On the Importance of ESG Factors
Firms have been facing increasing pressure from investors, lenders, regulatory bodies, and even NGOs, to adopt ESG initiatives. Most large global banks impose the Equator Principles—a risk management framework to assess a project’s environmental and social risk—on projects that they finance in order to ensure a minimum level of environmental and social standards. Additionally, a high percentage of Australian shareholders responded in a survey that they would withdraw their investment in companies that neglect their environmental and social responsibilities.
In a study conducted by Epstein and Schnietz (2002), it was found that, following the protests at the 1999 Seattle WTO Trade and the attendant negative media, Fortune 500 firms in the mining, logging, and oil industries saw their stock prices decline faster than other industries due to the public perception that they were more abusive to workers or the environment. ESG factors should thus be incorporated into the assessment of an investment’s risk, as they can have a real impact on share price.
As for direct financial impact, it is theorised that investors might view a firm’s ESG scandals as entailing higher risk, and thus, lower their buying price, raise supply costs, or reduce valuations. Hence, margins and returns fall with a higher perceived transaction risk. However, it is important to note that this is possibly just a matter of correlation, rather than causation, as firms with better management of long-term risks might incidentally promote good ESG performance. Additionally, it might be the case that companies with strong financial performances are more capable of meeting ESG demands, rather than their ESG policies being the cause of their strong financial performances.
While there is insufficient data to definitively conclude one way or the other, it seems nevertheless crucial for investors to incorporate ESG factors into risk assessment, for ESG related scandals or egregious failings can lead to a decrease in share price, and thus negatively impact their portfolio.
Coleman, L. (2011) ‘Losses from Failure of Stakeholder Sensitive Processes: Financial Consequences for Large US Companies from Breakdowns in Product, Environmental, and Accounting Standards’, Journal of Business Ethics, 98(2), pp. 247–258. doi: 10.1007/s10551-010-0544-8.
Galbreath, J. (2013) ‘ESG in Focus : The Australian Evidence', Journal of Business Ethics, 118(3), pp. 529–541.