The environmental, social and governance (ESG) pillars and key issues relate differently to companies’ financial performances depending on time horizon, industries and weighting schemes, according to research conducted by MSCI.

The study, entitled Deconstructing ESG Ratings Performance, tested the significance of the E, S and G scores of companies across various time frames, sectoral differences and weighting schemes between 2006 and 2019.

This initially involved testing MSCI’s ESG indicators by considering their economic transmission channels to financial variables and stock performances. This resulted in the top quintile of ESG scored companies to have higher profitability and lower levels of idiosyncratic and stock-specific risk compared to the bottom quintile for most ESG pillar and key issue indicators.

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MSCI found the governance pillar scores proved to be more significant than the environmental and social pillars over a shorter period, such as one year, in terms of their impact on profitability, idiosyncratic risk and systematic risk. This was because they were more directly linked to short-term events and incident risks.

Alternatively, over longer periods, environmental and social indicators became more significant as reflected by the stock-price performance. Two factors that proved this were carbon emissions and labour management which showed minimal significance on profitability over the short term but had the largest performance impact on all of MSCI’s 11 ESG key issues over the long term.

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Similarly, the governance pillar proved to have the biggest impact on the top and bottom 20% scored companies for sectoral differences. In particular, the financials and consumer discretionary sectors were most impacted by the governance pillars whereas the environmental pillar was more significant among the materials and energy sectors.

Source: MSCI ESG Research LLC

The average pairwise key issue correlation under the E, S and G pillars were reasonably low, according to the report. The most significant correlation between pillars was environmental with itself having an average score of 0.25. Therefore, MSCI views the key issues as approximately independent indicators in the subsequent analysis of their financial relevance.

Average pairwise key issue correlations under E, S and G pillars - Source: MSCI ESG Research LLC

MSCI also tested the most optimal method of weighting an ESG index as the usefulness to investors could vary depending on whether the index is equally weighting the E, S and G pillar scores across sectors or using a stand-alone E, S or G pillar score. In fact, the stand-alone governance pillar score demonstrated the most significance.

If the focus of the ESG rating is to measure risks that can impact a company’s share price short-term, then the governance indicators would have been given the highest weight during the study.

However, the most significant method was backward-optimising the statistical confidence level of the sector-specific ESG rating scheme rather than the stand-alone governance pillar score. Therefore, adding environmental and social risk indicators improved the aggregate ESG scores.

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