ESG INTEGRATION IN EQUITY ANALYSIS
by Abhijit Mhalsekar
ESG Investing is a term that is synonymously or interchangeably used with sustainable investing, ethical investing, socially responsible investing, or screening. The academic literature and investment practitioner have found a link between ESG and corporate financial performance Analysis of a meta-study on effect of individual ESG factors on corporate financial performance show that 62% studies show positive correlation with governance, 58% studies with environmental and 55% studies with social factors(1). Results from another meta study - 90% of studies on cost of capital shows higher compliance to ESG standards lowers cost of capital while 80% studies show it can influence the stock price performance(2). Research has shown that governance was integrated in equity valuations, however in the last few years environment and social factors have also received consideration.

(1)Friede G., Busch T., and Bassen A. (2015) “ESG and Financial performance: Aggregated evidence from more than 2000 empirical studies”.
(2)Clarke L. G., Feiner A. and Veihs M., (2015), “From Stockholders to Stakeholders” University of Oxford and Arabesque Partners.
It has been found that the main barriers of adopting or incorporating ESG are the know-how to integrate ESG factors in investment-decisions, the underlying ESG data itself. There are many ESG data providers such as MSCI, Bloomberg, Sustainalytics, Refinitiv etc. which provide scores or ratings for each of the ESG factors and provide aggregate ESG scores. However, the correlation for the aggregate score is found to be 0.485(3). Therefore, investment management companies have come up with their own proprietary models and large asset management companies are acquiring ESG data modelling companies.

Principles of Responsible Investment (PRI) along with Chartered Financial Institute (CFAI) have drawn a framework to integrate ESG factors in security valuation (see figure 1). The aim of this report is to understand the approach and methodology to integrate ESG factors in equity valuation.

(3)Chartered Financial Analyst (CFA) Institute (2020) – ESG Analysis, Valuation, and Integration.

Figure 1: ESG Integration Framework PRI and CFA

Approaches for ESG Investing in Practice (Source: CFA Institute)
Exclusionary Screening
It is one of the oldest forms of ESG investing approaches. It refers to avoiding investment in the stocks of companies based on values (e.g., tobacco or gambling companies) and norms (e.g., violation of laws pertaining to human rights (forced labour, child labour and environmental protection). The downside of this approach is that excluding (sin) stocks of companies, associated with industries mentioned above, without considering the impact on portfolio can lead to inferior investment returns(4).

Faith Based Investments are one such example of deploying value based negative screening strategies.

Best In Class Selection
This approach refers to investing in companies with industry best ESG scores in comparison with its peers or with improving ESG scores. This is also known as the positive screening approach. In this approach, a company is expected to have strong environmental, social and governance policies in place. Companies with strong environment policies tend to have lower operational expenses (low water and energy bills) and with high social scores tend to have higher productivity due to high employee satisfaction and lower reputational risk. In addition, stronger governance policies or framework helps to consolidate its position as a leader in the market.

Examples of best-in-class selection are NN Investments investing in ASICS (68.4 ESG score v/s industry average of 57.2) and Linde (74.7 ESG score v/s industry average of 63.3)(5).

Impact Investing
It is an approach on the rise and growing rapidly fuelled by investors intention to generate positive, quantifiable social and environmental impact coupled with financial returns(66). Investment management companies can integrate the Sustainable Development Goals (SDG) in the investment management and in its due diligence process. The investment management firm will track impact indicators mapped to the SDGs and report progress on the goals.

One such example is Incofin Investment Management through its instruments strives to reduce environmental and social impact (88% aligned to overall SDGs and strong to full alignment to SDGs 1, 2, 4, 5, 6, 8, 9, 10 and 16) by supporting the Colombian coffee growers to grow coffee sustainably(76).

(4)Hill J (2020) ebook: Environment, Social and Governance (ESG) Investing: A balanced analysis of the theory and practice of sustainable portfolio.
(5)CFA Institute (2015) – Environmental Social and Governance Issues in Investing – A guide for investment professionals.
(66)Global Impact Investing Network.
(76)Global Impact Investing Network.
Thematic Investing
It refers to investment in specific themes to address ESG issues such as clean tech (renewable energy), waste and water management, sustainable forestry, and agriculture, health products and education. It is based on the trends centred on social, industrial, and demographic. E.g., Alternative Energy themed fund, Air or Water themed fund.

Active Ownership
It refers to engaging the companies on issues pertaining to ESG and exercising ownership rights and voicing opinion for change. Upon mapping the material financial factors, performing investment analysis can support in the process of company engagement and/or inform voting decisions. This additional information gathered helps in influencing outcomes pertaining to ESG issues. Activism or activist investing is not nearly the same as active ownership approach which uses confrontation measures in public domain but can influence through discreet approach and dialogue.

