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Moody’s Finds ESG Risk Mitigation Delivers Higher Returns

Controversial events can cause lasting damage to shareholder value, analysis suggests.

Improved ESG practices lead to corporates acting as more secure investments, according to research papers by Moody’s Analytics in collaboration with ESG data firm RepRisk.

Findings from the ‘Business Impact of ESG Performance’ report showed significant and long-term effects of negative ESG-related events on firms’ stock returns.

The paper proposed a quantitative measure of ESG performance based on the controversies a firm experiences and studied the relationship between performance and stock market returns.

There have been several high-profile instances of firms facing lasting damage as a result of ESG-related failures. In 2015, Volkswagen shares dropped after it was revealed that the amount of carbon emissions from its vehicles were being deliberately underreported, while failures in corporate governance led to the collapse of US healthcare firm Theranos in 2018, and German firm Wirecard in 2020.

Covering 13,000 controversies at more than 3,000 public companies from 2013 to 2019, the Moody’s research found that ESG events have large and persistent negative effects on firm value, and the more severe the event the larger its impact. Moderate to severe ESG events resulted in an average -4% one-year excess equity return, which represents a loss of approximately US$400 million for a typical-sized firm in the study.

Moody’s said its findings were robust for firms of all sizes, and held particularly for firms in the energy and natural resources, consumer products, finance, and construction sectors.

But companies that learn from past controversies and revamp their internal ESG risk practices can lower their future rate of ESG events and reflect this improvement in their returns, the research also showed.

Losses from ESG failures grow over time

Measuring ESG performance using a Controversy Frequency Score (CFS) varying between 0 and 100, based on the events a firm experienced over the past two years, Moody’s found that a deterioration in performance driven by an increase in controversies is significantly related to stock market losses, both in the short-run and over a return horizon of one year.

Moody’s observed the largest losses in cases where a firm suffers its first ESG event in its first two years, consistent with investors viewing these new incidents as potentially indicative of broader issues at the company.

As an example of an ‘ESG event’ that could impact a firm, Moody’s cited a power plant explosion, which constitutes a destruction of value, while a levied regulatory fine represents a cash outflow.

While firms in the oil and gas giant have long faced criticism for their environmental performance, the most recent reputational risk to firms has come from the response of firms with exposure to or operations in Russia following the nation’s invasion of Ukraine. By April this year, more than 500 multinational companies had withdrawn from Russia following the invasion, including firms such as McDonald’s and Starbucks.

According to Moody’s, its results also show that losses consistently grow over time, meaning that in the short run, investors are underestimating the total cost of ESG performance to firms, a pattern traders could potentially exploit. Moody’s also found that these results could be suggestive for how a lender may want to incorporate ESG considerations into a traditional credit risk assessment.

Doug Dwyer, Managing Director at Moody’s Analytics, said: “We found that there is a meaningful benefit to a responsible ‘ESG risk management culture’ within a firm that can have a potentially material effect on equity returns.

“ESG controversies can inflict reputational damage with significant financial and legal repercussions. Firms that actively manage these risks do a better job of boosting shareholder value.”

The research was authored by Moody’s Analytics, which operates independently from Moody’s Investors Service, the credit rating agency.

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