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Investors have shown a strong interest in stocks that score well based on environmental, social and governance principles, but do improving ESG scores lead to higher share prices?

Small investors are pouring money into funds that focus on the theme, while giant pension funds and other sophisticated institutional players are embracing ESG principles as part of their mandates.

The shift goes beyond doing good with money: Analysts expect that companies that improve their profiles – say, with a commitment to reducing carbon emissions or adding diversity to boards – can benefit from a valuation boost as the stocks become palatable to more investors.

Turns out, betting on stocks with improving ESG scores can be a good call, although there are some details to consider.

Refinitiv crunched numbers for The Globe and Mail by screening for Canadian companies with a history of ESG scores since the end of 2018. Refinitiv then created two equal-weighted portfolios comprising 80 stocks each.

One portfolio consisted of companies that showed the biggest improvement in their ESG scores over this period; the second portfolio consisted of companies whose ESG scores either deteriorated or lagged over the same period.

Refinitiv compared returns for the two portfolios over a narrower time frame – since the start of 2020 – to accommodate any lags between improving (or declining) ESG scores and stock performance.

Both portfolios increased over this period after recovering sharply from last year’s pandemic meltdown. However, the portfolio of improving ESG scores outperformed the laggards by about five percentage points – with a particularly wide spread within the utilities and materials sectors.

Admittedly, this is hardly a definitive look at the impact of improving ESG scores. That’s because different providers can assess environmental, social and governance issues in different ways, with different scores.

A recent study by The Wall Street Journal looked at ESG scores from Refinitiv, MSCI and Sustainalytics and found that the performance of U.S.-stock portfolios based on these scores varied wildly. Since the scores themselves were inconsistent among providers, the portfolios could also be quite different.

The Canadian data from Refinitiv, then, would likely look different if they were crunched by another provider. Still, its numbers provide an interesting snapshot of what improving ESG scores – as opposed to high ESG scores – can do for a stock as companies address their profiles.

A number of Canadian energy companies and utilities, in particular, have taken noticeable strides toward reducing their carbon emissions and embracing renewable energy.

“How quickly that translates into financial benefits varies. It really depends on the agenda and the type of restructuring that businesses are going through,” Elena Philipova, director of sustainable finance at Refinitiv, said in an interview.

Nonetheless, she expects that the relationship between ESG improvements and share price performance is on solid ground.

Companies that improve their profiles can benefit from a lower cost of capital. As well, investor interest remains high. Even as the performance of exchange-traded funds specializing in renewable energy has disappointed in 2021, investors have added funds to them. Net inflows so far this year are already approaching last year’s record, suggesting widespread support for ESG even when stocks are down.

Enel SpA is a global poster child here: As the Italian energy utility improves its ESG profile by retiring coal and reducing carbon emissions, its share price has outperformed the S&P 500 by about 12 percentage points over the past three years (in local currency terms).

There’s also the flip-side to consider: Companies that fail to improve their ESG profiles could be at risk in the longer term.

“Companies that don’t understand where they face ESG risks or aren’t managing them effectively will feel the financial downside of being behind on this agenda, because it is linked to systematic financial risks,” Ms. Philipova said.

The somewhat amorphous quality to ESG scores means they are unlikely to underpin an investing strategy. But they’re certainly worth considering.

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