Has ESG Investing Changed Corporate Behavior?
Assets have flowed mightily into environmental, social and governance (ESG) funds, and new research shows that many corporations have changed their behavior, with benefits accruing to society at large.
In our book, Your Essential Guide to Sustainable Investing, Sam Adams and I provided the evidence demonstrating that:
- Improvement in environmental, social and governance (ESG) scores (ESG momentum) has resulted in improved valuation (lower costs of capital: higher P/E ratios and lower interest costs) – providing companies with an incentive to improve their scores.
- Companies with high ESG scores have had better risk management and better compliance standards, leading to fewer extreme events such as environmental disasters, fraud, corruption and litigation – they have had less tail risk.
- Firm engagement in ESG has instilled a sense of purpose to employees, which has motivated them, and motivated employees are more productive, enhancing firm value. Firms with high ESG ratings and high ratings on employee satisfaction have significantly outperformed – they have tended to be more profitable.
In addition to these findings, both economic theory and empirical evidence suggest that due to investor tastes/preferences and reduced risk, higher-scoring ESG stocks have lower expected returns. However, in recent years the dramatic increase in investor interest in sustainable investing has led to increased cash flows that have driven valuations of high-ESG-scoring firms sufficiently higher to offset the “sin” or “brown” premium, even creating in some cases a “greenium.” If new cash flows continue at the pace they have since 2017, the existence of a greenium could continue until a new equilibrium is reached.
An interesting question is: How do stock prices react to positive and negative ESG news? George Serafeim and Aaron Yoon sought to answer that question with their study, “Which Corporate ESG News Does the Market React to?,” published in the first quarter 2022 issue of the Financial Analysts Journal. They analyzed 111,020 firm-day observations for 3,126 companies over the period January 2010-June 2018 in order to determine how stock prices react to different types of ESG news. Their data, from TruValue Labs (TVL), tracks ESG-related information every day across thousands of companies, classifies news to positive or negative, and provides insights on how positive or negative the news is. The authors noted: “TVL is used by some of the largest asset managers (e.g., State Street) and asset owners (e.g., Global Pension Investment Fund of Japan) and employs big data and artificial intelligence to capture and analyze unstructured data.”
Their dataset included information from a wide variety of sources – including reports by analysts, media, advocacy groups and government regulators – and emphasized that the measures focused on vetted, reputable and credible sources that are likely to generate new information and insights for investors.
Their primary research design was on a firm-day panel where the dependent variable was the daily market-adjusted stock return, and their key independent variables of interest were indicator variables for positive and negative news on that day. In addition, they considered the industry-adjusted return as an alternative dependent variable. In analyzing the news, they separated the sample using materiality classifications from the Sustainability Accounting Standards Board (SASB). The table below shows the ESG theme and TVL classifications used to identify SASB classification of 30 ESG issues across 79 industries:
Serafeim and Yoon then split their sample according to SASB’s industry-specific materiality classifications to test whether investors react more strongly to news that is likely to provide financially material information. Following is a summary of their findings:
- Not all events were associated with significant price reactions – prices reacted only to issues identified as financially material for a given industry by sustainability accounting standards.
- The reaction was larger for news that was positive, received more attention and was related to social capital issues. The two most consistent themes with the largest price reactions relating to product impact attributes and impacts were customer welfare and product quality and safety.
- They found no price reaction for the sample of ESG issues that were not classified as material according to SASB standards regardless of how they restricted their sample.
- There were significant and positive price reactions for positive ESG news only for the sample classified as financially material ESG issues according to SASB standards – on average, the price reaction was 60 basis points (bps) on the day of the news and 75 bps during the two-day window from the day prior to the day of the news. They did not find significant price reactions for negative ESG news.
- Their results increased in economic significance when they restricted the sample to material news that received more attention (e.g., having more than five ESG articles on that day) – the market reaction to positive news increased to 218 bps, and the market reaction to negative news increased to -70 bps.
- When they further restricted their sample to include only the firm-date observations with more than seven material ESG articles, results were even stronger, as positive news generated one-day market-adjusted reactions of 340 bps and negative news generated market reactions of -138 bps.
- Their results were just as strong when using the industry-adjusted return as an alternative dependent variable.
- News classified under social capital (i.e., news that primarily relates to product impact – the positive and negative impacts that organizations have on customers due to issues such as product safety, quality, affordability and access) generated the largest and most significant market reactions for both positive and negative news – on average, the price reaction to positive news was 187 bps points on the day of the news and 241 bps during the three-day window around the day of the news.
- There were smaller but significant reactions for negative natural capital related news and positive human capital and business model innovation related news. For example, for positive human capital issues, aggregate positive reactions were 25 bps during one day before to one day after the news event, with no significant market reactions to negative human capital issues. For natural capital issues, negative news generated negative one-day reactions of -13 bps on average. For positive news on business model and social innovation, one-day market-adjusted reactions were 35 bps, with no market reaction to negative news.
Their findings led Serafeim and Yoon to conclude: “Investors differentiate in their reactions based on whether the news is likely to affect a company’s fundamentals, and therefore their reactions are motivated by a financial rather than a nonpecuniary motive.” They added that their “results suggest that some ESG news contain more value-relevant information than other news and that this information can be utilized by market participants.” Finally, they noted that price reactions tend to be “larger for ESG news that is positive, receives more attention, and relates to social capital issues relative to natural or human capital issues.”
The dramatic increase in cash flows into sustainable investment strategies has not been lost on corporations, as they have observed how those cash flows have impacted their cost of capital in positive (negative) ways, providing competitive advantages (disadvantages). The evidence presented by Serafeim and Yoon reinforces the message that the market has priced ESG information and that sustainable investment strategies have not only reduced corporate risks and improved profitability but also lowered cost of capital. Thus, sustainable investors can feel good that their investment strategies have been positively impacting corporate behavior, creating a better world for us all.
Larry Swedroe is the chief research officer of Buckingham Wealth Partners and Buckingham Strategic Wealth.
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