The Redemption Effect should prompt investors to rethink their approach to ESG. Just as value investors target undervalued stocks facing a controversy with a turnaround potential, we think investors should look for companies with poor ESG records that are likely to redeem themselves with more responsible practices.
Third-party ESG ratings do have some value. They can help investors understand the current position of a company on ESG issues. However, they don’t help predict how a company may change its behavior—or how its stock returns could be affected. That’s why fundamental investment research and active engagement with companies on ESG issues are essential to implementing an effective “ESG Improvers” strategy.
Emerging Markets: Fertile Ground for Finding Improvers
While ESG improvers can be found around the world, emerging markets offer especially fertile ground for investors. Emerging-market companies tend to have lower ESG ratings than developed-market peers, and there are relatively more companies that haven’t been rated at all. As a result, there are more opportunities for investors to unearth companies with improvement potential.
Anhui Conch Cement, a Chinese cement manufacturer, is a case in point. The company has a low CCC rating because of its subpar disclosure practices. Yet our research suggests that Conch consumes 28% less energy to produce cement than its BBB-rated peers. Current ESG ratings penalize the company for a lack of transparency—but fail to recognize its potential for improved ratings when its superior energy efficiency is acknowledged. As investors in Conch, we helped the company understand how to provide MSCI with data that could lead to an ESG upgrade.
Norilsk Nickel, a Russian mining and smelting group, suffered from a poor CCC ESG rating because of high emissions. However, the MSCI rating was based on a five-year average and didn’t take into account the company’s plans to upgrade its facilities and shut an obsolete smelter. Engaged investors could detect these changes, which led to a substantial reduction in emissions well before MSCI raised its ESG rating of Norilsk to B in December 2017.
These examples show why fundamental research and differentiated insight is needed to distinguish between chronic ESG offenders and reforming companies. We think it’s worth the effort. Investors who want to promote real societal improvements without sacrificing return potential should look for companies with share prices that don’t reflect their determination to clean up their ESG act.
Nelson Yu, Alex Pizzirani and Amy Yang contributed to this analysis.