The impact of ESG momentum in stock prices.
| Autor | Sverner, Carolina |
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Introduction
Investment strategies that, besides the traditional risk and return approach, take into account the exposition of companies to Environmental, Social and Governance (ESG) issues have become mainframe. According to Global Sustainable Investment Alliance (GSIA, 2020), more than US$35.5 trillion were invested in funds that claimed to be focused or to address ESG issues: a cumulative growth of 15% in two years, and 55% between 2016 e 2020. ESG investments represent around 36% of the total assets under management in the five markets analyzed by the report. (1) Both ethical reasons and the impact of ESG issues in the long-term performance are behind this behavior. Many financial analysts believe that the winner corporations will be those that treat Environmental, Social and Governance issues as key factors in their strategy.
Several studies propose that the ESG profile is negatively related to idiosyncratic and systematic risks. According to Benabou and Tirole (2010), the ESG profile of a company can affect its systematic risk because the sustainable practices impact the resilience of the corporation during periods of crises. Factors such as change of regulations, supply chain, technological and reputational risks also affect the idiosyncratic risk (Starks, 2009). Sayani and Kaplan (2020) and Bae et al. (2021) show that a higher ESG score reduces the risk of an abrupt drop in the share price. Dunn et al. (2018) find evidences that the stocks of companies with the lowest MSCI ESG score have a volatility 15% higher and a beta up to 3% higher than the stocks of companies with the highest scores. As ESG characteristics are reflected in the corporate risks, we can assume that they also impact the corporation cost of capital. Therefore, we should expect an appreciation in the share prices of companies that improve its sustainable practices.
Similar to Pastor et al. (2021), we raised the hypothesis that companies with better ESG practices have lower risks, and are preferred by investors who appreciate sustainability. In equilibrium, the shares of companies with better ESG practices are priced higher and consequently have lower expected returns. Therefore, in equilibrium, investors require a return premium to invest in companies with poor ESG practices.
We built the ESG factor, which is linked to the ESG rank of the corporations. Our first hypothesis proposes that the ESG factor is negatively related to the cross-section returns of the stocks.
Most of the studies in the academic literature find a positive relation between the quality of sustainable practices and firm value, but the causal effect of the ESG attributes in firm value can be either positive or negative (Gillan et al., 2021). On the one hand, ESG practices can create shareholder value because they increase future cash flows (ie: consumers pay a premium price on brands that have high reputation on sustainability issues, those companies hire more talented employees which are more productive), or because they reduce the cost of capital either due to the increase in shareholder utility or due to risk reduction. On the other hand, ESG practices can reflect agency problems, and top management can engage on those practices to maximize their utility instead of shareholders' utility (Benabou and Tirole, 2010). Several ESG practices reduce firm value, because they require heavy investments in CAPEX and incur in high short-term costs and expenses, while it produces uncertain positive returns in the long term (Cornell and Damodaran, 2020). Companies with better operational performance and lower risks are more able to, and have more resources to implement the best environmental, social and governance practices, and therefore, the causal direction is in the opposite direction: higher valuations and better operation performance lead to better ESG performance. Both causal directions predict a positive (negative) relation between stock price (return) and ESG score, and the identification of the causal direction is an econometric concern.
There is little consensus on what is material for each specific industry and region, which results in a lack of convergence in ESG scores of different providers (Berg et al., 2022). Consequently, there are still many inefficiencies in the pricing of environmental, social and governance practices (Pastor et al., 2021).
By logical extension of the first assumption, we can conclude that a change in the ESG profile can also provide useful information on equity valuation. Therefore, our second proposed hypothesis is that if the market appreciates sustainable practices, an improvement in the ESG performance should result in an appreciation on the stock price, while a deterioration in the ESG performance should bring about a stock price reduction. This second hypothesis tests how the stock price reacts to a change in the sustainable practice quality, reducing the identification problem of the first hypothesis.
