Rickard Nilsson, Director of Strategy and Growth at Esgaia, highlights recent academic insights into the effectiveness of ESG engagement.
This blog is a short version of the original article, as published via ESG Investor on the 7th of October.
The pillars of risk, return, and impact
As part of investors’ stewardship practices, engagement can, if well-executed, lead to positive results across the axes of risk, return and impact.
Engagement to reduce risks: In a recent study by Hoepner et al (2022), the authors analysed whether ESG engagements result in subsequent reductions in downside risk at portfolio firms. Measured using the lower partial moment of the return distribution and value at risk, they found significant subsequent reductions for successful engagements, demonstrating that engagement can indeed benefit shareholders by reducing firms’ downside risks.
Engagement to increase returns: Several studies confirm this hypothesis for successfully engaged companies. Dimson, Karakas & Li (2015), Barko, Cremers & Renneboog (2021), and Bauer, Terwall & Tissen (2022) all found positive market reactions to ESG engagements in their samples.
While the former study found improvements in operating performance, profitability, efficiency, shareholding, and governance, the second study found no changes to accounting performance, but sales growth increased significantly. Perhaps more importantly, in that study, the authors found particularly strong excess returns when targeting firms in the ex-ante lowest ESG quartile. Furthermore, in the third study, we learn of how successful material engagements significantly outperform their peers over the next 14 months, and of the stronger association with improvements in profitability, sales, and cost ratios, than in comparison to immaterial engagements. They also found a much higher success rate for engagements with multiple contacts.
The inference from these findings is that purposeful engagement with responsible activity levels can have a positive impact on returns and operating performance, especially so when targeting laggards and financially material issues.
Engagement to create real-world impact: With theories about investor impact abound, the report titled ‘The Investor’s Guide to Impact’ by Florian Heeb and Julian Kölbel (2021) is a good resource. The authors note that investors should consider the level of empiricism behind a given mechanism for achieving investor impact as they gauge confidence in their own potential impact. For example, shareholder engagement is assigned evidence level B (ranging from A-D), corresponding to empirical evidence, while ESG integration is assigned level C, corresponding to a model-based prediction, for which the price effect of market signals in theory could incentivise improvements.
Collaboration as an enabler
The evidence here is clear: collaboration should play a central role in investors’ stewardship practices. To further support such efforts will require addressing both regulatory hurdles and strengthening the mechanisms that pool investor resources.
Both Dimson, Karakaş & Li (2021) and Ceccarelli et al (2022) show that leadership is decisive in collaborative engagements. While the former demonstrate investor influence as crucial through e.g. following established processes, and being more numerous with a larger AuM represented, the latter show that despite owning only 2.2% of the average firm, ‘Leaders’ alone explained the positive relationship between institutional ownership and firms’ environmental and social performance. Even if this evidence was not strong enough to demonstrate a causal effect, the authors did note that while the majority of institutional investors advertise a commitment to sustainability, only a minority positively drive corporate sustainability.
Mind the gap in engagement practice
The effectiveness of ESG engagements needs to be put in question. In the aforementioned study on material ESG engagements, the success rate was just 20%, and in a study by Krueger, Sautner and Starks (2019), only one in four respondents reported successful climate engagements.
Furthermore, Gianfrate, Kievid and Nunnari (2021) found that engagement claims yielded no meaningful reduction of investees’ carbon footprint, except for the most polluting companies, for which the reduction however had a limited magnitude. The authors, therefore, concluded that responsible investors can help the decarbonisation of investees, and increase the level of impact, if their active ownership becomes more effective.
Increasing engagement effectiveness
Unless we expect regulators to step up and be solely responsible for reining in cost-externalising business decisions, we need investor stewardship and engagement to become more effective. Responsible stewardship is about quality, not quantity. It is about proper resourcing in people, processes, and systems, not just ticking a box to satisfy stakeholders.
It will certainly require more thoughtful strategies, greater transparency, and frankly, a healthy dose of self-reflection. Thus, if you haven’t already, you may need to ask yourself questions such as:
Are our stewardship priorities regularly updated?
What are the expectations on the team?
How satisfactory is coordination and involvement of investment teams?
Has there been adequate training?
How can we collaborate more?
What’s our approach to public policy advocacy?
Do we have proper escalation processes in place if progress is lacking?
In concluding, I’ll stay true to this article’s purpose by offering up one final (required) reading, a summary of academic research outlining success factors for corporate engagement.
Author: Rickard Nilsson, Spokesperson and Director Strategy & Growth at Esgaia.
With years of experience in the field of responsible investing, Rickard focuses on industry- and regulatory developments, market and academic research, and more. He has particular experience in investment stewardship and how engagement can help advance sustainability practices.