A review Sren Hvidkjr Head of Department, Professor of Finance, CBS - - PowerPoint PPT Presentation

ESG Investing: A review

Søren Hvidkjær

Head of Department, Professor of Finance, CBS

Focus of the Report

• and a roadmap

How do ESG strategies affect investor’s risk- adjusted return?

– Theoretical foundation – Classification of CSR/ESG studies – Evidence:

• Sin stocks: Negative sector screening
• ESG ratings: Positive/negative screening
• Event studies
• Active ownership
• A meta study

– Conclusion and implication of the results

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Theoretical considerations for the ESG investor

• For an equity investor who

– does not possess insider information and – does not engage in active ownership,

• the central performance question is not whether

ESG initiatives creates value in the firm, but rather whether the stock price accurately reflects the value of these initiatives.

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Abnormal Returns to ESG Strategies – why?

• Potential drivers of positive return to ESG
• 1. Underreaction to ESG information
• Evidence of underreaction in other cases
• Evidence of underreaction for intangible information
• 2. ESG strategies have become more common
• Potential drivers of negative return to ESG
• 1. Demand effect: If a stock is ignored by many

investors, the price falls which implies higher future expected return

• 2. Companies e.g. in the tobacco industry have

incentives to practice conservative accounting

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Abnormal Returns to ESG Strategies?

• Demand effect depends on

– How widespread are ESG strategies – Slope of demand curve for stocks

• Depends on arbitrage activity
• ESG strategies can lead to a lack of diversification

– More relevant for sector exclusions than single- stock exclusions

• ESG strategies can be costly

– Especially relevant for passive investors

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Corporate Governance and Active Ownership

• Potential principal-agent problems

– Underinvestment in ESG initiatives:

• Management has short horizon (myopic) e.g. because
• f career considerations.

– Overinvestment in ESG initiatives:

• Management’s social preferences are paid by the

shareholders

• Management uses stakeholder arguments for their own

gain.

• Corporate governance initiatives and active
• wnership can help resolve P-A problems

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Studies of Financial Effects of CSR/ESG

Classification:

• 1. Risk-adjusted abnormal returns to ESG portfolios
• 2. Event studies of market reaction to ESG events
• 3. Relationship between ESG/CSR and accounting-

based performance measures e.g. ROA

• 4. Relationship between ESG/CSR and the ex ante

cost of capital to firms

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Evidence of Abnormal Returns for sin stocks: Selected studies

Study Period Market Method Alpha p.a. Hong and Kacperczyk (2009, JFE, ABS 4* F) 1926- 2006 USA Equal weighted, FF 1-4 factor model relative to similar stocks 3-4% Fabozzi, Ma and Oliphant (2008, JPM, ABS 2 F) 1970- 2007 21 countries Equal weighted, 1-factor 8-12% Trinks and Scholtens (2017, JBusEth, ABS 3 NF) 1991- 2012 94 countries Value weighted, FF global 4-factor (misspecification) 8-13% Hoepner and Schopohl (2016, JBusEth, ABS 3 NF) 2001- 2015 Stocks

• excl. in

GPFG/AP Value- and equal weighted, FF 1 and 4-factor 3-4%

ABS rating explained p. 10 in the report. High to Low rank: 4*, 4, 3, 2, 1

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The Portfolio: Equal or Value Weighted?

Adamsson and Hoepner (2015) criticize Hong and Kacperczyk for equal weighting:

– HK regress an equal- weighted portfolio of sin stocks

• n a value-weighted market benchmark. This implies

that the outperformance could be driven by a small cap performance bias rather than sin stocks characteristics […]. This argument is founded on the empirical observation that small stocks outperform large stocks […]. The exceptionally good performance could hence be due to an over-weighting of small cap stocks and underweighting of large cap stocks.

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Hoepner-Schopohl

Hoepner and Schopohl’s presentation of results:

– We conduct a time-series analysis of the performance implications of the exclusion decisions of two leading Nordic investors, Norway’s Government Pension Fund-Global (GPFG) and Sweden’s AP-funds. We find that their portfolios of excluded companies do not generate an abnormal return relative to the funds’ benchmark index.