We built a factor linked to the upward trend of the ESG rank, and called it ESG Momentum (ESGM). Our hypothesis is that the ESG Momentum should result in a significant return premium in the explanation of the cross-section returns, because as sustainable practices improve, there is a reduction in the ESG risk, and consequently an appreciation in the stock price.
We used the relative position in the ESG scores (ESG rank) of Sustainatytics Morningstar as a proxy for ESG profile, and collected data of the stocks that compose the S& P 500 index to test both hypotheses during the period between June 2014 and June 2020.
This article brings two main contributions. Firstly, it addresses the relation between the current ESG profile of a company and its return, without investigating the direction of the causality. The second is related to the explanation power of the improvements in the quality of ESG practices on the stock returns. Both results are in accordance to our proposed hypotheses. We find evidence, yet weak, of a premium for poor ESG practices, that is, a negative relation between stock return and ESG score, and a premium for the ESGM factor, indicating that improvement in the quality of the ESG practices result in the stock price appreciation.
Evidences that share price reacts positively to ESG practices may motivate more players in the financial market to incorporate ESG momentum in their investment decision, creates incentives for the launch of funds focused on buying shares of companies improving ESG practices, and also support board members and top management in defending the implementation of corporate sustainability initiatives.
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Theoretical framework and hypotheses formulation
Halbritter and Dorfleitner (2015), Nagy and Giese (2018), Dunn et al. (2018), Giese et al. (2019a,b), Lee et al. (2021), Pastor et al. (2021) are some of the academic studies that investigate the relation between ESG ratings, risk metrics and returns. There is a lack of consensus in the literature, and this is expected, since the disclosure of sustainable practices of different companies and countries are heterogeneous (Baldini et al., 2018), ESG scores of different providers often diverge (Berg et al., 2022), and there is a broad spectrum about what is considered as an ESG investment.
Initially, social responsible investments (SRI) were limited to negative screening, that is, to exclude from the investment portfolio securities of companies with low ESG classification, or even whole sectors like tobacco, weapons and cigars, regardless of the specific sustainability conduct of a company. According Kotsantonis et al. (2016), this approach of ESG investing fails in capturing the value added by sustainable practices.
However, even among studies which consider other ESG investment strategies, as for instance positive screening (search for the companies with the best ESG score in relation to the peers), or ESG integration (systematic integration of ESG issues in the analysis and investment decisions, (2)) there is divergence in the findings.
Dunn et al. (2018) find evidences that stocks with lower ESG scores have higher total, specific and systematic risks. They also found that the ESG classification can predict future risks up to five years. Sayani and Kaplan (2020), and Bae et al. (2021) showed that, once controlled for other risk factors, companies with the highest MSCI ESG scores have historically lower frequency of tail risk, that is, sudden drops in stock prices.
Hong and Kacperczyk (2009) found evidences of a return premium in the "sin" stocks (alcohol, tobacco, and gaming). According to the authors, some investors, especially those that are norm constrained, like pension funds, abstain from investing in stocks that promote vice. A lower demand for those securities imply in lower stock prices, and consequently higher future returns.
Kotsantonis et al. (2016) propose that investors that are attracted by a company's sustainable practices may accept lower returns, and as a consequence, reduce its cost of capital. Both articles are in accordance to Pastor et al. (2021), which propose that in equilibrium, assets with better sustainable practices have lower expected returns than assets with poor practices, and this is due either to the investors preference for holding sustainable securities, or for a recognition that those assets have lower risk.
Halbritter and Dorfleitner (2015) observed that the explanation power of ESG score in stock returns is reduced along time. They built a portfolio long in the shares of companies with the highest ESG score and short in the shares of companies with the lowest ESG scores, and found a positive alpha in the period between 1991 and 2001. They observed a drop in the alpha after this period, and after 2012 the alpha found became not significantly different from zero. As more investors value good sustainable practices, the share price of companies with better ESG profiles rises, and their expected rate of...
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