The Cost of Buying Good ESG Companies

He found that, companies with ‘Negligible’ ESG risks sit near the territory of fair valuation. For ‘Low’ ESG Risk companies, investors are paying a 7% premium to fair value. At the other end of the spectrum, by contrast, the stocks that have ‘Severe’ and ‘High’ ESG risks trade at 16% and 8% discounts to fair value, respectively, and have average star ratings above 3-stars. Kelly explains: “If our analysts are correct, investors stand to outperform by investing in bad ESG stocks.”

Good ESG Names in Asia

Using the same parameters, we ran the data for the Asian equity market. The market presents a very difference case versus global peers. Whether we look at the six markets collectively or individually, there is a lack of a clear trend or a linear correlation between asset prices and ESG performance.

These 200-odd stocks are trading 10% discount on average. Companies with relatively less ESG risk exposure (rated as Negligible or Low risk) are priced 3% lower than the average, and so are those in the bracket with Severe ESG risk, which is 13% cheaper than the broad market. Why?

Globally, many companies that score High or Severe on ESG Risk reside in the energy sector. This issue holds true for the Asian markets as well. (In our coverage universe, these names are mainly from China). Three out of eight Asian names that carry severe ESG risks fall into the energy sector, precisely oil producers in China: CNOOC Ltd, PetroChina, and China Petroleum & Chemical.

As Kelly puts it, the energy sector is a research area that is “a notoriously difficult sector in which to make long-term stock calls,” because forecasting the price outlook, and thus companies’ cash flows, is difficult.  

Additionally, the ESG Risk Rating provided by Sustainalytics, a Morningstar company, is just one way to identify good or bad ESG companies. Kelly adds: “Several ESG rating services exist, each with different methodologies and therefore different rank orderings of companies.”

“In the academic literature, there are even more varieties of ways to score ESG. If we somehow had access to a Platonic ideal of an ESG risk measure, perhaps it would give us even a different conclusion as to whether good or bad ESG stocks are more expensive.”

Not One-to-One

At the moment, among the Severe and High ESG Risk companies that currently receive 5-star ratings are some Hang Seng Index constituents, CNOOC (00883), CK Infrastructure (01038), and WH Group (00288), and Nissan Motor (7201).

Kelly reminds investors that it’d be dangerous to think there’s any “one-to-one correspondence between ESG and investing returns that holds for all market environments.” He suggests that it all depends on relative valuations.

“The broader lesson here is that the impact of ESG on investing returns is a question that has no definitive answer. At some points in time, good ESG companies--however defined--will be relatively cheap as a group. At other times, as appears to be the case now assuming you believe our equity analysts, good ESG companies command a premium,” he concludes.

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