Ratings, Valuation, And Investing Mahak Kejriwal XIMB

The last few decades have witnessed a profound change in investing values. Consumers are aware of the environmental issues plaguing the Earth today and expect the businesses they interact with to be equally invested in addressing these environmental concerns. These ideas have now percolated deep into the investment avenues, with social justice for the environment taking center stage.

The Environment, Social, and Governance (ESG) investing sector is reported to boom to a mammoth $50 trillion market globally in the coming years. This article aims to understand this significant growth and the driving factors.

What is ESG Investing and why is it important?

ESG Investing refers to making the conscious choice of being more environmentally and socially concerned right from the core. While no rules are set in stone to attribute to what constitutes ESG investment, companies proactively working towards environmental protection and social improvement are considered promising examples.

This is extremely important for corporates today, considering the increasing awareness of consumers and the need to maintain ethics in a world of capitalism. Customers are more willing to pay for environmentally safe products, and the companies that fail to follow protocol face severe backlash, causing their reputations to take a powerful hit.

The Rise of ESG Investing and The Returns

The ESG sector has been seeing a tremendous rise owing to more and more interest from investors in projects scoringhigh on ESG.Thedrivingfactorsforthis canbeattributedto theregulatory benefits andrespect among the consumers that ESG companies enjoy. But, the concern is whether the investors can expect higher returns on ESG investing.

The answer is not definite and is subject to specific market conditions. To take this into perspective, let us consider the short run; the companies given high ESG ratings may get higher returns as more investors invest in them. Thisinferencestems from theinvestors’willingnesstopayahigherprice forESGcompanies, thereby ballooning the stock prices. However, the returns would probably be lower in the long run as the new equilibrium would dictate a more settled investor preference.

In this sense, it can be safely said that when the ESG companies have an increasing preference from the investors whose shares are increasing and unexpected new advantages in regulatory requirements and tax savings are unlocked, the highly rated ESG companies will be more likely to earn higher returns.

What are ESG Ratings?

An ESG measures how the company is working towards mitigating long-term environmental, social, and governance risks. The financial implications caused due to these issues should be discussed in financial reviews. Using ESG ratings in addition to the conventional financial analysis can help a company to better evaluate its potential in the long term by providing a broader perspective.

A good ESG rating speaks about the company taking care and being conscious of its impact on the environment and abiding by the regulations. This has become an essential metric for companies to consider. With growing awareness, customers are getting increasingly wary of the brand image and how a company portrays its ESG consciousness. To objectively assess a company's ESG performance, several ESG Rating Agencies have been up and about, the likes of MSCI and Sustainalytics. These Agencies aim to set companies globally regarding their ESG performance and create transparency by publicizing this data to their clients.

Scores are given for each aspect of the “E,” “S,” and “G,” which are then aggregated to give out a cumulative score. This data also helps in helping investors to identify the kind of ESG risks involved before investing financially in a business.

A good ESG score indicates that the company is invested in creating long-term value and is in better control of anticipating potential opportunities.

However, that being said, companies must keep track of maintaining a consistent performance across different rating agencies. Any discrepancy in the same might lead to serious customer trust issues, thereby creating severe repercussions for the brand image. They might feel the company uses unscrupulous means to “greenwash” the customers.

How to calculate the impact of ESG on valuation?

The critical issue with calculating the value of ESG in the financial analysis of companies is the need for its tangible nature. No uniform framework can help in consistently analysing the performance of different companies. Other issues include the need for more technical expertise.

However, different methods have been proposed for incorporating ESG in company valuation. One of the most preferred ones includes making precise adjustments in cash flow forecasts. For example, let us consider the oil spill in the Gulf of Mexico in 2010. It was the largest ever unusual mortality event caused by marine life.

This spill resulted in significant fines for the companies involved and led to the company being imposed with extremely stringent improvements in the operations and production, thereby creating more costs for the companies. This extra cost must be added to the Discount Cash Flows as these significantly additional fines can severely impact Future Cash Flows. Another critical example is mining companies, which can include the effects of shortages that are imminent in their future cash flows.

A significant advantage of this method is that it compels an investor to create a genuine issue out of an abstract concept like ESG. Making an impact on future cash flows forces them to concentrate on material problems. However, the difficulty of estimating the effect on cash flow due to rare events which create a considerable impact (like the oil spill) needs to be better understood. That being said, considering the importance of having jotted down financials, assumptions made in factoring in these ESG factors are also expected to be of high quality, thereby increasing the probability of a well-thought-out report.

Conclusion

In conclusion, pro-ESG investors will be happy with higher returns due to the higher valuations at a lower cost of capital. This would facilitate incentives for higher ESG adoption and investment. Generally speaking, they would be okay with earning lower returns for the companies that work in an ethical and environmentally-friendly way and for a cause they believe in.

Interestingly, the “anti-ESG” investors would also be happy as they would earn higher-return stocks in the long run. They might even benefit from the brown companies turning into green companies. From this perspective, ESG investing can be a win-win.

The importance of focusing on ESG ratings and the precautions to maintain consistent ratings across agencies have been mentioned. The lack of standardization in incorporating ESG in valuations was identified as a critical issue in accurately depicting the impact of ESG.