Does the S in ESG matter?
When it comes to ESG investing, the S always feels like the overlooked member of the family. Every investor (even those suspicious of ESG investing in general) agrees that governance is important and that a company with poor governance can pose a substantial risk in a portfolio. E, meanwhile, is like the George Clooney of the family: Handsome, smart, always the centre of attention. And then there is the S, which is a little bit like George Clooney’s sister Adelia.
But when it comes to creating corporate values (or family values), all are important. And in fact, research from the Otto Beisheim School of Management in Germany shows that the social element of ESG may be the most important contributor to corporate valuations. The study looked at more than 23,000 companies in 35 countries and their valuation (measured as Tobin’s Q) from 2003 to 2016. Running several different regressions, they looked at the impact a better E, S, and G score had on company valuations.
Looking at each component individually, there was a statistically and economically significant relationship between better E, S, and G credentials and company valuations. A 30% improvement in E, S, or G ratings led to an increase in Tobin’s Q by 14% to 19% after controlling for other factors like sales growth, profitability, turnover, financial leverage, firm size, etc.
Interestingly, a 30% improvement in the social rating of a company had the biggest effect, creating a 19% increase in corporate valuation, while an improvement along the environmental and governance dimension increased corporate valuations by 14% to 15%. But if the researchers looked at the influence of all three dimensions together, they found that the environmental and governance dimension often had no significant influence on corporate valuations or a much smaller one than when assessed individually. For example, the regression that showed a 19% improvement in corporate valuations for a 30% improvement in the social dimension and a 14% to 15% improvement for E and G showed a much more lopsided effect when all three dimensions were tested together. In that horse race, a 30% improvement in the social rating of a company led to a 16% increase in corporate valuation, while a 30% improvement in corporate governance led to a 7.7% increase in corporate valuation. Meanwhile, any changes in environmental ratings were inconsequential to the valuation of a corporation.
The problem with this result is that the impact of each dimension on corporate valuations changes from country to country and over time. With increased public focus on climate change, environmental metrics have become more relevant for corporate valuations. But the main message of the study, in my view, remains in place. The social component of ESG is at least as important if not more so than the other two components. It may be harder to measure and analyse the social component than the environmental and governance components, but that shouldn’t lead to benign neglect.