Do negative environmental, social and governance (ESG) incidents (environmental pollution,
poor employment conditions or anti-competitive practices) indicate poor firm management and therefore underperforming stocks? In his February 2021 paper entitled “ESG Incidents and Shareholder Value”, Simon Glossner analyzes ESG incident data to determine whether: (1) history is predictive of future ESG incidents; (2) high incident rates impact firm performance: and, (3) the stock market prices incidents. Using over 80,000 incident news items, firm information and stock returns for 2,848 unique U.S. public firms starting January 2007 and a smaller sample for European firms starting January 2009, all through December 2017, he finds that:
- U.S. ESG incidents triple from 2010 to 2014, suggesting increased attention to them. The worst industries for incidents are manufacturing, finance and mining.
- A relatively high past ESG incident rate predicts a relatively high future rate, relatively weak future profitability and relatively low future risk-adjusted stock return.
- A value-weighted portfolio of U.S. stocks in the top third of ESG incident rates generates -3.5% annualized 4-factor (market, size, book-to-market, momentum) alpha.
- The corresponding annual alpha for European stocks is -2.5%.
- Analysts apparently fail to understand the import of high past ESG incident rates. Firms with high rates generate annual abnormal returns of -1.4% after quarterly earnings announcements and -0.7% after subsequent incident news, accounting for three-fifths of underperformance.
- The ESG incident rate effect is stronger among firms with relatively high short-term ownership, high valuation uncertainty and low investor attention.
In summary, evidence indicates that high ESG incident rates negatively impact long-term firm value, and this impact only gradually materializes in associated stock performance.
Cautions regarding findings include:
- Concentration of incidents in the latter part of the sample suggests a very short effective sample period. The shortness of this effective sample raises the question of why the sample ends with 2017.
- Reported returns are gross, not net. Trading frictions, shorting costs and cost of data/analysis would work against exploitation. Shorting costs may be high for firms with very high ESG incident rates.
- Negative alpha does not mean negative return. Investors seeking to exploit the ESG incidents effect could consider: (1) a hedge portfolio that is long (short) stocks of firms with low (high) incident rates; and, (2) simply avoiding stocks of firms with high incident rates. The paper does not address these modes of exploitation.
- Though the study finds that the ESG incident effect survives within industry, a portfolio of stocks for firms with high incident rates would exhibit industry concentration.
- The methodology described is beyond the reach of most investors, who would bear fees for delegating portfolio development and maintenance to a fund manager.
