Rickard Nilsson, Director of Strategy and Growth at Esgaia, highlights recent academic insights into the effectiveness of ESG engagement.
Sustainable finance is undergoing an extreme change of pace. The mainstreaming of the industry has stimulated innovation on all levels, from the creation of new financial products, to a booming service provider space and novel research to help close knowledge and information gaps.
While this tells the story of a dynamic and maturing market, professionals are finding it difficult to stay informed of developments. To help lift some of this pressure, in this article, I summarise important research on the effectiveness of ESG engagement and what is required to increase it.
“No man is an island”
In this famous quote, the seventeenth-century English author John Donne spoke of how human beings are connected to each other, and how important that connection is for the well-being and survival of any individual. The analogy to asset stewardship here is that while investors and companies serve self-interests, they are still responsible for a common good, both in terms of an effective and sustainable market. In this context, investor-led stewardship is central to protecting the value of diversified portfolios by addressing diverging interests.
A theoretical lens
To influence the practices and behaviours of portfolio companies, dialogue and collaboration are often used by equity owners and bondholders to exert influence. From a theoretical perspective, this is well-explained by the social movement theory of interest-driven collective action, and the dialogic theory of effective communication.
Based on moral principles or pragmatic business concerns, social activism aims to challenge and encourage change in company practices. The social movement then arises when stakeholder influence takes the form of collective action, with some degree of coordination, shared identity, and continuity. Often taking the form of engagement dialogues, dialogic theory support this as a meaningful and effective communication tool for serving social change.
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.
See below for a summary of their recommendations of how investors can maximise their impact:
- Enable impactful companies to grow:
- Typical asset classes: private equity, private debt, and venture capital
- Allocate capital to young impactful companies in inefficient financial markets and consider investing in companies that require flexible or concessionary financing to scale their positive impacts
- Encourage improvement:
- Typical asset classes: public equity and debt
- Vote shares and engage with investees and screen holdings on transparent ESG criteria
- Influence the public discourse by being vocal about practices:
- Signal investment decisions to other investors and society at large
- If divesting from harmful industries, communicate this publicly
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
Shareholder advocacy and engagement has certainly not been spared from the broader debate around widespread greenwashing in responsible investing. Even with a lot of guidance from the likes of Principles for Responsible Investment and others, there are still clear differences in investor practices. The Financial Reporting Council (FRC) noted in a review of UK stewardship code signatories’ reporting that some relied heavily on examples of meetings with companies as part of general information-gathering and monitoring, rather than involving targeted engagement on specific issues.
Against this backdrop, we need to question the effectiveness of ESG engagements, and what we find in the literature should be concerning. 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 its purpose by offering up one final (required) reading, a summary of academic research outlining success factors for corporate engagement.
Rickard Nilsson, Director of Strategy and Growth at Esgaia, highlights recent academic insights into the effectiveness of ESG engagement.
Sustainable finance is undergoing an extreme change of pace. The mainstreaming of the industry has stimulated innovation on all levels, from the creation of new financial products, to a booming service provider space and novel research to help close knowledge and information gaps.
While this tells the story of a dynamic and maturing market, professionals are finding it difficult to stay informed of developments. To help lift some of this pressure, in this article, I summarise important research on the effectiveness of ESG engagement and what is required to increase it.
“No man is an island”
In this famous quote, the seventeenth-century English author John Donne spoke of how human beings are connected to each other, and how important that connection is for the well-being and survival of any individual. The analogy to asset stewardship here is that while investors and companies serve self-interests, they are still responsible for a common good, both in terms of an effective and sustainable market. In this context, investor-led stewardship is central to protecting the value of diversified portfolios by addressing diverging interests.
A theoretical lens
To influence the practices and behaviours of portfolio companies, dialogue and collaboration are often used by equity owners and bondholders to exert influence. From a theoretical perspective, this is well-explained by the social movement theory of interest-driven collective action, and the dialogic theory of effective communication.
Based on moral principles or pragmatic business concerns, social activism aims to challenge and encourage change in company practices. The social movement then arises when stakeholder influence takes the form of collective action, with some degree of coordination, shared identity, and continuity. Often taking the form of engagement dialogues, dialogic theory support this as a meaningful and effective communication tool for serving social change.
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.
See below for a summary of their recommendations of how investors can maximise their impact:
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
Shareholder advocacy and engagement has certainly not been spared from the broader debate around widespread greenwashing in responsible investing. Even with a lot of guidance from the likes of Principles for Responsible Investment and others, there are still clear differences in investor practices. The Financial Reporting Council (FRC) noted in a review of UK stewardship code signatories’ reporting that some relied heavily on examples of meetings with companies as part of general information-gathering and monitoring, rather than involving targeted engagement on specific issues.
Against this backdrop, we need to question the effectiveness of ESG engagements, and what we find in the literature should be concerning. 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:
In concluding, I’ll stay true to its purpose by offering up one final (required) reading, a summary of academic research outlining success factors for corporate engagement.
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