Analyzing two different ESG drivers: Investor preferences or sustainability ratings?
Spring 2022 saw three momentous events impacting ESG investment. First on everyone’s mind is Russia’s attack on Ukraine; the second was the release of a new UN climate report warning that we are now reaching irreversible tipping points for global heating; and last, a glimmer of hope, the US Securities and Exchange Commission, SEC, published a proposed rule requiring public companies to disclose how their operations affect climate change, or the risks they might face in a climate changing world.
The tools to advance sustainable investment within the broader Environmental & Social Governance (ESG) framework are many: Race-to-Zero; PRI – the UN Principles for Responsible Investment, investment index sustainability ratings, and more. Despite the recent rush for ESG investment, an increasing number of critics suspect that the ESG concept is flawed, both with regard to achieving the promised planetary and social relief, and when it comes to delivering alpha returns to investors over the long term.
In order to investigate which ESG mechanisms have the potential to actually deliver, and where more effort is needed, Mariassunta Giannetti, Professor of Finance at the Stockholm School of Economics, joined forces with research partners Nickolay Gantchev, University of Warwick, and Rachel Li, University of Alabama, to put the spotlight on two different ESG drivers in their newly released studies Does Money Talk? Market Discipline through Sell-offs and Boycotts and Sustainability or Performance? Ratings and Fund Managers’ Incentives.
If money talks, to what extent can ESG focused investors advance corporate ESG policies?
The first study, Does Money Talk, sets out to shed light on whether market discipline can really influence corporate behaviour. In more detail, the study explored to what extent ESG conscious investors vote with their wallets when companies face negative media revelations exposing ESG risk. The study also evaluated whether also small shareholders and consumers have the power to influence corporate ESG policies, or if it is just the large institutional block-holders that have a voice? Last but not least, the team looked into how investors and consumers with different social preferences react to ESG risk, based on the either the cultural attitudes towards ESG issues in their countries of origin, or the sustainability ratings of their investment portfolios.
“We noted that, in line with consumers, investors also have ethical and social standards leading them to spurn firms that fall short of their expectations in terms of environmental and social principles,” said Mariassunta Giannetti. “Maybe not surprisingly, this was shown to vary from country to country, depending on the level of ESG friendliness and differences in regulation.”
Importantly, the study shows that it is not only investor trading and consumer purchases that affect stock prices, but that divestitures by small investors and consumer boycotts also push companies to improve their E&S policies. “This is important, because for market discipline to be effective, the combined impact of investors and consumer actions must be large enough to affect a firm’s valuations in order to trigger changes in corporate behaviour,” continued Mariassunta.
These conclusions were reached by measuring changes in investor and consumer behaviour using a novel dataset to monitor ESG business conduct risks, as well as company specific violations of internal policies and international standards for listed companies around the world. The data provider used by the researchers, screens more than 80.000 media, stakeholder and third-party sources including print and online media, NGOs, government bodies, think tanks, newsletters, social media, blogs and others on a daily basis. In order to isolate environmental and social risks from firms’ broader governance risks, the team explored how investors with different E&S preferences traded stock at a given point in time.
“Through this study we have been able to shine a light on a previously little-known area, proving that market discipline can indeed play a powerful role when it comes to improving corporate ESG policies, as long as investors and consumers are sufficiently able to evaluate a firm’s ESG practices,” said Mariassunta. “That said, we noted that the strength of the ESG focus in a firm’s country of operation also plays an important role in its propensity to improve ESG policies following a valuation shock.”
Institutional investors have requested more uniform disclosure standards for corporate ESG reporting for quite some time in order to improve transparency. Despite that pressure, regulatory agencies have been reluctant to impose them so far, leaving the door open for media and private data providers to fill the information gap. “In light of this, even though shareholders are proving influential enough to exert market discipline on firms to improve their ESG policies, we still believe that a more uniform type of disclosure is needed. We are hoping this work will support important policy decisions in that debate.”
“This study proves that shareholders, even small ones, play a powerful role in putting pressure on companies to advance their ESG policies through market discipline. Even so, time is short, and more uniform regulation will probably be needed to accelerate ESG impact.”
