ESG engagement actively reduces downside risks

I keep on banging the drum for investor engagement with corporations on ESG matters. I have written before that if investors team up in a syndicate, they have a better chance of changing corporate practices and that investor engagement on climate change-related topics tends to reduce the carbon intensity of targeted companies. But now, I have come across a study that shows that and how successful engagement directly reduces downside risk in the share price.

The authors of this study got privileged access to the corporate engagement records of a large UK institutional investor. This investor documented a total of 1,443 engagements with 485 companies worldwide between 2005 and April 2018. The plurality of these engagements happened with US firms (313) and UK firms (278).

What the researchers did was track the downside risk (measured as value at risk and lower partial moments) of the shares of these companies in the two years before and after the engagement started. Then they compared the companies that the investor engaged with a sample of control companies with no engagement, but similar business characteristics and downside share price risks.

So, what happened to share price downside risks after the investor started to engage in ESG issues? Below is a chart that shows the reduction in Value at Risk for different results of the engagement. If the targeted company does not engage with the investor, there is no subsequent reduction in downside risks for shareholders. If the company at least acknowledges the issues at hand, a small reduction in Value at Risk of 6% compared to the pre-engagement level is visible. But if a company is convinced to act, the Value at Risk drops by about 30% on average vs. pre-engagement levels.

Reduction in Value at Risk after ESG engagement

Source: Hoepner et al. (2024)

That is quite a significant reduction in downside risks for shareholders. A deeper analysis of the kinds of engagement that create this reduction in downside risks shows that it is almost entirely due to environmental issues being fixed. The study shows that companies that act on the raised issues see a large drop in environmental risk incidents. Weighing the risk incidents by severity, companies that have been successfully engaged in environmental matters see their number of risk incidents drop by a quarter. And of course, if there are fewer incidents like spills, pollution, etc. the share price tends to have lower downside risks. As I keep repeating, ESG investment is risk management, nothing more, but also, nothing less.