In search of the Exclusion Premium

Cheng-En Li, Research Analyst at MainStreet Partners, explores how market performance of large-cap companies is influenced by poor ESG practices.

While grappling with uncertainty in capital markets caused by the exacerbation in inflation, mounting policy rates, and geopolitical tensions in 2023 and 2024, many institutions are now looking to align themselves more closely with good ESG practices in response to increased regulation and market demand. But a question in the mind of any investor is how ESG-related controversial behaviours can affect performance over the medium term.

Recently, we conducted research analysing data from 2023 to investigate this relationship between ESG behaviour and capital market performance, using the MSCI ACWI large-cap index as a benchmark. The study first examined whether the share prices of companies flagged for negative ESG behaviour show any discernible trends over the ensuing six months and over the full year in 2023. We then analysed the distribution of companies that have been flagged to determine if certain industries are more prone to ESG-related controversies.

Furthermore, leveraging sector return data, we assessed the performance implications of flagged companies in various industries, examining whether such industries underperform and if there is evidence of an ‘exclusion premium’. This is when outperformance is generated by ‘being selective’ and excluding companies with relevant ESG-related controversial behaviour.

Finally, we created sub-universes based on different ESG flags to explore how incorporating ESG behaviour into investment strategies can enhance performance and mitigate risk.

The findings indicate that this approach may affect the risk and return profiles of large-cap firms.

Negative impact of ESG controversies

ESG controversies/negative ESG behaviour refers to company practices that raise ethical, environmental or social concerns. We developed a framework to classify controversial events based on severity. The framework has five key performance indicators — scale, frequency, response, effectiveness, and transparency — to rate the news for the company with numeric score (ie, severity score) ranging from one to five; the company is assigned a yellow flag/red flag once the severity score exceeds the corresponding threshold.

We would then issue a red flag to a company that has engaged in any controversy that poses a significant threat to the company’s business and future performance, alternatively issuing a yellow flag to a company if the controversy is likely to develop into a material ESG risk.

Among the companies that were newly flagged in 2023, those with controversies over accounting standards and human rights saw their share prices fall over time. This was without considering the share price in the days when the controversies erupted, regardless of the severity. As for the companies that had already been assigned warning flags before 2023, there were also similar trends, particularly for those with controversies related to business ethics, environmental damage and human rights.

This shows that when companies face controversies in these areas, it can affect their value in the eyes of investors. For the newly flagged companies, the time frame is within six months after assigning the flag; for existing flagged companies, the time frame is the whole year in 2023. This highlights the importance of continually assessing and monitoring controversies to reduce risk within portfolios.

Sector-specific trends

While companies with ESG controversies are spread across different industries, certain types are more common in certain sectors.

The study found companies in the energy and materials sectors are more likely to face controversies related to environmental damage; companies in the industrials and consumer discretionary sectors are more likely to be involved in human rights controversies; and financial companies are more likely to be accused of business ethics related controversies.

This suggests that some industries are more associated with certain types of ESG issues, supporting the concept of financial materiality.

Avoiding bad apples can pay off

Regardless of the severity of the issue, companies with no ESG-related controversies outperformed those with them in some of these sectors. This was particularly the case in the industrial, information technology, energy, and material sectors. But the magnitude of impact varies slightly depending on the level of the controversy.

The ‘exclusion premium’ generated by this outperformance (in percentage terms) suggests that being selective and excluding companies with poor ESG records could lead to better performance, especially in sectors such as energy and materials where environmental concerns are more pronounced. The result in the table indicates that by using the data in 2023, the large-cap companies without negative ESG news are associated with potentially higher price movements.

Risk mitigation and portfolio resilience

Overall, our research found distinct patterns in share price movements tied to ESG controversies. This trend varied across sectors, with, for example, and as noted above, higher incidences of specific controversies like environmental damage in the energy and materials sectors.

Furthermore, the investigation into various ESG investment strategies revealed how much the outperformance in different sectors under different ESG strategies (ie, excluding red flagged companies or excluding both red flagged and yellow flagged companies) is. These findings reinforce the idea that integrating ESG factors into investment strategies is not only a matter of ethical alignment but also a crucial component in mitigating risk and enhancing the resilience of portfolios in volatile market conditions.

As the industry moves forward, it is evident that ESG considerations will continue to play a pivotal role in shaping investment landscapes, offering both challenges and opportunities for investors seeking sustainable and responsible growth.

Cheng-En Li, Research Analyst in ESG @ MainStreet Partners

 

Published by ESG Investor