What is the one sustainability factor that matters most for financial performance? It’s a question I’ve been asked for years. The answer, as common sense suggests, is it depends on the sector.
Now, using a long and consistent data history of granular sustainability factors, we can be more specific about which sectors, which factors and how much each matters. A recent analysis by my colleagues Liz Houston, Guido Giese, Xinxin Wang, and Zoltán Nagy analyzed the performance of publicly traded companies in 11 industry sectors using 12 years of data that underlie the aggregation of MSCI ESG Ratings through September 2024.
They build on what we’ve known already from previous research:
Sustainability risks can be distinguished between “event risks” that manifest in sudden, sharp losses in share price; and “erosion risks” that accumulate over several years into wider financial disparities between industry peers.
The quality of companies’ governance — as captured in aggregated form as a mosaic of indicators covering board, pay, ownership, and accounting — has historically manifested most clearly as event risks that torpedo a company’s share price over a short time-horizon. Environmental and social factors better explained differences in share-price performance over multi-year periods.
While it remains difficult to disentangle cause and effect when it comes to sustainability and performance, analytical advancements have allowed the industry to isolate the financial impact of an aggregated ESG factor that is distinct from traditional equity factors.
The new analysis examines the underlying sustainability factors that impacted two distinct measures of financial outcomes: significant drawdowns exceeding 50% of a company’s share price over three years, and stock-specific returns; that is portfolio returns net of traditional financial factors (as captured by the 17 style factors and numerous industry and country factors in MSCI’s Global Equity Model). The following table has the details:
To understand sustainability and performance, tape this table to your wall
Source: MSCI ESG Research. Data as of September 2024. Analysis covers constituents of the MSCI ACWI Investable Market Index (IMI). Analysis of environmental and social key issues from September 2012, analysis of governance key issues from July 2019. The difference in start dates reflects availability of data. Key issues are ranked by their reliability as an indicator, based on the statistical significance of the result.
With so many combinations of sector-specific issues, there is a lot to digest! Here is what struck me the most:
1. The materiality of the governance factor is not universal.
No single underlying sustainability factor has consistently predicted risk of significant drawdowns or stock-specific outperformance, not even governance.
Aligning broadly with the previous finding on the contribution of governance issues to risk of drawdown, this new analysis finds that in 9 out of the 11 industry sectors, the top statistically significant indicators contributing to reduced frequency of drawdown incidents included one of the underlying indicators categorized as “governance.”
Disaggregating further, however, reveals that most of the significant contributions categorized as “governance” have come from differences in corporate business ethics followed by accounting issues.
Where business ethics matters, it can matter a lot. Top quintile companies on business ethics in the consumer staples and industrials sectors, for examples, were 44% and 42% less likely to experience a 50%+ share price drop than bottom quintile companies over five years ending in 2024. (The analysis covers five years for governance issues and 12 years for environmental and social issues.)
2. People really are a company’s greatest asset.
In just over one-third of the sectors, three workforce-related factors — human capital development, labor management, and health and safety — emerged as top contributors to company-specific stock outperformance over the 12-year period.
- For communication services, companies in the top quintile of labor management and human capital development outperformed the stock returns of their lowest quintile peers on these indicators by 5.4% and 4% per year over this period.
- For consumer discretionary, human capital development alone contributed to over 7% per year of stock-specific outperformance of top quintile versus bottom quintile industry peers.
Further, in 10 of the 11 sectors, at least one of these three workforce factors was a top contributor to reduced drawdown risk.
- In fact, top quintile companies on managing health & safety in the consumer staples and real estate sectors experienced over 26% fewer incidents of significant drops in share price, potentially due to fewer accidents.
- And top quintile companies on labor management in the consumer discretionary and industrials sectors experienced at least 15% fewer incidents of significant drops in share price, potentially due to fewer labor-related conflicts.
3. In emissions-heavy sectors, pay attention to… emissions.
For companies in emissions-intensive industries, focusing on emissions was a winning strategy, potentially as a proxy for operational efficiency. In both the industrials and materials sectors, corporate performance on toxic emissions and waste was the strongest indicator of long-term outperformance. In fact, for materials companies, not many other issues mattered as much as toxic emissions and waste and carbon emissions, which together contributed to outperformance of top quintile companies over their bottom quintile peers by 3.7% and 2% annually, respectively, potentially through significantly reduced frequency of drawdowns.
Overall, we’ve learned that picking the one issue that matters most is not straightforward, but also not impossible. While broadly, environmental and social categories encompassed the most significant indicators that contributed to stock-specific outperformance in nine of 11 sectors, the underlying indicators that drove the outperformance still differed meaningfully. No two sectors shared the same combination of key sustainability issues that signaled either stronger stock-specific returns or the risk of sharp declines.
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Therein lies the opportunity for investors. Finding the combination of specific sustainability issues that generate the most value for a given industry and company can literally pay dividends.
About the analysis
The analysis involved creating size- and region-adjusted equal-weighted quintiles within each sector and for each key issue of the MSCI ESG ratings model. We excluded key issues that did not have significant weight in the MSCI ESG ratings methodology (i.e., those not deemed financially material). Quintiles were calculated on a monthly basis. Data start date for environmental and social key issues is September 2012, and July 2019 for governance key issues. New governance key-issue definitions and methodology were put in place in 2019 which differs significantly from previous methodologies, so a consistent governance key-issue dataset from 2012 was not possible to obtain. We chose to use the shorter time series, but with a more recent methodology. The end date is August 2024 for all key issues. We then compare the top (Q5) and bottom (Q1) quintiles in two main aspects:
- Drawdown risk: We evaluate the frequency of large drawdowns (exceeding 50% over the course of the next 3 years) in Q1 and Q5, calculate the statistical significance (t-stat) of the frequency differences. We then plot the relative percentage decrease of frequency between Q1 and Q5. With this definition, negative decrease means that the drawdown frequency increased. Key issues are then sorted by the statistical significance of the frequency differences. We refer to this type of risk as “event risk.”
- Long-term performance: We measure the annualized performance difference between the highest (Q5) and lowest (Q1) quintiles, adjusting for known systematic equity factors using the MSCI GEMLT model. We also assess the statistical significance (t-stat) of these performance differences and rank key issues accordingly. We refer to this type of risk as “erosion risk.”
Community relations and tax-transparency key issues were excluded from the study because of their short history of data coverage. To see the key issues assessed for companies in a specific sector, see MSCI’s ESG Industry Materiality Map.
