Financial advisors are being bombarded with questions from clients about the investment potential of ESG – Environmental, Social, and Governance – stocks as their popularity soars. ESG funds captured $51.1 billion in net new money from investors in 2020, according to Morningstar, which was a record and more than double the prior year. Many investors have assumed that a public company’s current ESG score is a key predictor of investment performance, but new research suggests that improvement in a public company’s ESG score is a better indicator of future investment performance.
Without question, a company’s ESG issues can be a material driver of performance, on both the downside and assessing future upside potential. In some cases, ESG factors have the potential to drive unacceptably wide or asymmetric ranges of long-term outcomes; while other issues, though not material today, could pose future risks if not adequately managed. Assessing the potential impact of ESG issues on a company is therefore critical to the investment process.
Pzena Investment Management analyzed MSCI ESG Research scores of public companies from Jan. 1, 2014–July 1, 2020 to test relationships between investment performance and ESG scores. Pzena found:
- Contrary to popular opinion, there is a weak relationship between ESG scores and investment performance.
- ESG improvement may be more important than a high ESG score. If so, weak ESG scores themselves would not automatically be a bad thing. In theory, investing in stocks with room for improvement is a win-win because stakeholders and society are better served when a company improves its ESG prudence.
- Not investing in companies that are actively trying to mitigate their ESG risk (even if they currently have low scores), may starve these companies of the capital needed to improve ESG credentials.
Enel S.p.A., an Italian diversified utility operating in 30 counties, serves as an example. The company is navigating the shift to widespread adoption of green energy while executing a comprehensive restructuring plan to position itself for success in a changing environmental landscape.
New management at Enel cut costs, implemented a culture of capital discipline, simplified the business and invested prudently to better position the company for the changing landscape, all of which was largely predicated on improvements in management’s approach to environmental risks and corporate governance practices.
In terms of the environment, Enel had been shifting its focus toward businesses that stood to benefit in the new utility landscape: electricity distribution, renewables generation and broader digitalization, such as smart meters. Today, Enel is the largest non-government-owned renewable operator in the world and is continuing to expand its renewable offering. In tandem, Enel is phasing out coal generation by 2025–2027 and will completely decarbonize by 2050.
Through these and other changes, Enel has transformed from an industry laggard for environmental and governance risks to an efficiently run industry leader with a stable business mix well-positioned for future growth in environmentally conscious markets. The company’s turnaround (from 2016 to 2019) broadly mirrors the performance period examined in the MSCI data. Over this time Enel’s stock experienced a 77% 3-year return, and the company was upgraded by MSCI from an A to AA ESG rating. If an investor had only focused on the A rating in 2016, and not on the active potential for improvement, a significant upside investment opportunity would have been missed.
Most ESG ratings are backward-looking, and likely don’t accurately depict the future of a company. Choosing not to invest in a company for low ESG scores, when potential is there, could prove to be a limiting move.
Evaluating ESG is no different than any other type of value investing—look beyond current numbers and assess what can be improved upon. Then, consider whether a company is willing to take steps toward attainable goals. If so, those companies could provide a potential source of deep alpha.
Caroline Cai and Rakesh Bordia are principals and portfolio managers at Pzena Investment Management in New York City.