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Hoepner-Schopohl table 3

AP7 AP1–4 GPFG Equal Value Equal Value Equal Value (1) (2) (3) (4) (5) (6) Panel A: CAPM model 1-factor Alpha 0.450*** (2.63) 0.286* (1.83) 0.373 (1.19) 0.346 (1.13) 0.425* (1.65) 0.364 (1.62) Obs. 166 166 109 109 162 162

• Adj. R2

0.83 0.77 0.73 0.39 0.67 0.59 Panel B: four -factor model 4-factor Alpha 0.361** (2.04) 0.204 (1.23) 0.519* (1.71) 0.345 (1.19) 0.373 (1.28) 0.292 (1.17)

• Adj. R2

0.85 0.78 0.76 0.47 0.67 0.60

• Monthly returns. *, ** and *** indicates significance at 10, 5, and 1% level.

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Hoepner-Schopohl Portfolios

10 20 30 40 50 60 70 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 No of Stocks

GPFG AP1–4 AP7

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ESG rating and Stock Returns

Borgers et al. (2013, JEF, ABS 3 F): Stocks with high ESG rating

• utperformed stocks with low rating, but not in 2004-9.

Halbritter and Dorfleitner (2015, RFE, ABS 1 F/NF) confirm this and find no return differences when extending to 2012, while Larsen (2016, F/I, ABS 0) finds a difference from 2012-2016 in raw returns.

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Did the Market Underreact to ESG?

• Borgers et al show high returns for stocks with

high ESG rating around earnings announcements in 1992-2004, but not in 2004-09

• Consistent with underreaction in the first period

followed by correct pricing in the second period.

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E, S or G? Environmental Evidence

• Limited environmental evidence:

– Studies based on ratings from Innovest use very short period – Studies based on KLD show inconsistent results

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E, S or G? Social: Employee Satisfaction

• Underreaction to intangible information:

– Realized profit higher than analysts long term estimates – However not abnormal returns around earnings announcement

• Kempf-Osthoff (2005) and Statman-Glushkov (2009) report

evidence based on KLD scores consistent with Edmans

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Study Period Market Data/Method Alpha p.a. Edmans (2011, JFE ABS 4* F) 1984-2009 U.S. large cap “100 best companies to work for in America” Value weighted returns subtracted from comparable stocks (size and market/book equity); Then FF 4-factor 2,1-3,5% Return difference up to 4 years after formation

E, S or G? Governance Evidence

• What is corporate governance

– shareholder or stakeholder perspective

Study Period Market Data/Method Alpha p.a. Bebchuk, Cohen and Wang (2013, JFE, ABS 4* F) 1990-99 2000-08 USA G- and E-index equal- and value weighted FF 1-4 factor Significant: 6-14% Insignificant

Auer (2016, JBusEth, ABS 3 NF)

2004-12 Europa STOXX 600 Sustainalytics ratings Sharpe ratios (<2%)

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Did the Market Underreact to G?

• Bebchuk-Cohen-Wang show high returns to

highly ESG rated stocks around earnings announcements in 1990-99, but not in 2000-08.

– Consistent with underreaction in the first period and correct pricing in the second.

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Event studies

• How does the market react to ESG

initiatives/incidents?

Study Sample Event return Fisher-Vanden and Thorburn (2011, JEEM, ABS 3 NF) 117 events in 1993-2008:

• EPA Climate leaders
• Ceres
• EPA CL: -1% event return–

equivalent to $3bn on average

• Ceres: 0% event return

Krüger (2015, JFE, ABS 4* F) 2,116 events in 2001-07 from KLD

• Neg. events have neg. return
• Pos. events have -/0 return

Flammer (2013, AMJ, ABS 4* NF) 273 WSJ articles in 1980- 2009 classified as eco- harmful or eco-friendly

• Eco-harmful: Neg. return
• Eco-friendly: Pos. return

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Event Example in Flammer (2013)

• WSJ 14/2 1991: Exxon Appears to Be Close to

Settling Valdez Suits for Less Than $1 Billion

– "It is our opinion that a $650 million settlement is a severe undervaluation of the natural resources damage caused by the oil spill, and that if this deal goes through, the state and federal governments have been severely outdealed by Exxon," said Mr. Miller.

