The impact of ESG scandals

ESG scandals are (luckily) a rare thing. If we rely on the RepRisk Relative Risk Indicator, then risk ratings in excess of 25 points happens only in one in 200 companies. And as I have reported here, RRI readings of 35 or above become existential threats for the CEO of a company. But once a company experiences an ESG scandal, it has significant and lasting consequences for the company, but also its peers.

One such ESG scandal that still looms large in many UK investors’ minds are the sweatshop practices in factories of UK fast fashion retailer boohoo. I have described it in some detail here, so I won’t go into the details. Suffice it to say that even today, almost three years later, the first thing investors think about when they think about boohoo tends to be that scandal. It’s akin to asking you what the first thing is that comes to mind when you think about BP…

A team of researchers from the US and Europe have investigated how US mutual fund managers react to ESG scandals. They found that if a mutual fund holds companies involved in an ESG scandal, they experience abnormal outflows from investors. In the month after a significant fund holding experienced an ESG scandal, outflows of affected funds increase by nine percentage points.

Fund managers react to such ESG scandals by divesting from the affected company. In about 67—80% of all cases, fund managers sell the company affected by an ESG scandal afterwards. This could be because fund managers don’t believe a quick recovery in share prices is possible, or because they need to divest from affected companies because they want to stop the bleeding from outflows. Either way, fund managers affected by ESG scandals show all the signs of a snakebite effect: they want nothing to do with that company and remain reluctant to invest even a long time after the event.

In fact, the snakebite effect spreads to other companies in the same industry and sector as the affected companies. Fund managers who have experienced an ESG scandal in their portfolio holdings are becoming more active in engaging with other companies in their portfolios on ESG matters. For companies in the same industry as affected companies, fund managers are far more likely to vote in favour of ESG proposals at AGMs, in particular when the ESG scandal revolves around governance issues.

In general, active fund managers start to really engage with companies if their portfolio has been hit by an ESG scandal in the past. This change in behaviour is even more pronounced for managers of traditional active funds than for managers of sustainable funds. On the other hand, managers of passive funds don’t change their voting behaviour at all, once again showing that passive investment funds are agnostic about the risks of the companies they invest in. No matter what, they have to hold these companies anyway, so the incentive to engage with companies to improve ESG risks is low. Active fund managers, on the other hand, have a big incentive to engage with companies because if they don’t they are at risk of losing assets and thus their income.