ESG Shareholder Engagement Reduces Downside Risk

New research documents a case where a U.K.-based investor engaged with companies and got them to respond to environmental, social and governance (ESG) issues, thereby reducing the risks associated with those stocks.

Sustainable funds set an annual record for net flows in 2020, which was the fifth calendar year in a row that feat was achieved. Flows reached $51.1 billion – $20.5 billion in the fourth quarter alone. Investor interest has been accompanied by academic research on the impact of sustainable investments not only on ESG issues but also on valuations, the cost of capital, returns and risk (including downside, or tail, risk). For example, Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy and Laura Nishikawa, authors of the 2019 study, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” concluded:

  • Companies with strong ESG characteristics typically have above-average risk control and compliance standards across the company and within their supply chain management.
  • Because of better risk-control standards, high ESG-rated companies suffer less frequently from severe incidents such as fraud, embezzlement, corruption or litigation cases that can seriously impact the value of the company and therefore the company’s stock price.
  • Less frequent risk incidents ultimately lead to less stock-specific downside or tail risk in the company’s stock price.
  • Lower systematic risk means a company’s equity has a lower beta and investors require a lower rate of return. That translates into a lower cost of capital, providing a competitive advantage.