AS Malaysia moves ahead in adopting best practices with respect to environmental, social, and governance (ESG) issues, companies listed on the Main Market of Bursa Malaysia are now required to disclose sustainability matters.

Meanwhile climate change-related disclosures aligned with the Task Force on Climate-related Financial Disclosures recommendations will come into force for companies with financial year ending on or after Dec 31, 2025.

To assist listed companies, Bursa Malaysia has launched the Sustainability Reporting Guide and Toolkit as well as the Centralised Sustainability Intelligence (CSI) platform, which guides and enables listed companies to assess carbon emissions across their value chains and streamline their sustainability reporting respectively.

Companies adopting Bursa Malaysia’s CSI Platform will have data that are more aligned and measurable as well as comparable to one another, especially those within the same industry.

ESG Scores

The ultimate objective of a structured and measurable ESG framework is to achieve an ESG score that gives stakeholders an idea as to where a company stands in its ESG journey and assess a company’s key weakness.

Of course, a good ESG score is always welcome but it is unlikely that a company would have a perfect score as there are many parameters and areas to be assessed.

Bursa Malaysia also is at the forefront when it comes to rating with the FTSE4Good Bursa Malaysia Index (F4GBM), which was launched in December 2014. The index presently has 120 constituents, a five-fold increase since its inception when only 24 companies made the cut, and with a net market capitalisation of RM725bil as at the end of June 2024.

F4GBM uses the FTSE Russell ESG model, which has three main exposure levels, across 14 different themes, 300 plus indicators, and five rating scores.

In practice, not all indicators are applicable; on average, about 125 indicators are applied per company.

The specific ESG ratings of the listed companies assessed are currently not shared publicly.

Instead, they are reflected in quartile or “star” banding on Bursa Malaysia’s website. A four-star ranking assigned to companies in the top 25% quartile, a three-star ranking for companies in the 26%-50% quartile, a two-star ranking for companies in the 51% to 75% quartile and a one-star for those in the bottom 25% quartile.

In essence, a four-star company has an ESG score of 3.7 or higher; a three-star company has a score between 2.5 and 3.6; a two-star company has 1.3 to 2.4; and a one-star company has 1.2 and below. For inclusion into the F4GBM, a company must achieve a rating of 2.9 and above.

Out of the 120 constituents of the F4GBM, 45 are rated four stars, 73 are rated three stars and two others are rated two stars.

At the same time, nine listed companies with a four-star rating and 140 with a three-star rating failed to make the cut for one reason or another.

This could be due to the constituent being named in the excluded list, the constituent may have failed the liquidity test, or the company may be involved in controversial issues or incidents.

Value of ESG

As ESG is part of life and business today, we are increasingly challenged to see what an ESG score means for the valuation of companies, businesses, or even simply for the application of a loan facility. For example, in the property sector, developers or asset owners are increasingly adopting environmentally friendly products that reduce energy or water usage. This can improve the asset owner’s operating cashflows via higher rental rates, which in turn results in higher valuation.

There have also been studies done that showed companies that are leading in the ESG transformation journey enjoy a premium valuation and outperform in total returns calculation.

However, at the same time, what we have seen from a valuation perspective is mostly considering the “environmental” assessment as these are more quantifiable compared with “social” or “governance”, which are seen as more subjective in nature and not easily quantifiable.

In addition, different standards may deploy different ratings for the social or governance aspects as different jurisdictions may deploy different parameters as acceptable standards.

We all know that the best way to value a company is using the discounted cash flow (DCF) approach and among the parameters in this model is the discount rate applied.

The discount rate or the weighted average cost of capital (WACC) itself is a function of the cost of equity and the cost of debt.

Companies that are at the forefront in adopting best ESG practices, especially those related to environmental, will be able to secure much cheaper financing than those that do not.

In the Malaysian context, banks can provide cheaper financing for companies that adopt environmentally friendly incentives that lead to lower emissions, greater energy usage, or reduced water consumption.

In addition, due to improved perception for companies in the ESG journey, a higher ESG rating does lead to a lower beta, reducing the cost of equity, leaving everything else equal.

In this instance, one can conclude that adopting good ESG practices can boost valuation, both from a lower cost of debt and equity, and ultimately, improve the valuation of a company, business, or asset.

Valuation Matrix

In the Malaysian context, broking firms are beginning to provide ESG scores for companies under their coverage with some providing simply a score using their in-house ESG matrix but without incorporating the scores into the valuation matrix while at least one broking firm is attaching a discount or a premium based on its in-house ESG scores to its valuation model.

The issue is whether this is an acceptable approach in incorporating ESG scores into valuation as the scores are generated in-house rather than a credible reference source and whether a premium or discount applied is appropriate.

This is due to the fact that an exact score for two companies in different industries means entirely two different perspectives as they are measured on different grounds.

For example, if a real estate investment trust, a bank, and a construction company have obtained the same ESG score, it does not mean that their respective ESG scores translate to the same premium or discount on their valuation.

Similarly, an aluminium smelter plant with the exact ESG score as a diversified construction-based company is unlikely to have been measured using the same ESG indicators and cannot be given the same premium rating due to the equal ESG scores obtained by the two companies.

However, two banks with identical ESG scores can be said to be comparable and can be assigned a premium or discount to their valuation, but again, by doing so, does it reflect the actual valuation uptick due to a lower WACC?

A more logical and robust ESG and detailed approach is needed when taking an ESG score as part of the valuation methodology. It has to be objective, data-driven, and reflective in the actual lowering of the company’s cost of funds, and ultimately the WACC, which in turn, will boost the valuation of a company.

Using an ESG score of a company to determine the valuation of a company is seen as flawed and must be avoided at all costs. Hence, while we recognised that the market is willing to pay a premium for ESG-compliant companies and may outperform those with lower scores, the actual boost to the valuation of a company can only come from lower WACC, which in turn will boost the company’s DCF value.

The article was first published by The Star.

Photo by engin akyurt on Unsplash.