Historically, companies with high ESG scores have been associated with having higher levels of corporate valuations. However, this is simply a correlation between ESG scores and valuation, not proof of causation. This study focuses on the question of causality and the implications of this on company returns and valuations.

Critical definitions to understanding the conclusions of this paper include:

• ESG Profile: An abstract term used by investors to evaluate characteristics, such as corporate governance, ownership structure, and gender diversity, etc., to determine the future financial performance of a company.
• MSCI ESG scores: A proxy for ESG profiles used in this paper to calculate ESG momentum.
• ESG Momentum: The year-on-year change of MSCI ESG scores (‘ESG momentum score’).

The first part of the report focuses on ESG momentum and describing its implications and assumptions on the research results. It begins by establishing ESG momentum as an independent factor free from equity factor biases by conducting a test of correlation between the MSCI’s Barra GEMLT model and ESG momentum. Results from this test showed that ESG momentum was uncorrelated to factors in the Barra GEMLT model. Afterwards, a distribution of ESG momentum was created using MSCI World Index data to see that ESG momentum was slightly skewed towards upward movements in ESG scores, i.e., the data set used in this research had more upward ESG score shifts than downward shifts.

The next section looked at the financial performance of ESG momentum in developed and emerging markets. The simulation used was based on a hypothetical investment situation and covered 2009-2018 for developed markets and 2013-2018 for emerging markets. In both markets, it was found that companies with positive ESG momentum outperformed those with negative ESG momentum and that emerging markets outperformed developed markets. These results were primarily caused by stock-specific performance created by the difference in stocks of companies with stronger ESG momentum and weaker ESG momentum. As a result, proving that changes in company ESG profiles influenced the prices of stock.

The final part of this report analysed whether the starting point of ESG scores impacted the company’s financial returns. By separating the universe of companies in developed markets into three groups – those with high initial ESG scores, medium initial ESG scores, and low initial ESG scores – results found that the strongest return was generated by those in the middle group (2.59%). In contrast, the bottom (0.82%) and top (0.66%) initial ESG scores produced relatively lower returns. As the three groups had similar volatilities and the differences between average ESG momentum was minor, the level of risk undertaken and ESG score upgrades and downgrades had no impact on these results. Instead, data revealed a non-linear relationship between ESG score and valuation where the strongest financial performance would be found where the curve was steepest (middle range of ESG scores).

Finally, it is concluded that a change in a company’s ESG profile would impact valuation levels and stock prices that the market or other factors could not explain.

1. This report showcases that companies who ranged in the middle of ESG scores of developed markets would experience the greatest financial performance effect. It provides the ESG-valuation curve as evidence of this, where its shape is a contributing factor to each group's expected financial performance.
2. The level of financial performance effect is determined by the steepness of the ESG-valuation curve, where there is a higher financial performance effect with greater steepness. The shape of the curve follows that reminiscent of a cubic function around the centre; however, it flattens out at the front and the end. This contributes to why middle ESG scores were higher than those from the top and bottom group.
3. The convexity of the ESG valuation curve allows an ESG score upgrade to have a stronger impact on valuation than a downgrade. This is because the steepness of the curve is higher above the middle point than below it.
4. ESG momentum in MSCI World Index data had a slight negative degree of autocorrelation. This means that companies whose ESG scores improved over one year may see their score reverse next year. However, this may result from MSCI ESG scores (which are used as a proxy for ESG profile) showing the relative position, between 0 and 10, of the company against its competitors.