• Eco-friendly or eco-harmful news?

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Event: Interaction with G

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Study Result Fisher-Vanden and Thorburn (2011, JEEM, ABS 3 NF) Companies with low governance (G-index):

• Higher probability of participating in EPA CL
• More negative event return

Krüger (2015, JFE, ABS 4* F) Companies with low gearing and lots of liquidity (free cash flow theory, Jensen 1986)

• More negative return to positive ESG initiatives

Active Ownership

• Potential principal-agent problems create an
• pportunity for active ownership to create value

Study Sample Event return Dimson, Karakas and Li (RFS, 2015, ABS 4* F) 382 successful and 1,770 unsuccessful engagements in 1999- 2009 for a large ESG investor

• Success – over the following year
• 1-year abnormal ret. of 7%
• Higher ROA
• More ESG investors
• Unsuccessful: No effect

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Active Ownership

Both ES and G initiatives are value creating if successful

Dimson, Karakas and Li (2015)

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A Meta-/Vote Count Study

• Friede, Busch and Bassen (2015, JSusFinInv, ABS

0) review meta studies of 2200 underlying

• studies. They report:

– “large majority of studies reports positive findings” between ESG and financial performance – “the results show that the business case for ESG investing is empirically very well founded.”

• Some reasons to be skeptical …

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A Meta-/Vote Count Study

• Evidence of bias in the underlying studies and

especially in the review studies.

– As an example Clark, Feiner and Viehs (2015) finds a positive connection in 94 out of 110 studies, but some of the classifications

• are wrong – Fisher-Vanden and Thorburn (2011)
• are due to simple cash flow effects – Krüger (2015),

Capelle-Blancard and Laguna (2010)

• double counts studies – Edmans (2011, 2012), CG

studies

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A Meta-/Vote Count Study

• Lots of studies shows correlation between ESG and

accounting performance measures such as ROA

– but the relevant question for an investor is if the market has already incorporated this into the stock price

• It is notoriously difficult to conclude causality from

correlation, especially with accounting performance measures

– the causality question is usually ignored in the CSR literature

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A Meta-/Vote Count Study

• Friede, Busch and Bassen conclude that they

– “clearly find evidence for the business case for ESG

• investing. This finding contrasts with the common

perception among investors. The contrary perception

• f investors may be biased due to findings of portfolio

studies, which exhibit, on average, a neutral/mixed ESG–CFP performance relation.”

• However, compared to FBB, investors might in fact

better understand that what matters in the ”business case” for ESG investing are indeed the results from the portfolio studies.

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Conclusion and Implications 1/4

• Substantial evidence of sin stocks outperforming

– Sector based screening destroys value for investors/savers – Conflict of interest especially in pension funds with mandatory participation

• between the fund manager and the savers
• among savers

– A solution to the conflict of interest requires non- binary models – Higher cost of capital is equivalent to a consumption tax

• except for distribution of revenues

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Conclusion and Implications 2/4

• Evidence of high returns to highly ESG rated

stocks: Especially in 1991-2004, not in 2005-2012, but maybe since 2012

– limited evidence of the E-ratings effect – portfolios based on social screening (employee satisfaction) have yielded abnormal returns. – corporate governance: high return in 1990-99, but not subsequently

• No evidence that high ratings yield low returns

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Conclusion and Implications 3/4

• No evidence of the stock market reacting positive

to ESG/CSR initiatives

– indicates principal-agent problems – P-A problems can be resolved with good corporate governance – interpretation: High ES rating is good if G is high, but bad if G is low (more research is needed here)

• Value in active ownership

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Conclusion and Implications 4/4

• ESG strategies experience strong growth

– historical evidence should be interpreted with even greater caution – when profitable strategies become common, the profit disappears – This especially applies to simple strategies such as ESG ratings – more sophisticated use of ESG information and active ownership?

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