- While governance showed more financial significance in the short term, environmental and social issues’ contributions to stock-price performance unfolded largely over our full 13-year study period.
- As opposed to “event” risks that were more immediately priced in by investors, some issues, such as carbon emissions, presented a risk of “erosion” to competitiveness over time and degraded financial performance over a longer time horizon.
- Over the 13-year span of our study, an overall ESG score that aggregated industry-specific weighting of all three E, S and G pillars showed better long-term results than any of the individual pillar indicators.
Focusing on the long term has become a mantra of many institutional investors who have adopted environmental, social and governance (ESG) investment principles over the past decade. But does ESG really address companies’ long-term risks and performance? Our research indicates that some ESG issues are more long-term than others.
Our analysis in “Deconstructing ESG Ratings Performance” explores the relative impact of E, S and G issues on companies’ financial fundamentals and stock-price performance between December 2006 and December 2019. We found that, while governance consistently showed more significance than the other issues on financial fundamentals at a given point in time, environmental and social issues’ contribution to stock-price performance unfolded largely over the full 13-year study period.
What accounts for the difference? Our analysis suggests that markets may have more quickly priced in ESG event risks that materialized over a shorter time horizon. Where governance has been composed of more issues directly associated with these risks, a more limited set of environmental and social issues has often more actively been associated with such events. Some issues, such as carbon emissions, could instead have represented a risk of “erosion” to competitiveness over time and degraded financial performance over a longer time horizon.
We extended previous research on how the overall MSCI ESG Rating has impacted financial risk and returns through three economic-transmission channels: the cash-flow channel, whereby companies better at managing intangible capital such as employees may have been more competitive and hence more profitable over time; idiosyncratic risk, whereby companies with stronger risk management practices may have experienced fewer incidents that triggered unanticipated costs, such as accidents; and systematic risk, whereby companies that used resources more efficiently may have been less susceptible to market shocks such as energy-price fluctuations.
We examined how each of the three economic-transmission channels performed across the aggregate MSCI ESG scores that underly the ESG Rating, as well as its constituent components — the individual E, S and G pillar scores — by comparing the top- and bottom-scoring quintiles (Q5 and Q1, in z-score format) against the financial variables associated with each economic-transmission channel (see exhibit below).1
Active-Exposure Analysis of MSCI ESG Scores, Including Pillar Breakdown
Data from December 2006 to December 2019 for MSCI World Index. Source: MSCI ESG Research LLC
Consistent with our previous research, the highest-rated quintile on the aggregate MSCI ESG score showed higher levels of profitability, lower levels of idiosyncratic risk and lower levels of systematic risk.
Supporting the conventional wisdom about the primacy of governance issues, our results show that the G score was indeed the most significant in measuring exposure to these financial factors, from 2006 to 2019, while the S score was the weakest. In this analysis, ESG scores were at most one year old at any given date. Thus, the transmission channel analysis inferred relatively short-term links between ESG and financial characteristics.
Looking Beyond One Year
The conventional wisdom had its (time) limitations, however, when we examined stock-market performance over the full 13-year study period.
We created equal-weighted Q5 to Q1 quintiles (based on their scores) from the MSCI World Index to determine the total MSCI ESG score and each E, S and G pillar score, rebalanced monthly between December 2006 through December 2019. The exhibit below shows the stock-performance difference of the top and bottom quintiles within the MSCI World Index.
Performance Difference of Q5 and Q1 Quintile Portfolios in MSCI World Index
Data from December 2006 to December 2019 for the MSCI World Index (local currency). This exhibit shows the top-performing quintile (Q5) minus the bottom-performing quintile (Q1) for the aggregate ESG score and each individual pillar score. Source: MSCI ESG Research LLC.
During our 13-year study period, all three pillars outperformed in the Q5-Q1 analysis: The highest-scoring companies outperformed the bottom-scoring companies by between 7% (for S scores) and 31% (for aggregate ESG scores) on a cumulative basis. Contrary to the previously discussed analysis of economic-transmission channels, the S-pillar score showed nearly the same positive results as the E pillar. Furthermore, the total ESG score — which is constructed from industry-specific weightings of the E, S and G scores — exceeded each individual pillar’s score and was also the least cyclical.
In addition, there was a clear difference between the previous analysis of economic-transmission channels, which showed that the G score had the strongest financial significance in all three transmission channels, and the stock-performance analysis, where performance differences between the three pillar scores were relatively small and the aggregate ESG score provided the best results.
The differences in the time horizons used are critical to this analysis. The transmission-channel analysis looked at the differences in the quintiles’ profitability and risk profile in the year after the publication of company ESG Ratings. Using this one-year forward basis, G enjoyed a clear advantage over E and S in terms of active exposure to profitability and lower stock-specific and systematic risks. The story is very different, however, when we analyzed stock-market performance over the 13-year time frame, suggesting that some financial effects of companies’ aggregate ESG profiles may have unfolded slowly over time.
