by Michael Connor
Companies that invest in the management of environmental, social and governance (ESG) risks are far better prepared to deal with business “shocks” and can demonstrate to investors a “resilience” that potentially translates into higher stock market valuations, according to a new report by the consulting firm Deloitte.
Investors are paying more attention to ESG risks than ever before, and are likely to continue doing so, according to the report. “Those companies that are demonstrably prepared for ESG shocks can better mitigate the downside risks, both short- and long-term,” Deloitte says. “This makes disclosure on how companies manage their ESG risks all the more critical, because it can help capture investor interest and establish the long-term value of ESG management.”
The report says the strongest evidence that ESG performance impacts financial performance is found in short-term events. Negative news on human rights issues associated with a company have triggered an average $892 million drop in market value, according to the report, while protests and boycotts on labor and consumer issues can cause a 1 percent drop in stock prices in the days around the event.
Investors are growing more sensitive to ESG news, the report found, and with each decade since 1980, have reacted more to negative environmental news. “A good rule of thumb is that one negative story is the equivalent of five positive stories,” the report says. “On the upside, a positive ESG reputation adds an extra layer of protection – what we call an ESG halo.”
In an interview, Dinah Koehler, who leads sustainability research at Deloitte Research, said the firm “does see a trend in how businesses, primarily large businesses, are treating ESG…There’s more intent to integrate ESG into products and services, the business model and the culture of the company.”
However, Koehler thinks, the “real innovation and exciting stuff” in managing ESG risk will likely be implemented by small and medium-sized companies. “They’re more nimble,” she says. “They’re on a growth trajectory, but they don’t have to achieve these phenomenal rates of growth in terms of volume that the big companies have to achieve.”
As an example of how investment in stakeholder engagement pays off as a preventative strategy, Koeheler and the report point to research which shows that gold mines with better engagement with the local community have a higher valuation than mines with contentious stakeholder relations because “they have typically experienced a higher success rate of extracting the gold.”
In the broader picture, attention paid to ESG risk doesn’t necessarily lead to a “pot of gold” when it comes to investing in the stock market, Deloitte says. The report discounts some academic research which attempts to show that ESG stock indices outperform a benchmark index. “Claims of sustained outperformance of an index are inherently questionable because, if true, investors will quickly arbitrage away the effect,” according Deloitte.
“This outcome is not entirely surprising,” the report says. “Most companies adopt an incremental approach when they take action to improve their ESG performance, often indistinguishable from business as usual. Disentangling the effects of those efforts from other long-term drivers of market value is difficult.”
When asked to rate – on a 1 to 10 scale – how far along big companies are in integrating ESG risk management into day-to-day operations, Koehler says “in terms of talking and intent, I’d say we’re a 4 or 5” out of 10, with 10 being the highest.
Management of ESG risks is likely to improve in the future, according to Koehler, driven by consumer and investor demand for greater transparency, the growth of social media, and a variety of unforeseen events that could “shock” companies. “Now it’s just a matter of people (managers) believing, a) that this is really crucial to the survival of the business, and b) that they can actually do something about it,” she says.