Environmental and social issues, such as climate change, health and safety standards and labour rights have become increasingly important to companies, as failing to adhere to best practice standards can lead to public scrutiny and debate. Apart from their adverse reputational effects on companies, scandals and accidents can also lead to a significant decline in company value, as demonstrated by the Volkswagen emissions scandal in 2015 and BP’s Macondo oil spill in the Gulf of Mexico in 2010. A better awareness of environmental, social and governance (ESG) factors, such as corporate governance or health and safety standards, might have contributed to protecting the companies from significant financial losses or to upholding their reputation.
The materiality of climate change, health and safety standards and labour rights is more pronounced in some sectors than in others. However, companies that pursue sustainable business strategies and have superior environmental, social and governance (ESG) standards are often the preferred investment targets for some of the world’s largest institutional investors1 as they tend to deliver better risk-adjusted returns and have a lower volatility of cash flows, both ultimately leading to higher company value and thus benefitting shareholders. 2Robust and convincing evidence points to a positive correlation between good sustainability practices and company performance.3 Nonetheless, the mainstream investor community tends to think of environmental and social factors as less of a value driver4 than corporate governance because the latter is perceived to be directly linked to company valuation and comprises some of the mechanisms controlled by investors, such as the composition of board of directors. A plethora of studies reveals that well-governed companies tend to outperform5 their poorly-governed counterparts, even though there is some evidence that this effect may have been fading in recent years.6
Surprisingly, environmental and social issues have been under much less scrutiny by researchers and institutional investors alike. This might be due to the common misperception that topics such as climate change, health and safety and labour rights are difficult to quantify and as intangibles might not be directly linked to company performance or correlated with a company’s cost of capital. Their lack of tangibility makes it difficult to incorporate these factors into a standard company valuation analysis, which mainly rests on financial information, while in general financial markets have found it difficult to price in ESG information.
A good example for this is employee well-being, which, as an intangible ESG issue, is mostly assessed with the help of employee surveys and questionnaires. While these methods can be a good indicator for the well-being of employees, the nature of a survey might influence the generalisability of the findings. Nevertheless, researchers and investors eventually realised the potential value-add from employee wellbeing, which has led to the issue becoming an important social topic.
Nowadays, there is robust evidence which suggests that employee satisfaction, or well-being, not only increases the productivity of the workforce, but that this productivity gain also translates into an overall better financial and operational performance. Research shows that a portfolio consisting solely of the companies with the highest employee satisfaction delivered a risk-adjusted outperformance of 3.5% per annum between 1984 and 2009.7 This is an economically meaningful return and further evidence implies that asset owners could benefit from investing in the best-in-class companies in relation to any ESG dimension. Research also shows that better and more sustainable policies with respect to intangible factors8 benefit not only shareholders but also non-financial stakeholders.
It is therefore crucial that investors assess a company’s ESG performance by paying attention to topics such as climate change, health and safety standards and labour rights.
Over the course of the last three years, we engaged with many companies on climate change, health and safety and labour rights. As Chart 1 reveals, we increased the intensity of our engagements over the last few years in all three areas. The number of objectives we engaged on in relation to climate change/carbon intensity rose from 25 in 2013 to 41 in 2015. The trend is similar for health and safety and labour rights, which show an increase from 19 to 25 and from 26 to 51 respectively.
Our proprietary milestone systems allows us to identify and track progress in our engagements. Looking at the number of objectives for which we observed progress, such as a change in the milestone rating, we also noted several positive trends, as shown in Chart 2. The number of objectives on climate change/carbon intensity issues where we were able to achieve progress rose from nine in 2013 to 23 in 2015 and from six to 16 for health and safety issues.
The number of objectives with progress also doubled for labour rights objectives from 14 in 2013 to 28 in 2015, reflecting the growing success we have in our engagements.
Engagement by institutional investors on the aforementioned issues is increasingly important because stock markets are slowly but steadily picking up the value-add from ESG information. When a growing number of market participants is incorporating this intangible yet material information, in combination with more media coverage, the correlations observed between sustainable ESG practices and financial market performance may disappear at some point in the distant future when ESG factors will already be priced in.
From a corporate finance theory point of view, this might have immediate consequences for ESG investment strategies which exclusively rely on a best-in-class approach whereby only the companies with the highest ESG standards are included in the investment portfolio. To benefit from these ESG investment strategies in future, we believe investors should back up their investment strategies with corporate engagement on ESG and strategy issues, which allows them to take advantage of a company’s improvements in ESG. This approach would reflect the fact that ESG is a dynamic approach which can only be harvested if engagements are undertaken.
Research undertaken of Hermes EOS’ proprietary ESG engagement data in the extractives sector by Andreas Hoepner, Ioannis Oikonomou and Xiao Yan Zhou of the ICMA Centre at the Henley Business School in the UK has revealed how engagements on the aforementioned topics can increase value and provides a convincing argument for institutional investors to conduct engagements with investee companies.9