution to the search for new sustainable technologies and the offer of socially useful goods or services that improve the general well-being of consumers. These aspects also extend to the correctness of sales practices and the safety and quality of the products.
In the workplace, the ability to establish strong working relationships with employees through matching their compensation and benefits. The latter are intended to improve the working environment in the medium to long term and improve worker morale. There must be compliance with non-discriminatory policies and practices towards employees and the creation of an environment that is respectful and open to diversity.
In terms of health and safety, the efficiency of the company is sought when it comes to provide a healthy and safe workplace. It includes the quality of work policies and programs that promote the personal development of workers, even outside the company.
The returns of SRI companies
But let’s talk about returns. First of all, it’s fair to mention existing limitations on the ability to perform a retrospective test of the hypothesis of the returns you contributed by this type of companies. The reason behind this problem is how to rate a company on its I, S and R characteristics. There are external rating agencies that offer us a scale of scores, although this is not without problems in offering measurements.
First, methodology can be opaque and subjective and different vendors often produce scale of hot spots. An EV producer like Tesla is an example that is often cited: One rating agency rates it high on its green credentials and poorly rated by another based on the agency’s assessment of its governance.
Second, the data coverage of companies is not always complete and is particularly incomplete for smaller companies and in emerging markets where transparency is under development.
Third and last, the further we go back in time, the more likely it is that scoring data will not adequately capture real-time ISR challenges. The data may not have been available or was not disclosed at the time, and more importantly, the data that is actually relevant to the price of the assets has likely changed over time.
Having said this, the manager RSC Global Asset Management offers us an interesting analysis based on the compilation of different studies on the profitability of ESG companies.
Several other studies have shown that the MSCI KLD 400 social index – launched in May 1990 is the first socially responsible investment index – outperformed the S&P 500 index (US stock exchange).
Specifically, the 2015 Morgan Stanley study found that the MSCI KLD 400 social index achieved an annualized return of 10.14% compared to 9.69% for the S&P 500 index from July 1990 to December 2014.
A difference of half a point may seem laughable. But if we look at the long term, a accumulated excess profitability of 102.36% between 1990 and 2014.
The Bank of America Merrill Lynch study of 201832 (using data from Thomson Reuters and MSCI) analyzed the SRI scores of 17 companies in the S&P 500 index that have failed since 2005. The study found that these companies showed a significant deterioration in your ISR scores during the previous five years bankrupt. The investigation showed that if an investor had only held stocks with above-average ISR ratings during the study period, they would have avoided 15 of the 17 bankruptcies.
Glossner published a study in 2018 that looked at the returns on stocks of “controversial” companies, far from SRI benchmarks. It found that a portfolio of controversial U.S. companies had significant abnormal negative returns and alpha between -3.5% and -3.7% per year. The same exercise was carried out with a portfolio of controversial companies in Europe and the results were similar: significant abnormal negative returns and alpha between -2% and -2.9% per year.
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