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E-MailAndreas Hoepner is Professor of Operational Risk, Banking & Finance at the University College Dublin Smurfit Graduate Business School. This post is based on a recent paper by Professor Hoepner; Ioannis Oikonomou, Associate Professor in Finance at the University of Reading ICMA Centre; Zacharias Sautner, Professor of Finance at Frankfurt School of Finance & Management; Laura T. Starks, the Charles E. and Sarah M. Seay Regents Chair in Finance at the University of Texas at Austin McCombs School of Business; and Xiaoyan Zhou, Postdoctoral Research Associate at the University of Oxford-Smith School of Enterprise and the Environment. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here).
Direct institutional investor engagement on aspects of corporate environmental, social and governance (ESG) performance has become increasingly prevalent in financial markets worldwide. Given the frequency of recent tail risk events such as the Deepwater Horizon Oil Spill, the Equifax Hack or the Covid-19 pandemic among others, it is not surprising that many institutional investors actively engage with their portfolio firms to reduce ESG risk exposures. Specifically, the goal is to achieve higher standards of ESG practices because these practices are believed to serve as an insurance mechanism against value-destroying tail risk events. Often the engaging shareholders are large institutional investors, also called “universal owners” due to their highly diversified, long-term portfolios. These portfolios, which reflect global financial markets, are exposed to ESG risk because of externalities from economy-wide factors, such as climate change, as well as externalities from individual portfolio firms (that also affect other firms in their portfolios).
In our research we analyze whether ESG engagements result in subsequent reductions in downside risk at portfolio firms. We employ proprietary engagement data provided by a large institutional investor, who is considered to be (one of) the most influential activists when it comes to promoting and developing firms’ ESG standards. While this institutional investor invests its own money in the engaged firm, the unique business model is to speak on behalf of other large investors in its ESG engagement activities, with currently more than $1 trillion in assets under advice (as of Q1 2020). In our study, we analyze 1,712 engagements across 573 targeted firms worldwide, covering the years 2005 through 2018. The institutional investor provided us with full access to the engagement database, including engagement activities, action reports, and the investor’s measures of engagement success. We find that over this period corporate governance engagements are the most common, accounting for 43% of all engagements. These engagements frequently center on executive pay and board structure. Engagements focusing on environmental issues, especially climate change, constitute 22% of the sample, while engagements on social (20%) and strategy (16%) are a little less common.
The institutional investor uses four milestones to track the success of each intervention. These milestones reflect (i) whether the investor raises a concern with a target company (Milestone 1); (ii) whether the target acknowledges that a concern was raised (Milestone 2); (iii) whether the target takes actions to mitigate the concern (Milestone 3); and (iv) whether the investor considers the engagement successfully concluded (Milestone 4). While the engagement process takes, on average, half a year to reach Milestone 2, a successful completion usually takes about three years. 31% of the engagements successfully achieve all four milestones by the end of the sample period, 52% achieve Milestone 3, and 82% reach Milestone 2.
We examine the relationship between the engagements and the target companies’ downside risk using two different measures. We first use the lower partial moment (LPM) of the second order to capture the distributions of returns that fall below the 0%-return-threshold. Different from stock-return volatility, this measure only reflects negative return fluctuations, thereby differentiating from common deviation based risk measures to more closely reflect many long-term investors’ perceptions of risk. As an alternative measure we calculate the investment’s value at risk (VaR).
Across both measures, our analysis provides evidence that the institutional investor’s successful ESG engagements lead to significant subsequent reductions in the portfolio firms’ downside risk. Our evidence of this risk-reduction effect derives from two complementary methodologies, a difference-in-differences (DID) approach and a factor model approach. In the DID regressions, we compare changes in downside risk around the engagement relative to a control group of firms. We find that the unsuccessful engagements, those that do not reach Milestone 2, do not generally lead to downside risk reductions. However, we observe a substantial risk-reduction effect for those targets where at least Milestone 2 was achieved. The magnitude of this effect increases sharply, by a factor of five, if we impose a stricter definition of engagement success and consider only engagements where at least Milestone 3 was achieved. For these successful engagements, the lower partial moment decreases by an average 0.419 after the engagement, relative to control firms. This risk-reduction effect is economically significant, representing roughly 38% of the variable’s standard deviation in the pre-engagement period.
We complement this analysis with a second factor model approach in which we group target and control firms into treatment and control portfolios and examine changes in the treatment portfolio’ stock-return loading on a downside-risk factor relative to the equivalent loading of the control group. We find the downside-risk factor loading to significantly decrease after Milestone 2, and especially Milestone 3, have been achieved, suggesting that the firms that respond to the investor engagements become less sensitive to aggregate downside risk. This finding corroborates the DID analysis evidence for a risk-reduction effect due to ESG engagement.
Our paper contributes to the literature on shareholder engagement by providing novel evidence that supports the hypothesis that investor intervention into corporate ESG practices reduces downside risk. Specifically, our findings complement work that focuses primarily on the effects of ESG engagements on the first moment, i.e., firm values or returns.
The complete paper is available here.
