Friday, 24 August 2012

ESG considerations really do affect share values

In a recent post on corporate governance I outlined what ESG is and how it is different from ethical investing.  This post will deal with why, even if you do not think of yourself as a particularly 'activitist' or ethically driven investor (i.e. your decision is first about the return that you get) you should build some sort of ESG framework into your decision making process because it really does affect valuations.

A recap of what ESG considerations are

Investing with ESG considerations in mind can be thought of as a 'positive screen' for those firms and investments which operate in ways which
  • Minimise damage to the Environment
  • Promote Social well being
  • Are proactive about good Governance
How do ESG considerations affect valuations

It is much easier to see how bad performance in ESG considerations affects valuations negatively than how good performance affects it positively.  This is because bad performance often results in valuation impacts that you can point at whereas proponents of ESG investment argue that good performance creates or enhances a business over the business life.

For this reason I will be focusing below on how bad performance with respect to ESG negatively impacts valuations.

  • There are several ways in which companies which do not look after the environment are penalised.  Most of these have to do with legal ramifications or government regulations
    • For example the tragic oil spill in the Gulf of Mexico was expected to cost BP US$7.7 (see link) and this amount comes straight off the valuation of the company. 
    • Another example is the introduction of the carbon tax in Australia which taxes the largest polluters in the country, reduces profitability and thus the value of your investment
  • Although we do not think of environmental concerns as having an impact on our valuations - in a world which is concerned with global warming and the sustainability of resources you should evaluate the environmental performance of your investment and it's impact on your valuation
  • On the positive front, with the current focus on clean energy, companies which actively reduce pollution or deal with environmental issues are seeing a premium attached to their valuations.  You need to decide how much you want to pay for this premium but the fact is that this is also impacting valuations
  • Generally speaking it is hardest to see the impact of social considerations on valuations.  However you can see it very clearly in some situations including
    • When workers strike due to poor working conditions, the business is often brought to a standstill or affected significantly which affects profitability and thus valuations
    • Poor PR can kill a business and in an age where news spreads amazingly fast over twitter and other social media, acting in a way which is seen as socially irresponsible (including something as simple as selling inappropriate children's clothing) can be detrimental to business valuations
  • It is often the hardest to pick the companies which will be affected by social issues such as these.  If you are trying to avoid poor performers perhaps avoid companies which typically have issues with their workforces or companies which offer goods which are considered dubious or questionable by the broader community

  • Governance issues are often the ones that affect valuations the most.  They can also be the hardest to pick up before the fact but you need to constantly be vigilant about them due to the significant impact they can have on valuations
    • An example in the media recently was related to Standard Chartered which had to pay $340 million to the New York Banking regulator due to transactions with Iranian entities
    • Further if management incentives are not aligned  with shareholder interests you will see bad decisions made.  The now dead externally managed listed equities model is a perfect example of this.
  • You can never pick when companies are going to do something illegal but you can pick things like bad incentives, excessive pay and bad decision making.  You should avoid companies which exhibit these traits because they will have an impact on valuations

As should be pretty obvious from the examples above, ESG considerations really do impact valuations and you should make sure that you think about these when considering your valuations and what price you are willing to buy and sell at. 

No comments:

Post a Comment