ESG ‘best signal’ for future risk in equities

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A new report by Bank of America Merrill Lynch states ESG is the “best signal” they’ve found for future risk, particularly within financials, energy and materials and real estate and utilities.

The report is a follow up to research conducted in December when the bank found investors could have avoided 90 per cent of bankruptcies by considering ESG factors.

The results prompted the bank to complete a follow-up report.

In its latest findings, BAML found stocks with high ESG scores signal higher future return on equity, lower future earnings volatility, and future alpha.

“High quality stocks based on measures like ROE or earnings stability tended to deteriorate in quality, and low quality stocks tended to improve just on the principle of mean reversion,” the report says. 

“But ESG appears to isolate non-fundamental attributes that have real earnings impact: these attributes have been a better signal of future earnings volatility than any other measure we have found.”

Within energy and materials, environmental factors were the strongest signal and helped identify alpha opportunities, ROE and earnings risk, while social was the strongest indicator for real estate and materials.

However, ESG scores were most effective as a signal within financials.

In particularly, US financials that did not survive the global financial crisis saw disproportionate ranks for diversity, shareholder rights and compensation policy.

In a May survey, BAML found corporations believed 5 per cent of float was held by ESG-orientated clients, but according to institutional clients this is closer to 20 per cent.

BAML also found 85 per cent of investors want improved disclosure on ESG factors in company filings.

Today Mark Carney released the final report from the Task force on Climate-related Financial Disclosures, which requires corporates to incorporate climate risk into their financial reporting.

It will be presented to the G20 next month.