What Matters Most In ESG Investing: How To Spot Opportunities Across Market Cycles And The Capital Structure

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Bhakti Mirchandani

Bhakti Mirchandani Contributor Investing

I write about public policy and sustainable and impact investing.

Solar panels containing photovoltaic cells float on water at a hydro electric dam. Photographer: Daniel Rodrigues/Bloomberg
Solar panels containing photovoltaic cells float on water at a hydro electric dam. Photographer: … [+] © 2018 BLOOMBERG FINANCE LP

Pensions, insurers, endowments, and foundations are asking asset managers to incorporate elements of sustainability and inclusion into their investing. Responding to investor interest is complex. There are over 600 environmental, social, and governance (ESG) frameworks and standards, and materiality—focusing on sustainability issues that drive stakeholder decision-making—varies across industries, the capital structure, and economic cycles. Sustainability Accounting Standards Board (SASB) is perhaps the most widely accepted of the sustainability standards. SASB’s Materiality Map SASB is championed by an Investor Advisory Group with an aggregate $40 trillion in assets, including BlackRock BLK +1.7%, which in January asked the 15,000 companies in its portfolio to publish disclosure in line with industry-specific SASB standards by the end of the year. SASB’s Materiality Map outlines how material ESG factors vary across 77 industries. Institutional investors and issuers would benefit from analogous materiality maps by asset class, strategy, and phase in the economic cycle. 

What Matters For Bonds and Publicly Traded Equities

Governance. Since bonds are often secured, corporate governance (G) scores are less relevant to bond yields. New research by Halling, Yu, and Zechner demonstrates that better overall ES performance leads to lower bond yields – even after controlling for other factors that drive bond yields, such as bond ratings, leverage, and profitability. Regarding equities, many studies have concluded that strong firm governance leads to superior operating performance and/or greater stock returns, but more recent research demonstrates that positive correlation between governance and equity returns was stronger in the 1990s and inconclusive in 2000s.[3] This is due in part to broad-based improvements in corporate governance in the wake of the Enron and Worldcom crisis and improved investment stewardship post-Global Financial Crisis. 

Environmental and Social. Materiality also varies across bond ratings: the relationship between strong environmental (E) and social (S) scores and lower new issue spreads is only significant for bonds rated BBB or below and for those that do not have a rating.Since the effects of E and S ratings on spreads are predominantly driven by lower-quality issuers, E and S performance may be considered to reduce credit risk. 

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Actively Do Good vs. Do No Harm. Halling, Yu, and Zechner demonstrate that higher product-related E and S scores reduce the cost of debt. Higher scores for the environment, community, and human rights – which get much more attention by the media – are actually linked to a higher cost of debt, although the results are statistically insignificant. Thus, it seems that the “actively do good” aspects of ES matter more than the “do no harm” in terms of bond yields.   

The opposite is true for equities.  Analysis of global equities, as approximated by MSCI All Country World Index (ACWI) ACWI +1.5%—which represents 85% of the global investable opportunity set—from 1999 to 2017 indicates that lack of ESG controversies is a stronger predictor of 5-year return on invested capital than ESG scores. MORE FOR YOU

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What Matters During Booms and Busts

Recent TruValue Labs research concludes that materiality changes over time—a concept called dynamic materiality. This is true for bond yields across economic cycles. 

To illustrate, during expansions, when there are tighter labor markets, strong employee relations reduce new issue bond yields, perhaps because strong employee relations help with recruiting and retaining top talent. There is also no relationship between corporate social responsibility (CSR) activities as a proxy for social capital and bond spreads.

By contrast, during recessions, employee relations scores are insignificant, and high-CSR firms are able to raise more debt at lower spreads, better credit ratings, and longer maturities. These effects are stronger for firms with higher expected costs of debt.

In addition to these cyclical trends, there are also acute shifts in materiality, caused by exogenous shocks like COVID-19, which increased the materiality of the following COVID-19 related social issues between January and June 2020: access and affordability, customer privacy, data security, employee health and safety, labor practices, product quality and safety.