The active ownership actions are listed below:
  1. Voting at Shareholder meeting
  2. Filing complaints with regulatory/authority
  3. Active Dialogue with company representatives
  4. Raising questions during Q&A at the general meeting for shareholders.
  5. Issuing press releases
  6. Positioning to gain board representation

ESG Integration
It refers to systematically integrating ESG factors in the valuation model based on the risk and opportunities relevant to the industry. It does not mean selecting the best in an industry or sector based on the ESG or neither excluded as in exclusionary screening strategy. For Anglo American, a mining company, RobecoSAM adjusted the operating cost by 400 bps which reduced margins by 80bps due to inadequacies in management of occupational health and safety at its platinum mining sites and issues related to labour wages and strikes, which reduced the target price by 7%. Additionally, they increased (adjusted) the weighted average cost of capital (discount rate) by 50 bps which reduced the target price by 12%. Cumulative reduction in the target price by 19%.

Sustainability Accounting and Standard Board (SASB) has categorised the above-mentioned material ESG factors based on the industry. It is difficult to know the factors that are relevant to each industry, therefore SASB has simplified by identifying (materiality map) the financially material issues that are likely to impact the financial and operating performance of a company and are important from investors point of view(98).

(98)Sustainability Accounting and Standard Board https://www.sasb.org/standards/materiality-map/
Material ESG Factors used for Equity Analysis (87)
ESG Integration in Fundamental Strategies

Forecasted Financials
Revenue – Income Statement Adjustment
Revenue forecasts are drawn depending on an industry’s growth and whether the company is gaining or losing its market share. ESG factors are then integrated in these future projections to reflect the risk and opportunities depending on the investment level by increasing or decreasing the revenue growth rate.

Operating Cost, Operating Profit and EBIT Margin – Income Statement Adjustment
Based on the Influence of E, S, or G or combination of ESG factors, an investor can make assumption to increase or decrease future operating cost or adjust them directly. Or can chose to adjust the operating margin. Studying the trend of the ESG data, the investor can forecast the operating cost explicitly depending on the data disclosed by the companies.

Example: High operating costs in case of high employee turnover or reduced operating margin due to high fatality rates or increased costs due to changes in legislation. i.e., Social Factor influencing the adjustments in the Income statement.

Asset Book Value – Adjustment to Statement of Financial Position (Balance Sheet)
An asset’s anticipated cash flow can be negatively impacted by the influence of ESG factors on long term basis or cause permanent closure. This in turn can negatively influence the net present value of the assets. This results in an impairment charge and will drive a company’s book value down.

Capital Expenditure – Cash Flow Statement Adjustments
The analyst may increase or decrease the forecasted investment in capital expenditure depending on the company’s ESG score.

(87)The tabular data has been collated from Fundamentals of ESG (2015), Principle of Responsible Investment (PRI) (2016) and From Stockholders to Stakeholder (2015).

Sycomore Asset Management SPICE Rating
Valuation Model Variables
Beta and WACC (Discount Rates)
It is ideal to price the apparent ESG risks into the company’s valuation, but it is difficult to factor it in. By performing a peer analysis within the sector and ranking them based on high/low ESG ratings or scores is an approach used to adjust the Beta or Discount rate. This will in turn reduce or increase the fair value of the stock.

Sycomore Asset Management provide a SPICE (Supplier, People, Investors, Clients and Environment) Rating for each company in the investment universe which forms the basis of gauging a company’s sustainability efforts. This rating is then used to adjust beta of a stock and incorporated in the valuation model(109).

Terminal Value or Perpetuity Growth Rate
Company may not be a going concern or curtail its operations due to violations with respect to ESG factor and therefore the analyst may reduce to lower value or assign a zero-terminal value, or an adjustment is made to the perpetuity growth rate.

Forecasted Financial (Valuation) Ratios
The effect on the financial ratios is assessed based on the adjustments made to forecasted financials and the estimated future cash flows.

Sensitivity / Scenario Analysis
Adjustments are made to set of input variables (sensitivity analysis) to understand the output which is not known in complex cases and different Scenario Analysis is carried out depending on ESG information available it is applied to valuation models to compare the difference between the base-case and the ESG-integrated security valuation.

Portfolio Management
Based on the ESG scores, a higher weightage is given to stock with Higher ESG score or rating and the laggards are underweighted.

(109)Principles for Responsible Investment – PRI (2016) “A practical guide to ESG integration for equity investing.”

Effect of Climate Change Risk on Company’s Financial and Operational Performance
(Source: Institute for Climate Economics)

Summary of Case Studies:
ESG Integration in Equity Valuation
ESG Integration in Equity Valuation (con't)
September, 16 / 2021
Abhijit Mhalsekar
ESG Research Analyst

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