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Does ESG impact company valuations? An Australian perspective

The importance of environmental, social and governance (ESG) issues in driving value creation continues to accelerate across the Australian corporate and private equity landscape. While this emerging trend is becoming more mainstream, there is still a degree of opacity on the relationship between ESG performance and company value; namely which ESG elements have the biggest impact on value, and whether companies with strong ESG performance attract a premium.

The world of ESG performance quantification has historically been fragmented, driven in part by the inherent differences between ESG issues that are material to companies based on their sector and geographic location. This has been compounded by the lack of an authoritative set of global ESG reporting standards, which has resulted in a lack of standardisation when calculating and reporting on ESG performance.

While there are a range of activities underway to address these challenges, including the development of a consistent set of global ESG reporting standards under the International Sustainability Standards Board, the realisation of these benefits will take some time.

Meanwhile ESG ratings provided by various third-party agencies provide a useful proxy to understand and compare companies’ ESG performance. However, each of these third parties utilise their own proprietary methodologies and lack alignment. In fact, the average correlation of ESG scores for seven of the largest ESG rating providers is only 0.45, compared to an average of 0.99 for credit ratings by major agencies, an astonishingly weak result!

There is a growing body of research to show the correlation between ESG and share returns. In particular, performance on material ESG issues has been found to be more influential, with outperformance on immaterial ESG issues tending to drag down returns[1]. ESG indices tend to outperform benchmarks, albeit in many instances, marginally[2]. Event studies which seek to address the ‘causality vs. correlation’ criticism of other ESG studies have found evidence of an improvement in the cost of capital and P/E multiples 36 months after ESG rating upgrades[3].

In relation to the Australian market specifically, our analysis of companies in the ASX200 (as a proxy for the Australian listed market) over a three year period from 2019 through 2021, has highlighted the following key insights:

  • There is a ‘size effect’ – larger companies have better ESG ratings, despite similar reporting scope coverage.
  • There seems to be a reasonable positive correlation between total shareholder returns (TSR) and improvements in ESG scores over a three-year horizon. This holds for excess (industry-adjusted) as well as absolute TSR.
  • Improvements in ESG scores also correlate positively with improvements in valuations multiples (EV/EBITDA, EV/Revenue and P/E) over this horizon. 

Of the three ESG pillars, the Environment or ‘E’ score seems to be the most persuasive when it comes to excess TSR, whereas the Social or ‘S’ score is most closely matched with earnings multiple improvements.

Despite survey evidence suggesting a decrease in the cost of capital for companies that improve their ESG metrics, with anecdotal evidence of a greater weight of capital seeking ‘ESG friendly’ investments, our analysis of the Australian listed market does not show such a relationship.

The jury is still out as to whether ESG-linked outperformance represents a market inefficiency that will eventually disappear over the longer term horizon.

However, in the interim, it is vital that corporate and private equity companies prioritise the following

  • Have an informed understanding of the ESG issues relevant to their business and/or portfolio companies, value chain and key stakeholders
  • Disclose performance data relating to material ESG issues in a transparent and consistent manner
  • Prioritise investment in ESG initiatives that align with these material issues and the overarching strategic priorities of the business and/or portfolio companies.: