Although the inclusion of environmental, social and governance (ESG) factors in investment decision-making has been steadily on the rise, one major obstacle has stood in the way of a more meteoric increase.
That is the continued belief held by many that the integration of ESG is a threat to returns in their investment portfolio.
Of course, pension funds need to put the interests of their beneficiaries first. First and foremost that means ensuring they will have a pension when they retire. But fiduciary duty now also requires pension funds to take into account material ESG risks in their investment decision-making to ensure pensioners can retire into a relatively safe and sound environment.
And these two goals are not at odds with each other.
Research undertaken of Hermes EOS’ proprietary ESG engagement data in the extractives sector by Andreas Hoepner, Ioannis Oikonomou and Xiao Yan Zhou of the ICMA Centre at the Henley Business School in the UK has revealed that companies engaged with generate on average 4.4% higher annualised returns compared with their equivalent non-engaged peers.
In addition, the study found that engagement has a risk-reducing effect. Engaged companies are less volatile and reductions in downside risk are material, ranging from 110 to 340 basis points per average monthly risk exposure, depending on the risk measure applied.
Better stock market performance of the companies engaged with – in terms of risk reduction as well as return enhancements – is driven by Hermes EOS’ self-assessed success rate. Hoepner’s team could not identify a single other statistically significant driver of the improved performance at engaged companies versus propensity score matched control companies in the same sector. Their research came to the conclusion that intervention with a company’s chair and corporate social responsibility managers enhances the chances of successfully completing an engagement, while a confrontational tone reduces its success. Furthermore, persistence in contact with companies – for example follow-up calls – also appears to have return-enhancing effects, while frequent interactions with top management seem to constrain upside potential. However, the same frequent interactions with top management are the most significant drivers of downside risk reduction for the average company engaged with. Thus, there appears to be a risk-return trade-off for the specific case of interactions with top management.
The research focused on the engagement themes of climate change/carbon intensity, oil sands, health and safety, human rights, board structure, remuneration, capital structure and risk management. Engagement progress was assessed according to Hermes EOS’ milestone system. Milestone 1 involvers raising an issue with the company or other relevant third party, while milestone 2 indicates recognition by the company or relevant third party that the concern is valid. Milestone 3 means a plan has been put in place to address the particular issue, and milestone 4 is the successful delivery of the objective.
Engaged companies which achieved milestone 3 or 4 produced on average 1.8% more relative return than those which only achieved milestone 1 or 2. In addition, those that achieved milestone 3 or 4 bear on average 3.9% less relative downside risk than those companies that only achieved milestone 1 or 2.
It can therefore be concluded that engagement is value enhancing. Previous research undertaken by Hoepner also found that ESG criteria can lead to greater portfolio diversification. And in 2014, research released by Hermes Global Equities showed that corporate governance standards have a meaningful impact on shareholder returns, proving that companies with poor or worsening standards of corporate governance have tended to underperform.
Hoepner’s team started with research on the extractives sector as the industry has been forced to tackle ESG issues around the world because each stage of natural resource development is widely considered as one of the most environmentally and socially disruptive activities. Every stage of the natural resources development from exploration, extraction, processing to transportation involves high environmental and safety risks, particularly as most natural resources are extracted in developing countries and often within the territory of indigenous peoples, where national regulation can be insufficient. Therefore, ESG risk management seems a particularly crucial notion for the extractive industry.
The team around Hoepner will now focus its research on other sectors.
The ESG research on the extractives sector can be accessed by emailing Hoepner at [email protected] and will shortly be available on the ICMA Centre’s Discussion Paper series.