Why might that be the case? We hypothesized that financial markets were largely focused on events that could immediately affect company valuations. This effect tended to be captured more by the issues associated with G, such as fraud or ethics breaches. In contrast, the E and S scores were composed of underlying industry-specific environmental and social issues, only some of which could trigger tangible, event-driven risks such as accidents, strikes or oil spills — and only for certain sectors. Other issues — such as managing human capital or carbon emissions, which carried high weights in the E and S scores of specific sectors — did not tend to erupt into tangible, negative events.
To probe this further, we used the frequency of stock-specific drawdowns as a measure for event-driven risks as proposed in our earlier research. Every year, we counted the number of companies that suffered drops in market value exceeding a given level during the three years following a monthly rebalancing and compared the frequency of these drops for the highest- and lowest-scoring quintiles. Again, we used size-adjusted quintiles to ensure that potential differences in risk were not due to differences in size.
In the exhibit below, we plotted the ratio of drawdowns observed in the top and bottom quintiles.
Q1/Q5 Ratio of Drawdown Frequencies
Data from December 2006 to December 2019 for the MSCI World Index. Source: MSCI ESG Research LLC
Compared to companies in the bottom-scoring quintiles, those in the top-scoring quintile experienced fewer drawdowns. This finding was true for each of the E, S and G scores for losses ranging from 40% to 90% of market value over the next three years. For example, companies scoring in the lowest quintile on governance issues in a given month were on average 2.4 times more likely to lose over 90% of their market value over the course of the next 36 months than the best-scoring companies on governance.
Governance showed the biggest difference between top- and bottom-scoring companies in drawdown frequencies, followed by the social score and then the environmental score. That difference supports our hypothesis that governance-related incidents such as ethics breaches impacted a stock price quickly, with the greatest differences occurring for companies at the tail end of the loss threshold — i.e., with losses of more than 90% of market value. Up until the tail, the social score saw greater differences than governance in the ratio of drawdown frequencies for top- and bottom-scoring companies, possibly because it contained Key Issues — indicators that underlie the pillar scores and are proxies for ESG characteristics — for certain sectors that also related to event risks. Such risks included accidents, strikes or labor conflicts (e.g., the labor management Key Issue) that could have immediately affected a company’s stock price. However, other S-pillar risks, such as talent scarcity (the human-capital management Key Issue), surfaced more slowly.
While some environmental risks such as toxic spills could also be construed as event-driven, the Key Issues that underlie the environmental score for certain sectors include issues, such as carbon-emissions management and those related to regulatory changes, that were less event-driven but may have affected companies’ businesses over longer periods.2
Unfolding, Forward-Looking Risks
A longer-term effect may be especially pertinent for environmental risks, where there is growing public attention to climate change. We examined sectors3 where environmental risks such as carbon emissions or water stress carried a high weight in the E-pillar score. The utilities sector had by far the highest carbon-emissions intensity (more than twice the next most intensive sector, the materials sector) and water use (more than nine times the next most thirsty sector, the materials sector).
We studied the stock performance of the companies carrying the highest- and lowest-quintile environmental scores (Q5-Q1 for the E pillar) for utilities and materials, as shown in the exhibit below. In both sectors, stocks with high environmental scores outperformed the low-scoring companies (relative to the underlying MSCI World Index over the 13-year study period) by roughly 60%. The long-term performance suggests that environmental risks may not have been discernible from differences in exposures to profitability and risk factors at a given snapshot in time — or even in large drawdowns over a three-year forward horizon. Yet, these risks’ impact on stock performance within these sectors became more apparent over longer periods of time.
Cumulative Performance Difference of Q5 and Q1 E-Pillar Portfolios, in Utilities and Materials
Data from December 2006 to December 2019 for the MSCI World Index (local currency). Source: MSCI ESG Research LLC
What Really Matters?
We found different ESG risks were associated with very different time horizons: Some ESG risks (especially in the Governance pillar) were event-driven (accidents or strikes) and may have shown a financial impact in the shorter time frame. By contrast, some ESG risks may have represented long-term trend risks or trend opportunities that unfolded over multiple years.
What does this mean? If the focus of an ESG rating is to measure risks that can impact a company’s exposure to financial factors in the short term, then governance indicators showed the best financial results, in our analysis.
However, over longer time periods, we found that a more balanced overall signal that aggregated industry-specific environmental and social issues showed better results than any of the individual pillar indicators, including the governance score.
In the longer-term sample, E, S and G all mattered.
1We used size-adjusted quintiles to ensure potential financial differences were not due to differences in size.
2For example, airlines face mandatory requirements to reduce their fleets’ carbon intensity by 2026 through the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).
3For sectors, we use the Global Industry Classification Standard (GICS®) jointly developed by MSCI and Standard & Poor’s.