ESG shareholder engagement and downside risk
Andreas G F Hoepner, Ioannis Oikonomou, Zacharias Sautner, Laura T Starks, Xiao Y Zhou
Review of Finance, Volume 28, Issue 2, March 2024, Pages 483–510, https://doi.org/10.1093/rof/rfad034
Institutional investor engagement on environmental, social, and governance (ESG) issues has become increasingly prevalent in financial markets. A primary goal of these engagements is to engender higher standards of corporate ESG practices that serve as an insurance mechanism against harmful, risk-inducing events. In this paper we examine the relationship between investor engagement of a portfolio firm and the firm’s subsequent downside risk.
We employ proprietary engagement data provided by a large institutional investor based in the UK that covers 1,443 engagements across 485 targeted firms worldwide between 2005 to 2018. The investor most commonly engages firms regarding governance issues, which account for 51% of the sample engagements and frequently center on executive pay and board structure. The next most common engagement type (26%) consists of those that relate to environmental issues with a primary focus on climate risk.
To examine whether the investor’s ESG engagement activities reduce the portfolio firms’ downside risks, we employ two measures that reflect the potential wealth-protection motives of ESG engagements: the target firm’s value at risk (VaR) and the lower partial moment (LPM) of the second order. Using monthly data for the downside risk measures over two-year windows surrounding the investor’s initial engagement, we find the engagements to be associated with subsequent reductions in the target firms’ downside risks. These effects are driven by the engagements internally classified as successful by the investor. The VaR declines by 0.205 from before to after the engagement, which is economically significant (9% relative to the standard deviation). We do not detect a risk reduction effect of unsuccessful engagement. Engagements over environmental topics—primarily over climate change—deliver the highest benefits in terms of risk reductions.
We provide evidence on a channel through which the observed engagement activities reduce downside risk. As the risk reductions we document originate primarily from environmental engagements, we focus on negative outcomes related to environmental incidents, which we measure using news-based data from RepRisk. We find large and highly significant decreases in the number of environmental risk incidents at target firms that exhibit large engagement-induced downside risk reductions. For such targets, the number of incidents declines by 26% from before to after the engagement.
Given the increasing engagement by institutional investors on ESG issues, our analysis contributes new insights into understanding the channel through which ESG engagement can create value for investors beyond affecting returns.