Engagement on ESG issues key to managing downside risk, experts say

Companies engaging in ESG-related conversations can mitigate and reduce their downside risks, according to a study published in the Review of Finance by the Oxford University Press. 

The argument, framed within a context of the increasing recognition of the importance of ESG factors in investment decision-making, highlights that engagement on ESG issues can yield tangible benefits for investors by lowering a firm’s downside risks. 

It states: ‘Institutional investor engagement on ESG issues has become increasingly prevalent in financial markets. A primary goal of these engagements is to engender higher standards of corporate ESG practices that serve as an insurance mechanism against harmful, risk-inducing events as well as mitigating the likelihood of regulatory, legislative or consumer actions against the firm.’ 

The study, titled ESG shareholder engagement and downside risk, delves into proprietary data obtained from a large UK institutional investor – which remains anonymous – on 1,443 engagements the investor had across 485 targeted firms globally, from 2005 to 2018 – although data for 2018 is only partial. 

The measure of engagement success consists of four milestones, the study says. The first is where the investor raises a concern with a specific company or target; the second is where the target acknowledges that concern; the third is when the target decides to act to address the concern; the fourth is the milestone that marks the successful completion of the engagement. 

Firstly, the study finds that ESG engagements reduce both value at risk (Var) and the lower partial moment (LPM), two key metrics used to measure downside risk. Specifically, the Var is a statistic that quantifies the extent of possible financial losses within a company or a portfolio of companies over a specific timeframe. The LPM is defined as a framework that models moments of asset returns that fall below a minimum acceptable level of return on investments. 

The study data shows that engagements focusing on environmental issues, particularly those around climate change, have the most impact on lowering downside risk. The study also reveals a notable connection between successful engagements on such topics and subsequent decreases in environmental incidents at targeted firms. 

Interestingly, findings show that the investor tends to engage firms more on governance issues, with 51 percent of the overall engagements focusing on executive pay and board structure. Environmental issues make up just over a quarter of the total number of engagements (26 percent) with a focus on climate risk, while dialogues on social issues represent a lower 23 percent of the total ESG-related interactions. 

Explaining why the environmental issues-related engagements weigh more in reducing downside risk, the study authors write: ‘While engagements on environmental and social issues could be expected to reduce downside risk due to lower probabilities of harmful risk-inducing events, it is less obvious why engagements on governance issues should result in decreased downside risks.

‘In fact, one may argue the opposite: such engagements could be intended to increase risk-taking if undiversified managers take too little risk compared with what is optimal for diversified shareholders.’

But while not all governance engagements are expected to reduce downside risk, those ‘that originate from illegal activities or fraud’ might, as they are in shareholders’ interests to address.

Commenting on the findings, Mary Winn Pilkington, senior vice president of IR and public relations at Tennessee-headquartered Fortune 500 firm Tractor Supply Company, says: ‘The study seems to support that a company that takes care of its team members, customers and the environment will likely be stronger in the long run. At Tractor Supply, we consistently over-index to sustainable funds relative to our peers. I attribute this to our long-standing stewardship program that has been in place for more than 15 years.

‘As a purpose-driven company, we are committed to helping our customers live [the] ‘Life Out Here’. Over the years, we have fostered active engagement on ESG topics with our shareholders. I believe ESG risk-management is a competitive business advantage for us that positively impacts our reputation as a company, our ability to attract and retain team members, our culture, business operations, risk management and access to a wider range of investors.’ 

Asked what measures Tractor Supply finds the most effective in lowering its downside risk, Pilkington highlights two key metrics. ‘We monitor two key measurement criteria: [the first] is the percentage of our shareholder base we have engaged with on ESG topics; [the second] is how we index relative to our peers in holdings by socially responsible or ESG funds,’ she explains.  

‘We have seen an increase in our shareholders that are classified as ESG, as well as widening the gap [between our volume of] sustainable investors [and that of] our peer group. Fundamentally, by doing what is right for our business, we are also able to attract a wider style of investors that can help enhance our valuation.’ 

‘Meaningful reductions’ 

Scrutinizing the engagement process, the study’s authors find that meaningful risk reductions occur only when at least the second milestone – when the target acknowledges the existence of an issue raised – is achieved.  

The study also highlights the sectoral and thematic distribution of engagements, shedding light on  investors’ priorities and strategic focus areas. In terms of themes, we have already highlighted how governance, environmental and social issues are the top three engagement topics. For industries, the data shows that investors tend to have more ESG engagement with companies in the financials, basic materials, consumer goods and oil & gas industries.

Geographically, the study reveals that engagements with companies in the US are the most frequent (22 percent), followed by the UK (19 percent) and Japan (7 percent). These top three are followed by other Asian economies and other countries in Europe.

This regional breakdown seems to be in line with the number of ESG regulatory frameworks and, in some cases, legislation that has been impacting certain regions more or earlier than others.

Cover image credits : lexiconimages, – stock.adobe.com