Competing incentives? Sustainability or performance through the lens of Morningstar’s Globe Ratings.
This segways to the second study conducted by the team, Sustainability or Performance? Ratings and Fund Managers’ Incentives, which evaluates a more eye-catching sustainability driver, namely how mutual fund managers and investors in the United States resolved the trade-off between sustainability and performance, based on Morningstar’s sustainability rating model, Globe Ratings.
The Chicago-based investment research firm Morningstar first established its Star Rating system in 1985. The simple, easy-to-understand Morningstar platform, ranking performance from 1 to 5 stars, quickly became a favourite of analysts, advisors and individual investors in the mutual fund world. In response to investors’ growing requests for more transparency in order to evaluate ESG investments, Morningstar went on to launch their Globe Ratings in 2016.
The new sustainability rating proved very successful in the immediate aftermath of the launch, swiftly increasing investment flows to the funds with the highest Globe Ratings. The funds with the lowest sustainability ratings quickly lost money, however.
Mariassunta explained that with the introduction of the Globe Ratings the investment behaviour of mutual fund managers radically changed, substantially increasing their demand for stocks with high sustainability ratings in order to improve their Globe Ratings. Many sustainable stocks soon became overvalued, making them less attractive to investors. On the other side of the see-saw, funds with strong incentives to improve their Globe Ratings, began to offload high-sustainability stocks that prevented them from making a sufficient leap in the rankings. This contributed to skewing the ESG investment mechanism, pushing investment flows in the wrong direction, eventually forcing fund-managers to make trade-offs between sustainability and performance.
Looking into how fund managers and their investors went on to resolve this trade-off, the research team found that funds with stronger incentives to improve their Star Ratings started to purchase under-valued low-sustainability stocks, and sell overvalued high-sustainability stocks. Consequently, the performance of funds with less sustainable portfolios improved, ending up attracting larger flows than other funds. It only took a few quarters for fund managers to completely lose interest in the Globe Ratings. “We noted, that in offering fund managers two different incentives in parallel, Morningstar effectively undermined the purpose of its sustainability Globe Ratings.”
In conclusion, the Sustainability or Performance study suggests that shareholders, and primarily institutional investors, in this group of US-based mutual fund managers, care more about performance than sustainability when having to make hard choices. Hence, sustainability-ratings tools of the type launched by Morningstar seemed to offer only a limited and short-term ESG investment boon. Looking at the long-term effects, the ranking appears to have caused a vicious cycle, driving investment flows towards low-sustainability stocks rather than high sustainability companies, essentially rendering doubt as to whether the mechanism is fit for purpose.
“We noted, that in presenting fund managers with two different incentives that run in parallel Morningstar effectively undermined the purpose of its Globe Ratings.”
No time to lose – understanding ESG investment drivers
When queried about the reason for conducting these two studies, Mariassunta explained that while the effectiveness of ESG drivers is currently being explored by many financial researchers around the world, these two cover angles that have not previously been investigated.
“In the case of Does Money Talk, it’s clear that investors with an explicit ESG focus, or those operating out of a jurisdiction with a strong ESG culture, can exert considerable impact on advancing firms’ ESG policies. The question is whether the mechanism is strong enough to drive the speed of change we need in other geographical areas, or to attract more conventional types of investors, in order to meet the ambitious sustainability goals that many countries around the world have set up for themselves?”
“The same applies when looking into Morningstar’s sustainability ranking, which helped us build a better understanding of how investment flows, inadvertently, can be driven in the wrong direction by competing incentives, undermining the entire purpose of the tool.”
Asked whether she believes that the Russia-Ukraine war and the alarming findings of the recent UN climate report will affect ESG investment flows materially, in the context of the findings of the two studies, Mariassunta replied that big global shocks often serve to advance topics and mechanisms that have stalled.
“Clearly, we have no time to waste when it comes to ensuring that the ESG investment framework and methodologies are strong enough, well understood and fit for purpose. We are hoping the insights coming out of these two studies will combine to inform the current policy debate in the quest to deepen both the transparency and the understanding of ESG investment,” Mariassunta concluded. “We depend on it like never before.”