Which ESG issues matter most? Defining event and erosion risks

This article first appeared on MSCI.com

• Very different ESG issues can be material for different industries. Our research suggests that risks can be divided into two main types: ‘event‘ risks and ‘erosion‘ risks to companies’ long-term competitiveness
• Environmental key issues were purely erosion-driven (they unfolded over time). Social key issues showed a mix of event-driven and erosion-driven characteristics, while governance issues had the highest share of event risks
• Highly active portfolio managers may want to focus on mitigating short-term event risks. In comparison, portfolio managers building diversified portfolios with long investment horizons may be more focused on long-term erosion risks.

Which ESG issues have mattered most for companies’ financial performance?

Very different ESG issues can be material for different industries, a view adopted by organizations such as the Sustainability Accounting Standards Board, which has promoted industry-specific indicators for corporate disclosure. These issues range from pollution (environmental) and labor rights (social) to board diversity (governance). Our research suggests that, rather than categorizing issues by E, S or G, ESG risks might be better divided into two main types: ‘event‘ risks and ‘erosion‘ risks to companies’ long-term competitiveness.

Industry differences

Our research used scores from the MSCI ESG Ratings of the MSCI ACWI Investable Market Index’s constituents from 2012 to 2019. In the MSCI ESG Ratings methodology, key issues are selected and weighted for each of the Global Industry Classification Standard (GICS®) sub-industries based on potential exposure to the respective issue.

Some GICS sub-industries are exposed to as few as four underlying key issues, while others are exposed to as many as eight.

Our analysis focused on the 11 key issues that are most commonly used in calculating a company’s ESG rating and thus show the broadest historical coverage of companies within MSCI’s dataset:

• Environmental (‘E pillar’): Carbon emissions, water stress, toxic emissions and waste
• Social (‘S pillar’): Labor management, health and safety, human-capital management and privacy and data security
• Governance (‘G pillar‘): Corporate governance, business ethics, corruption and instability and anticompetitive practices.

Transmission channels

We extended previous research on how the overall MSCI ESG Rating has reflected financial risk and returns through three economic-transmission channels:

1. The cash-flow channel, whereby companies better at managing intangible capital (such as employees) may have been more competitive and hence more profitable over time
2. Idiosyncratic risk, whereby companies with stronger risk-management practices may have experienced fewer incidents that triggered unanticipated costs, such as accidents
3. Systematic risk, whereby companies that used resources more efficiently may have been less susceptible to market shocks such as fluctuations in energy price.

We examined how each of the three economic-transmission channels performed across these 11 key issues by comparing the top and bottom-scoring equal-weighted quintiles against the financial variables associated with each channel. We employed profitability, residual volatility and systematic volatility as target variables to test the financial significance of each of the three transmission channels.

We found that, of the three transmission channels, the idiosyncratic-risk channel showed the most significant results across the 11 key issues tested. Furthermore, the key issues categorized under the governance pillar showed, on average, the most significant results of all three channels. Companies with strong corporate governance had significantly better profitability, lower stock-specific risk and lower systemic risk than low-scoring companies across the governance key issues during the seven-year study period of December 2012 to December 2019. In addition, within the set of social key issues, health and safety showed significant empirical results.

These results indicate that, during the study period, financial markets were largely focused on events that could immediately affect company valuations. What about key issues that capture intangible ESG characteristics over longer periods?

Event vs erosion risks

Some key issues aim to capture risks related to events – such as fraud and oil spills – that can affect companies’ stock price over short periods. Other key issues, such as resource efficiency, relate more to long-term risks that can erode a company’s stock price over long periods. Some key issues may exhibit characteristics of both event and erosion risk.

Are we able to verify these two types of ESG risks? To do so, we need to quantify event and erosion risks using appropriate risk and performance measures.

Event risk: For each key issue, we created equal-weighted quintile portfolios, which we rebalanced on a monthly basis. We compared the frequency with which the top-scoring (Q5) quintile and the bottom-scoring (Q1) companies experienced a 90 percent or greater stock-price drawdown in the 36 months after the publication of a company’s rating. We used the Q1/Q5 frequency ratio as a measure for the effectiveness of identifying event risk – the higher the ratio, the more effective.

