How to dodge a BP or Barclays

For risk-wary investors it's an attractive idea: an early warning flag that signposts companies whose unsustainable business models or poor governance leave them vulnerable to gaffes and disasters.

Unfortunately, there's no magic index or indicator which flashes a red light before a company crisis such as Barclays' rate-rigging or BP's 2010 Gulf oil spill. Yet there is evidence that environmental, social and governance (ESG) indicators do correlate with company performance, as measured by stock price or other measures of return on equity.

The rationale behind ESG scores is to widen the information available about a company, under the maxim that you can only manage what you measure. But there are plenty of areas of uncertainty. Which ESG data are most useful? Exactly how far and why ESG scores correlate with company performance? Are investors allocating their assets accordingly?

ESG is a relatively new generation of indicators which arose from an earlier wave of socially responsible investment (SRI) scores and ethical screening. The latter sprang from an environmental movement and a new generation of investors who wished to avoid certain sectors, such as arms manufacturing. The more recent ESG indicators took a different tack, preferring to select top performers regardless of sector, on the basis of scores on environmental (for example pollution), social (health and safety) and governance (board oversight) criteria.

A review by Deutsche Bank of the two approaches, published last month, found performance diverged according to the inclusive, ESG approach, or the negative, exclusionary screen, SRI approach. Their report found agreement in the literature that high ESG scores correlated positively with company performance, while SRI added less upside, showing a positive or neutral correlation.

The backdrop to the development of ESG scoring was a growing disenchantment with the performance of SRI funds and investor concern about a wave of massive, corporate governance-related bankruptcies in the early 2000s, including that of Enron.

The United Nations became involved in the mid 2000s with its "principles for responsible investment".

For investors, one challenge is how to apply now voluminous ESG data with hundreds of individual data points. A recent report by Harvard Business School authors in the Journal of Applied Corporate Finance found that at present the market – investors and analysts and so on – is most interested in companies' ESG transparency.

Such interest may reflect an assumption that failure to disclose data, for example on pollution, safety or staff turnover, probably also implies poor performance on those metrics, and in turn poor management. However, a basic correlation analysis with share price performance using Asset4 (a Thomson Reuters subsidiary) data showed very weak correlation between the two.

The analysis was of the MSCI group of the world's 1,600 biggest companies. A correlation coefficient of 1 indicates a perfect, positive relationship, while a value of minus 1 shows a perfectly negative relationship. A value of around zero shows weak or no correlation.

This analysis suggests investors may be mistaken in thinking disclosure is a guide to return on equity.

One challenge, then, is how to apply ESG data: the Deutsche Bank report shows a comprehensive sustainability rating – not a focus on disclosure or other isolated data points – correlates with performance.

A second challenge is to go beyond establishing a correlation, and unravel causality.

A third is for investors to act on the information. As investors pay more attention to ESG data, this could create further momentum for the approach.

On the investment side, investors with assets worth about $32 trillion have signed up to the UN's PRI, implying some scope for such a feedback. On the corporate side, about 2,200 companies have signed up to the non-financial reporting guidelines under the Global Reporting Initiative, a non-profit body affiliated with the United Nations, compared with around 50 a decade ago.

The bandwagon then seems to be rolling and companies will likely be increasingly judged by more than just their short-term profits performance. Maybe ESG reporting guidelines should be on more CEO reading lists this summer.

This article was originally published by Reuters. Republished with permission.