Investors Can Do Well If Companies Do Better On ESG
– David Wanis, July 2021
Classical capital allocation theory suggests constraining a portfolio must be sub optimal and by imposing a higher cost of capital on ‘bad’ ESG companies, by definition, increases the return hurdle and as such the return generated by these stocks. By penalising bad ESG practices through a higher discount rate and removing them from your portfolio you must be willing to accept a lower return.
This may hold in theory, where the market is static and all actors are rational with fixed preferences, however we think dynamic markets, reflexive behaviour, shifting investor preferences and the transition period of adjusting discount rates mean the reality we observe (and are currently observing) may be very different. This may explain why we currently see outperformance from ESG factors where theory suggests the reverse.
A Toy Model of ESG Transition Discount Rates & Value Impact
Let us assume we have three companies – average (A), good (G) and bad (B) as measured by their ESG behaviour but in every other way the same. To date, assume the market has not cared about ESG and is only interested in financial performance. As such, the equity discount rate for each is the same (say 10%).
The market state then changes, where the marginal investor values ESG behaviours and allocates capital using discount rates reflecting this view – in our model means reducing the discount rate for the ESG Good company G (from 10% to 8%) and increasing the discount rate for the ESG Bad company B (from 10% to 12%). This doesn’t happen immediately as only the marginal investor has changed their allocation model, but we assume it occurs gradually across all investors over 15 years.
The result by year 15 (remembering we have the same expected free cash flow stream forecast for all companies) is the value of Company G (ESG Good) has increased by 2.3% per annum faster than Company A (Average) and Company B (ESG Bad) has increased by 1.7% per annum slower. This 4% per annum spread between G and B is what is observed by investors over 15 years as the market adjusts to the new discount rates.
So yes, assuming the market currently has not already completely adjusted to new, ESG aware discount rates, investors can for a long period of time do well by doing good.
The argument about higher returns (due to higher discount rates) from the bad ESG company may hold true – but it is true from year 15, not year one if we are starting at a lower discount rate than where we will end.
This is not novel. We have observed many times in markets where significant changes in investor preferences, expressed through discount rates, have a meaningful impact on returns through long transition periods. Think about the change in demand from long term, non-tax paying superannuation funds and the impact they have had on the pricing of illiquid property and infrastructure over the past 25 years. Or perhaps how the share of assets invested passively has changed the marginal pricing of securities included in vs excluded from indices.
As investors start to see a relationship between ESG behaviour, consumer demand and financial performance, forecast cash flow expectations may move in the direction of better behaviour, compounding the discount rate effects on value.
Investors Can Make an Even Bigger Impact
Yes, we should promote more sustainable industries and move towards a net zero target. Despite those efforts, continued Australian (and global) consumer demand for petrol (or coal, or cigarettes) for the next 30 years means we must also lower the impacts of any high emission supply as much as possible over that time.
To improve portfolio ESG characteristics, many investors limit exposure to sectors with large negative environmental and social impacts. Sectors such as technology, industrials, healthcare and consumer staples are favoured while energy, real estate, financials and materials are avoided. One problem with this approach is many of the low emitter industries are such not due to their efforts, but due to the nature of their activity. Heavy emitting industries with poor environmental and social practices that improve may make the greatest difference. We would guess the benefits to global sustainability outcomes of an improvement to the worst performing heavy emitters is likely to have a much greater environmental impact than what low impact companies with an already negligible carbon footprint can incrementally achieve.
The win here can be two-fold. Companies recognised as ESG improvers are rewarded with a lower discount rate. Heavy emitters who deliver meaningful improvement will not only make the biggest difference to real world global sustainability but may reward their shareholders with higher returns if they can do enough to get out of the discount rate sin bin.
Cigarette Smokers and Anti-Vaxxer are a Reality
The scientific linkage between the rate of lung cancer and regular smoking has been known “beyond reasonable doubt” for over 70 years. Cigarette manufacturers settled their legal liability in the U.S and Australia more than 20 years ago when around 25% of Australians were regular smokers. In Australia today, despite plenty of government disincentives, almost 12% of the population aged over 18 still smoke regularly. Vaccine hesitancy in the middle of a global pandemic is a non-trivial concern to reaching herd immunity across the Australian population in 2021/22. What science knows, what governments incentivise and how people behave are not the same thing and is unlikely to change anytime soon.
As investors discuss the future state of a cleaner economy, we need to consider the likelihood not every consumer is going to agree with or follow good science. It may be “agreed” there should be no coal fired power, no petrol cars, no employee discrimination, no unethical treatment of animals and ultimately no companies rewarding shareholders whilst punishing society – however history suggests a reasonable chance in 20 or 30 years many of these industries will remain for as long as consumer demand for their products exists.