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.
Andreas Hoepner, Ioannis Oikonomou, Zacharias Sautner, Laura Starks and Xiao Zhou contribute to the sustainable investing literature with their April 2021 study, “ESG Shareholder Engagement and Downside Risk,” in which they examined whether engagement on ESG issues can benefit shareholders by reducing firms’ downside risk, measured using the lower partial moment (drawdowns) and value at risk. They began by noting that an increasing number of institutional investors are actively engaging with firms to reduce the risks of ESG exposure: “Generally the goal is to engender higher corporate ESG practices that serve as an insurance mechanism against harmful, risk‐inducing events as well as mitigating the likelihood of regulatory, legislative or consumer actions against the firms.”
They examined whether ESG engagements are associated with subsequent reductions in downside risk at portfolio firms. They employed proprietary engagement data provided by a large U.K. institutional investor with more than $500 billion in assets under advisement. The investor’s team consisted of more than 30 professionals who engaged on its own behalf as well as on the behalf of clients. The authors explained: “This investor is considered to be one of the most influential activists when it comes to promoting and developing ESG standards at firms. Further, the investor not only has the weight of its own holdings, but also speaks on behalf of other large institutional investors.” Their data included 1,712 engagements across 573 targeted firms worldwide, covering the years 2005 through 2018.
Four milestones were used to track the success of each intervention:
- Milestone 1: Whether the investor raised a concern with a target company.
- Milestone 2: Whether the company acknowledged the concern that was raised.
- Milestone 3: Whether the company took actions to address the concern.
- Milestone 4: Whether the investor successfully completed the engagement.
Following is a summary of their findings:
- 43% of engagements centered on corporate governance issues, such as executive pay and board structure; 22% of engagements related to environmental issues, with the primary theme being climate risk; 20% of engagements related to health and safety issues, supply chain topics and illegal acts such as bribery and corruption; and 16% of the engagements were driven by concerns over a firm’s business strategies, accounting and auditing issues, and corporate risk management.
- It took the investor six months on average to reach milestone 2, and an average of 35 months until the entire engagement was successfully completed.
- Environmental engagements led to the quickest actions, on average, to be implemented in response to the investor’s demands (milestone 3). In contrast, governance engagements took the longest time to complete milestones 1 and 2.
- Strategy engagements required a longer duration for milestone 4 than governance or environmental engagements, probably because larger organizational changes are typically required in these types of engagements. Social issues took an equivalently long time for eventually accomplishing an engagement success (milestone 4).
- Social issues were quickest to be acknowledged by targets, but targets were then slow in defining a suitable action and implementing changes. Governance engagements were the slowest to be acknowledged and slowest for an action to be defined. However, they were the quickest on average in terms of implementation, presumably because board resistance had been overcome once an action had been defined.
- Of the 1,712 engagements for which the investor raised a concern, 538 (31%) successfully achieved all four milestones by the end of the sample period; 888 (51.8%) achieved milestone 3; and 1,410 (82.4%) reached milestone 2.
- Across all 1,712 engagements, there were no significant reductions in downside risk as a result of the engagement. However, once they conditioned on the engagement achieving milestone 2 (82.4% of the engagements), there was a meaningful risk‐reduction effect (about 7% of the variable’s standard deviation in the pre‐engagement period). The magnitude of the effect increased by a factor of five if milestone 3 (51.8% of the engagements) was achieved (the target management started to take actions). This risk‐reduction effect equaled roughly 38% of the variable’s standard deviation in the pre‐engagement period.
- Engagement over environmental topics (primarily over climate change) delivered the highest benefits in terms of downside‐risk reduction (about 40% of the variable’s standard deviation in the pre-engagement period).
Their findings led the authors to conclude that “sensitivity to the downside-risk factor significantly decreases after milestone 2, and especially milestone 3, have been achieved, suggesting that the firms that respond to the investor are less sensitive to aggregate downside risk.” They added: “Given the increasing engagement by institutional investors on ESG issues, our analysis contributes new insights into understanding the channel through which ESG engagement can create value for investors.”
The takeaway for those interested in sustainable investing is that by expressing their values through their investments, their actions are having a positive impact as they drive firms to improve their ESG scores to reduce their cost of capital.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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