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Following the latest environmental disaster in the Gulf of Mexico, the socially responsible investment crowd divided into two camps: those who had held BP in their portfolios and those who now claimed that their environmental, social and governance (ESG) analysis led them to avoid the stock.
Statistically speaking, it is prudent to acknowledge the limits of ESG ratings with respect to predicting individual disasters, while acknowledging the importance of these ratings at the aggregate portfolio level. Due to the Law of Large Numbers, as the number of outcomes increases, the average value settles closer to the expected outcome. Having avoided BP because of ESG concerns may be heralded as a triumph, but it does not necessarily indicate the effectiveness of ESG ratings.
Focusing on a single environmental disaster, moreover, ignores the central benefit of socially responsible investing – that by investing in companies with superior ESG characteristics, portfolios can achieve superior risk-adjusted returns. Rather than extrapolate from the isolated experience of BP, let’s instead look to the aggregate evidence to find compelling reasons to incorporate positive ESG scoring in the investment process.
Understanding and analyzing environmental, social and governance ratings
ASSET4 is Swiss company that collects environmental, social and governance data on over 3,000 global companies. I used ASSET4’s ESG ratings, which incorporate a wide array of non-financial data:
- Environmental: Resource reduction, emission reduction, product innovation
- Social: Workforce and employment quality, workforce health and safety, workforce training and development, workforce diversity and opportunity, society/human rights, community, and customer/product responsibility
- Governance: Board function, board diversity, compensation policy, vision and strategy, and shareholder rights.
ESG data carry significant sector biases. For example, the technology, consumer staples, and industrial sectors are over-represented among highly rated companies relative to their proportion of the total investment universe, whereas financials and services are significantly under-represented.
Additionally, the ESG data carry significant biases with respect to common risk factor exposure. Companies with high ESG scores tend to have lower beta and far less earnings variability. By contrast, poorly rated companies have lower dividend yield and a higher P/E ratio on average.
Controlling ESG scores for sector biases by rating companies on a sector-by-sector basis is an effective means of correcting for most of the aforementioned biases. I analyzed the risk attributes of these sector-normalized ESG scores.
Why environmental, social and governance data are an effective risk indicator
Companies with poor ESG practices are prone to higher litigation costs, and they are increasingly being forced to answer to activist shareholders. Risks to each respective area include:
- Companies with poor environmental practices may face significant fines for environmental impact or significantly higher future capital expenditures if they are caught off-guard by stringent new environmental regulations.
- Companies with poor social practices, such as questionable human rights practices (either in their direct business or in their supply chain) may suffer impaired demand and client loyalty because of product boycotts.
- Companies with poor governance practices, such as a lack of board diversity, are more likely to suffer mismanagement or fraud.
Again, it is difficult to predict with any precision when any of the above might impact any one given company, but each of these represents a real potential risk to business as usual.
