Posted: 15 Apr. 2022 5 min. read

Does ESG impact company valuations? An Australian perspective

The importance of environmental, social and governance (ESG) issues in driving value creation continues to accelerate across the Australian corporate and private equity landscape. While this emerging trend is becoming more mainstream, there is still a degree of opacity on the relationship between ESG performance and company value; namely which ESG elements have the biggest impact on value, and whether companies with strong ESG performance attract a premium.

Measuring ESG performance

The world of ESG performance quantification has historically been fragmented, driven in part by the inherent differences between ESG issues that are material to companies based on their sector and geographic location. This has been compounded by the lack of an authoritative set of global ESG reporting standards, which has resulted in a lack of standardisation when calculating and reporting on ESG performance.

While there are a range of activities underway to address these challenges, including the development of a consistent set of global ESG reporting standards under the International Sustainability Standards Board, the realisation of these benefits will take some time.

Meanwhile ESG ratings provided by various third-party agencies provide a useful proxy to understand and compare companies’ ESG performance. However, each of these third parties utilise their own proprietary methodologies and lack alignment. In fact, the average correlation of ESG scores for seven of the largest ESG rating providers is only 0.45, compared to an average of 0.99 for credit ratings by major agencies, an astonishingly weak result! 

Correlation across 7 major ESG rating providers

Despite their shortcomings, ESG ratings are now widely used by a range of stakeholders to assess ESG performance.

So, do companies with a stronger ESG performance attract a premium?

There is a growing body of research to show the correlation between ESG and share returns. In particular, performance on material ESG issues has been found to be more influential, with outperformance on immaterial ESG issues tending to drag down returns[1]. ESG indices tend to outperform benchmarks, albeit in many instances, marginally[2]. Event studies which seek to address the ‘causality vs. correlation’ criticism of other ESG studies have found evidence of an improvement in the cost of capital and P/E multiples 36 months after ESG rating upgrades[3].

In relation to the Australian market specifically, our analysis of companies in the ASX200 (as a proxy for the Australian listed market) over a three year period from 2019 through 2021, has highlighted the following key insights:

  • There is a ‘size effect’ – larger companies have better ESG ratings, despite similar reporting scope coverage.
  • There seems to be a reasonable positive correlation between total shareholder returns (TSR) and improvements in ESG scores over a three-year horizon. This holds for excess (industry-adjusted) as well as absolute TSR.
  • Improvements in ESG scores also correlate positively with improvements in valuations multiples (EV/EBITDA, EV/Revenue and P/E) over this horizon. 

Of the three ESG pillars, the Environment or ‘E’ score seems to be the most persuasive when it comes to excess TSR, whereas the Social or ‘S’ score is most closely matched with earnings multiple improvements.

Despite survey evidence suggesting a decrease in the cost of capital for companies that improve their ESG metrics, with anecdotal evidence of a greater weight of capital seeking ‘ESG friendly’ investments, our analysis of the Australian listed market does not show such a relationship. 

What can companies do to improve their ESG performance to drive increased value?

The jury is still out as to whether ESG-linked outperformance represents a market inefficiency that will eventually disappear over the longer term horizon.

However, in the interim, it is vital that corporate and private equity companies prioritise the following: 

  • Have an informed understanding of the ESG issues relevant to their business and/or portfolio companies, value chain and key stakeholders
  • Disclose performance data relating to material ESG issues in a transparent and consistent manner
  • Prioritise investment in ESG initiatives that align with these material issues and the overarching strategic priorities of the business and/or portfolio companies.

 

[1] Khan, M., Serafeim, G., & Yoon, A. (2015). Corporate Sustainability: First Evidence on Materiality. The Accounting Review. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2575912

[2] Hong Kong Exchanges. (2020). Performance of ESG Equity Indices Versus Traditional Equity Indices. Retrieved from https://www.hkex.com.hk/-/media/HKEX-Market/News/Research-Reports/HKEx-Research-Papers/2020/CCEO_ESGEqIdx_202011_e.pdf, Giese, G., Lee, L.-E., Melas, D., Nagy, Z., & Nishikawa, L. (2019). Performance and Risk Analysis. Retrieved from https://www.msci.com/documents/10199/b07d04e1-2cce-9f35-5400-0e5cf4a0c76a

[3] Giese, G., Lee, L.-E., Melas, D., Nagy, Z., & Nishikawa, L. (2019). Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance. The Journal of Portfolio Management. Retrieved from https://jpm.pm-research.com/content/iijpormgmt/45/5/69.full.pdf; Serafeim, G., & Yoon, A. (2021); Which Corporate ESG News does the Market React to? Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3832698; Cui, B., & Docherty, P. (2020). Stock Price Overreaction to ESG Controversies. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3559915

More about the authors

Salil Zutshi

Salil Zutshi

Director, M&A

Salil is a Director in Deloitte's M&A practice, and has over 16 years of corporate and commercial finance experience, including transformation and strategy roles in industry, as well as due diligence, financial modelling and most recently specialising in valuations. He has led a number of large, complex projects including valuations for a variety of purposes: independent expert reports, litigation support, financial reporting and taxation compliance. Salil has a particular interest in dispute-related valuations, valuations of infrastructure assets, and the linkage between environmental, social and governance (ESG) issues and company value.

Rochel Hoffman

Rochel Hoffman

Director, M&A

Rochel Hoffman is leading the Australian ESG M&A team. Prior to this, she was a Director in Deloitte’s Sustainability and Climate Change practice. Rochel has 10 years of ESG experience delivering sustainability advisory services, including ESG materiality assessments and due diligence, stakeholder engagement, sustainability strategy, ESG disclosure development and climate change governance, scenario analysis, risk management and TCFD disclosure development to clients across a diverse range of sectors, including, infrastructure, logistics, mining, waste management and energy. Rochel is known for her high level of client service and deep ESG and sector knowledge.