TOKYO -- When assessing a company's performance, investors are increasingly concerned about factors that do not appear on the financial statements -- environmental, social and corporate governance risks.
Linda-Eling Lee, global head of ESG research at U.S. securities index provider MSCI, said those criteria matter a lot when investing in companies in emerging markets as "higher-rated ESG companies do tend to be demonstrating stronger risk management."
Lee recently sat down for an interview with the Nikkei Asian Review in Tokyo to discuss the latest trends in ESG investments.
Q: Why did ESG factors start to become important in the investment world?
A: A huge area of growth in ESG investment is in financial value-driven objectives. There, investors have come to realize that there are ESG risks and opportunities that can actually impact the long-term risk-adjusted returns of a portfolio. So they care about looking at information that is not necessarily addressed in the financial statements, that really captures how well a company is positioned in the long run, and it really is about trying to build portfolios that will perform well over the long term.
Q: What were the triggers for the recent change?
A: I think it's been driven a lot by the United Nations' Principles for Responsible Investment [launched in 2006]. Also, there have been triggering events over the last decade. One is the global financial crisis, another is the BP oil spill. Those are the kinds of events where investors, especially the very large-rate investors, realized that over the long run, for them to meet their long-term obligations 30, 40, 50 years down the road, they actually need the economic system and the whole financial market to be much more resilient.
Q: Is ESG a means of managing risk or of driving returns?
A: We definitely think it's both, where a lot of it is about risk management and avoiding downside risk. In fact, a lot of quantitative research that has been done among sell-side researchers shows that companies are less volatile and less prone to experiencing negative events and credit downgrades if they are good managers of their ESG exposures. There are also opportunities in terms of the way companies manage their ESG risks.
Q: What happens to companies that don't care about ESG?
A: What a lot of investors are doing is pricing in that risk. They want to be compensated for the extra risk a company is taking, therefore they may either decide that the company is too expensive and therefore they invest less in it, or they may decide not to invest in it. It's all about value and whether or not the company's value is reflecting its risks.
Q: How do you see ESG activities by Asian companies?
A: I think it is relatively new for a lot of Asian companies in terms of just understanding what investors are seeking. I think the first thing these companies are trying to understand is what types of standards and concerns investors have around governance.
Each company has slightly different areas they want to focus on. In China, there is an unbelievable amount of activity that is very policy-driven around green finance. And they are very committed to using capital allocation to green the investments and the infrastructure in companies throughout the Chinese economy. Environment is a very, very big focus. In particular, climate change, carbon, water pollution. Those are top-of-mind issues for Chinese investors and ministries and the entire investor industry.
Q: What problems do you see in Asian companies, from the perspective of ESG?
A: Generally across the market in Asia, I would say corporate governance is a concern that is much more shared broadly in this region. Western investors, if you will, do have a global standard of expectations when it comes to corporate governance practices. That can make it challenging for them to invest in Asian companies because the opaqueness and issues with their shareholder rights is something that can keep some of them back. And you do see investors apply discounts to companies in Asian markets because of those types of concerns.
Q: Do MSCI's ESG indexes outperform benchmarks?
A: In our experience, the indexes that use ESG ratings, which are focused on the financially material factors we were talking about, the ones that are essentially selecting for higher-rated companies, do actually tend to outperform their benchmarks.
We have seen that to be the case especially for emerging market companies. So our most basic ESG flagship indexes are basically taking our market cap indexes and selecting for the top half in each industry. Despite being sector-neutral, those have tended to outperform, especially in emerging markets. In emerging market companies, the higher rated ESG companies do tend to demonstrate stronger risk management. Higher returns come from avoiding the bottom half rather than picking the top half.
Q: When you evaluate companies' ESG, how do you find "greenwashing" activities?
A: First of all, the ratings model that we run is only maybe 30-40% based on the company disclosures. A lot of the model is based on estimating their risks by looking at their business segments. We also look at a lot of government databases and NGO databases and academic information to find some of these incidences when companies pollute somewhere, or they've harmed a village or something like that. We have a team of analysts who are only looking for controversies at companies.
When examining their disclosures, one very important way we try to verify the data is we benchmark against their peers. It becomes obvious when companies say things that are off because it doesn't seem plausible relative to their peers. This is especially true when they report numbers that [make us wonder] how is that possible given how big their operation is?
Interviewed by Nikkei staff writer Kentaro Iwamoto