Erosion risk: We compared the annualized cumulative financial performance of these top-scoring (Q5) versus bottom-scoring (Q1) companies for each key issue as a measure for erosion risk.

We saw distinct differences across the issues categorized under the E, S and G pillars.

Environmental key issues:

• The three environmental key issues – carbon emissions, water stress and toxic emissions – were driven by erosion risk. They showed positive long-term differences between the top and bottom-scoring companies. But both top and bottom-scoring companies showed negligible differences in propensity to event risks.

Social key issues:

• The key issues under the social pillar showed more balanced results, with differences in labor management (such as mitigating labor conflicts) showing strong event-risk and erosion-risk characteristics. In fact, top-scoring companies on labor management not only outperformed bottom-scoring companies by an average of 3 percent per year, but also showed significant reductions in event risks – that is,  the top-scoring companies experienced severe stock-price losses only one fifth as frequently as the low scorers
• Health and safety showed equally strong positive long-term performance differences but showed minimal differentiation on event risk between high and low-scoring companies
• Interestingly, though high-profile cases such as Equifax and Facebook might have suggested otherwise, differences in companies’ management of privacy and data security have not historically contributed to positive performance during this period, nor have the top-scoring companies avoided more negative events than low-scoring companies.

Governance key issues:

• Governance-related key issues as a whole showed the strongest results along both risk dimensions. But business ethics and anticompetitive practices showed much stronger event-risk characteristics with minimal erosion risk. The bottom-scoring companies on business ethics were approximately four times more likely than top-scoring companies to experience a severe stock-price loss during this period, while the bottom-scoring companies on corruption were only about 1.5 times more likely than the top-scoring companies to do so
• In contrast, corporate governance – and especially the corruption key issue – showed positive long-term differences, with stronger erosion-risk characteristics and less event-driven risk differentiation.

Erosion-driven ESG issues understandably grab fewer headlines than the more abrupt and sometimes dramatic event-driven issues. How have these key issues performed over the entire seven-year study period?

Carbon emissions (E pillar) showed the most significant gross outperformance of all key issues, with health and safety and labor management (both S pillars) and corruption (G pillar) in second, third and fourth place, respectively. Between 2012 and 2019, for these four top-performing key issues, the outperformance of the top-scoring companies over the bottom companies ranged from 26 percent (carbon emissions) to 21 percent (labor management) cumulatively, or 3.8 percent and 3 percent on an average annualized basis. These top-performing key issues indicate that erosion risks were more evenly distributed across the three pillars than event risks, which were more concentrated in the G pillar.

In addition to considering absolute-performance differentials, we also employed MSCI’s Barra Global Total Market Equity Model for Long-Term Investors (GEMLT) to parse the extent to which these performance differentials could be attributed to common factor exposures or were related to stock-specific performance. After controlling for other factors, we found that 10 out of 11 key issues showed a positive stock-specific performance contribution, with only privacy and data security showing a negative result. In fact, of the 11 key issues, five showed a stock-specific performance contribution of at least 1 percent per year over the study period.

Implications for portfolio managers

Empirical evidence suggests ESG risks can come in different flavors: event-driven, erosion-driven or a mixture of both. While environmental key issues such as carbon emissions were purely erosion-driven – in other words, they unfolded continuously over time – key issues in the social pillar were more balanced; some, such as labor management, showed both strong event-driven and erosion-driven performance characteristics.

Governance-related key issues ran the gamut: all four key issues categorized under governance showed event and erosion-driven performance characteristics, with the highest share of event risks among the three pillars. The governance key issues’ event-risk characteristics help explain why governance as a whole has consistently shown the strongest significance for stock-price risks over shorter periods of time.

Our finding has important implications for the relevant time horizon for ESG integration in portfolio construction. Highly active portfolio managers building concentrated stock portfolios with relatively high turnover may want to focus on identifying and mitigating short-term event risks. This group may find erosion risks to be less relevant if these risks unfold over longer time horizons.

In comparison, portfolio managers building broad diversified portfolios with long investment horizons – such as indexed or buy-and-hold investors – may be more focused on long-term erosion risks in their choice of ESG criteria and ESG integration and may aim to mitigate event risks through diversification. They may face headline risk from unexpected events, but may feel it’s a reasonable tradeoff against potential erosion risks.